Risk

Making decisions is an underlying base of all economics.  Economics depends on the decisions people make, and it changes with the changes in decisions.  So in order to know how economics works, one has to know how the brain makes decisions based on its own judgments.  There are many different things that go into making a decision, some consciously and some not; I will mainly go into the impact of gains versus losses. Consider the following choices:

Get $900 for sure or 90% chance to get $1,000

Lose $900 for sure or 90% chance to lose $1,000

Most people would choose the first option in the first problem, but the second in the second problem.  People would rather gain money for sure than risk getting nothing, but would want a chance for whether or not they lose money.  Along with this, people dislike losses more than they like gains.  This graph shows people value the money they lose more than the money they gain; this will lead them to need odds to be much more in their favor in order for them to take the risk.

http://prospect-theory.behaviouralfinance.net/

"Basic Concepts." - Dickinson College Wiki. Wikipedia, 3 May 2007. Web. 17 Dec. 2012.

Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011. Print. Page 279.

Loss Aversion – gains vs losses

When a coin is flipped:

If the coin turns up tails, you lose $100

If the coin turns up heads, you win $150

Would you take the risk?

Most people would fear losing $100 more than hope to gain $150.  This is called loss aversion, and the loss aversion ratio is usually between 1.5 and 2.5, so if you could lose $150 or gain $250 then people would be likely to take the risk.

This also works subconsciously, in scenarios like golfing.  When a player is near the hole that person might be faced with two situations: putt to avoid a bogey, or putt to achieve a birdie.  Not making par is seen as a loss, whereas missing a birdie is just not getting a gain.  Now, this shouldn’t affect how well golfers putt with each of these goals in mind, but it does. After analyzing more than 2.5 million putts, Devin Pope and Maurice Schweitzer found that players were more successful when putting for par than for a birdie, with a difference of 3.6% success rate. If Tiger Woods had putted as well for birdies as he did for par, he would have earned almost $1 million more per season.

http://www.alexwhittaker.org/?p=26
http://www.youtube.com/watch?v=nOX1Hn-bw1k 

"Incorporating Loss Aversion into Your Sales Pitch." Incorporating Loss Aversion into Your Sales Pitch. The Spruance Group, 2012. Web. 17 Dec. 2012.

Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011. Print. Pages 303-304.
Wray, John. "Brain Fail 1 - "Loss Aversion" (Preview)." YouTube. YouTube, 03 Nov. 2010. Web. 15 Dec. 2012.
Alex. "Disappearing Bacon: An Application of Prospect Theory (2)." – Whittaker's Chambers. Carrington, 16 June 2009. Web. 13 Dec. 2012.

Losses vs Costs

Would you rather accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5, or would you pay $5 to participate in a lottery that offers a 10% chance to win $100 and a 90% chance to win nothing?

These two scenarios are actually the exact same, but in a survey more people chose the latter, because losses are weighted more heavily than costs in people’s minds.  Someone would rather pay $5 to gamble at the risk of losing nothing than to gamble by paying nothing and risk losing money.

There was a debate about whether gas stations could charge different amounts depending on the method of payment, cash or credit.  The credit-card lobby wanted, if the difference was allowed, it to be labeled as a cash discount rather than a credit surcharge, because people are more willing to not get a discount than to have to pay a fee. Businesses can use these strategies about the different aspects of decision making to their advantage when trying to make their side of the decision more appealing.

http://www.washingtonpost.com/blogs/rosenwald-md/post/two-gas-prices-cash-and-credit-is-this-fair/2012/06/26/gJQAuK8K4V_blog.html

Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011. Print. Page 364.

Rosenwald, Michael S. "Two Gas Prices: Cash and Credit. Is This Fair?" Washington Post. The Washington Post, 26 June 2012. Web. 15 Dec. 2012.

"Nudge Blog." Nudge Blog. Nudge, 8 Aug. 2008. Web. 17 Dec. 2012.

Stocks

The fact that people generally dislike losing more than they like gaining has a profound impact on the stock market.  At the end of a week, investors are more likely to sell stocks that have increased in value, or at least have gone down the least, because they don’t want to lose the money of the stocks that have failed them.  This means that people hold on to their depreciating stocks longer, putting off having to take the loss and hoping it will rise. This leads to more loss of money in the long run.  Even professional money managers hold on to losing stocks twice as long as those that are winning.  Also added into this is the “Risk” post; people are more likely to take risks on losing money than on gaining money.  So they’ll sell stocks that they know they’ll earn money on, but hold on to stocks that they’re losing money on because they’re more willing to accept the risk in case the stock goes back up.

http://us.beyondbullsandbears.com/2012/10/11/loss-aversion/

Lehrer, Jonah. "Loss Aversion and the Stock Market." The Frontal Cortex. Science Blogs, 30 Sept. 2008. Web. 17 Dec. 2012.

"When Averting Loss Can Lead to Averting Gains." Beyond Bulls Bears. Franklin Templeton Investments, 2012. Web. 17 Dec. 2012.

