Sunday, December 19, 2010

The Uncertainty Effect | Wired Science | Wired.com

The Uncertainty Effect

In The New York Times, Christina Romer, the former chairwoman of President Obama’s Council of Economic Advisers, addresses the role of uncertainty in our continuing economic problems:

The deepest and most destructive uncertainty we face centers on the overall health of the economy and its prospects for growth. Unlike other postwar recessions that were caused by tight monetary policy and high interest rates, the recent downturn resulted from the bursting of a housing bubble and a financial crisis. Because we are in largely uncharted territory, figuring out how and when the economy will recover is much harder than usual.

One sign of heightened macroeconomic uncertainty is that the forecasts of respected analysts are all over the map. According to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, the difference between the highest and the lowest forecasts of unemployment a year from now is about twice as large as it was before the crisis. And forecasters’ reported uncertainty about their longer-run forecasts has shown no sign of improving over the last year. If professional forecasters are unsure of the future, businesses and consumers certainly are as well.

Why is uncertainty so dangerous? Why does it keep us from spending money and investing in factories and hiring new workers? I think part of the answer is revealed in an interesting Science paper led by Colin Camerer, a neuroeconomist at Caltech. Camerer’s experiment revolved around a decision making game known as the Ellsberg paradox. Camerer imaged the brains of subjects while they placed bets on whether the next card drawn from a deck of twenty cards would be red or black. At first, the players were told how many red cards and black cards were in the deck, so that they could calculate the probability of the next card being a certain color. The next gamble was trickier: subjects were only told the total number of cards in the deck. They had no idea how many red or black cards the deck contained.

The first gamble corresponds to the hypothetical ideal: investors face a set of known risks, and are able to make a decision based upon a few simple mathematical calculations. We know what we don’t know, and can easily compensate for our uncertainty. As expected, this wager led to increased activity in the parts of the brain (like the striatum) involved with the expectation of rewards, as subjects computed the odds and calculated their expected earnings. Unfortunately, this isn’t how the real world works. In reality, our gambles are clouded by ignorance and ambiguity; we know something about what might happen, but not very much. When Camerer played this more realistic gambling game, the subjects’ brains reacted very differently. With less information to go on, the players exhibited substantially more activity in the amygdala, a brain area reliably associated with fear conditioning. In other words, we filled in the gaps of our knowledge with fear. And it’s this inexplicable fright – an irrational by-product of not knowing – that keeps us from focusing on the possibility of future rewards.

The fear of uncertainty can have profound consequences on human decision-making. Consider this 2006 study by the economists Uri Gneezy, John List and George Wu. They demonstrate a disturbing phenomenon called “The Uncertainty Effect.” Here’s the basic idea: According to expected utility theory, people make risky decisions by balancing the value of all possible outcomes. So let’s say that you’re betting on the flip of a coin. If it’s heads, you win $1.05. However, if it lands on tails, you have lose $1. Overall, the expected utility of this gamble comes out in your favor – the potential payout is five cents bigger than the potential loss – and so you should accept. However, as Kahneman and Tversky demonstrated decades ago, the vast majority of people don’t accept this gamble. The possibility of a loss (and the feeling of uncertainty) more than outweighs the temptation of the extra nickel.

Gneezy, et. al. point out that the uncertainty effect can sometimes lead us to make decisions that are utterly ridiculous. Take this hypothetical:

We asked participants to state their willingness-to-pay (WTP) for either a $50 Barnes and Noble gift certificate, a $100 Barnes and Noble gift certificate, or one of five lotteries in which they would win either the $50 or $100 gift certificate. The probabilities of the better prize, the $100 gift certificate, were .99, .60, .50, .40, and 01. Participants were told that the gift certificate had to be used within the next two weeks.

Not surprisingly, people were willing to pay larger amounts of money when the bigger gift certificate ($100) had better odds. They offered, on average, $45 for the guaranteed $100 gift certificate, and $26.10 for the guaranteed $50 gift certificate. So far, so obvious: This is basically the Groupon business model. But then, when the economists introduced the concept of uncertainty – people now had to contemplate uncertain rewards – the subjects started acting crazy. For instance, when they were given a 50 percent chance of winning the $100 gift certificate and a 50 percent chance of winning the $50 gift certificate, the subjects were only willing to pay $16. In other words, they valued a risky prospect – a 50/50 gamble between the two gift certificates – less than its worst possible outcome, which was getting the $50 gift certificate. The mere fact that the lesser gift certificate was associated with a whiff of uncertainty – even when the uncertainty was all upside! – still led to a 38 percent reduction in the willingness to pay.

One can easily imagine a similar bias at work in the current economy. Because every decision is shaded with uncertainty – nobody knows what will happen, and those who pretend to know what will happen disagree – we discount the value of expected rewards. The hint of risk triggered the amygdala, and that aversive feeling made us less interested in shopping at Barnes and Noble, even when we were getting a guaranteed gift certificate. This the curse of uncertainty: it makes everything feel unappealing.

via wired.com

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