Benefit-Cost Analysis

When people make economic decisions, they usually weigh the benefits with the costs to see if the outcome is worth the expense.  Benefit-cost analysis tries to put the costs and benefits into dollar amounts in order to compare them; the specific term is generally related to government processes.  The process of benefit-cost analysis was first formed over 150 years ago by the French engineer Jules Dupuit, though its first major use was in the 1930s in the evaluation of the federal water projects, and has been used in many government decisions since.   When government policy-makers weigh the benefits and costs of a policy in question, they only take into account the values held by individual members of society.  Benefits are measured by how willing people are to pay for what they get out of the policy, while the measurement of costs is how much money would be needed to compensate for negative outcomes.

http://www.youtube.com/watch?v=3LeV98kPKFk

Portney, Paul R. "Benefit-Cost Analysis." : The Concise Encyclopedia of Economics. Liberty Fund, Inc., 2008. Web. 15 Dec. 2012.

O'Loughlin, Eugene. "Problem Solving Techniques #7: Cost-Benefit Analysis." YouTube. YouTube, 18 Feb. 2010. Web. 15 Dec. 2012.

Alemanno, Alberto. "2011 Annual Meeting of the Society for Benefit-Cost Analysis." - Alberto Alemanno. Muchbeta, 11 May 2011. Web. 15 Dec. 2012.

Benefit at cost of others

The question is how you can tell whether the benefits to some people outweigh the costs of others.  Economists didn't want to decide one choice that helps millions of people is better if it still hurts thousands; how can you tell whether the help to some outweighed the hurt to others? John R. Hicks came up with a compensation test to decide that.  The test was whether the people helped could compensate for the losses of others and still be better off, whether they actually did help or not.  If they could, then the decision is good.  For example, free trade in cars helps millions of consumers but hurts thousands of workers.  But using the compensation test, it was found that the amount gained by buyers was far greater than the amount lost by workers and stockholders, so therefore free trade in cars is good.  The graph indicates that the price of new cars has been falling an average of 2.5% every year.  This link gives more information in support of free trade in cars:

http://mjperry.blogspot.com/2010/04/economic-lessons-on-free-trade-from.html

"John R. Hicks." : The Concise Encyclopedia of Economics. Liberty Fund, Inc., 2008. Web. 15 Dec. 2012.

Perry, Mark J. "CARPE DIEM." CARPE DIEM. Blogspot, 4 Apr. 2010. Web. 15 Dec. 2012.

Benefits vs Costs of Flossing

There are many instances of weighing monetary costs and benefits, but here is an everyday example of a decision everyone has to make: floss every day, or accept the consequences of losing teeth.  When comparing marginal cost with marginal benefit, you have to know how much flossing, or even dentist checkups, affects how many teeth you will lose.  In this chart, it shows how many teeth remain naturally versus how many remain when the person gets regular checkups.  So what people have to decide is whether the time it takes to get checkups and floss is worth the couple of teeth that they will be able to keep in the long run.  In this, like other decisions, one has to take into account opportunity cost; what are you giving up to take the time to floss?  In 64% of cases of lost teeth, they attribute it to decayed teeth—which is a result of not brushing teeth-- whereas only 28% were from bad gums, which is caused by not flossing.  This link has more research and statistics regarding the issue:

http://www.nature.com/bdj/journal/v189/n11/full/4800840a.html

Caplan, Bryan. "The Marginal Tooth." , Bryan Caplan. Liberty Fund, Inc., 2012. Web. 15 Dec. 2012.

Adult Dental Health Survey: Total Tooth Loss in the United Kingdom in 1998 and Implications for the Future." Nature.com. Nature Publishing Group, 9 Dec. 2000. Web. 15 Dec. 2012.

Crime

Another example is in the crime world.  People commit crimes because people respond to incentives, and it’s the most attractive offer available to them.  The decision to commit a crime is a result of cost/benefit analysis. For instance, consider mugging and gun control. People against privately owned handguns propose that in a fight between a criminal and a victim, the criminal would win because they have more reason to learn to use a gun. But say that 1 in 10 little old ladies carry a handgun, and 1 in 10 of those mugged happen to kill the mugger.  On average, the muggers get the money, but by weighing the benefits and costs they may realize that the amount of money a little old lady has isn't worth the 1 in 100 chance of dying. So the muggings decrease, not from lack of muggers, but lack of desire to mug.  Thus to stop someone from doing something you don’t want them to, you don’t have to make it impossible, just unprofitable, and vice versa, for something in the economy such as marketing.

http://www.youtube.com/watch?v=Lp28Jgn-8e8
http://www.aic.gov.au/publications/current%20series/tbp/41-60/tbp042.html

Friedman, David D. "Crime." : The Concise Encyclopedia of Economics. Liberty Fund, Inc., 2008. Web. 15 Dec. 2012.
"Motion to Pull." RSS. TV Tropes Foundation, 13 Dec. 2011. Web. 15 Dec. 2012.
"Old Lady Stops Robbery at Jewellers Northampton Feb 2011." YouTube. YouTube, 08 Feb. 2011. Web. 13 Dec. 2012.
Dossetor, Kym. "Cost-benefit Analysis and Its Application to Crime Prevention and Criminal Justice Research." Australian Institute of Criminology. Australian Institute of Criminology, 18 Mar. 2011. Web. 13 Dec. 2012.