Economics – Parts Per Billion

Settling accounts with the losses

Why do we get so confused while selecting the best smartphone model and end up selecting high-costing ones? Why do people still fall for easy money schemes, Ponzi schemes, Pyramid schemes even though they are well informed about similar fraud cases? Why most of the people are ready to buy a million-dollar lottery ticket costing few pennies even when they know that the chances are very low? Why do people fall in the spiral of gambling even when they have hit the rock bottom of debts? Why retail investors are continuously losing huge amount of money in stock market when they know that it is a loss-making venture? What convinces them to continue further? Why people always lookout for complete cover while selecting insurance policies even when they know that chances of those problems are really low? Prospect theory has answers to these questions.
Daniel Kahneman and Amos Tversky’s Prospect theory shows certain behavioral effects called certainty effect, reflection effect and isolation effect while making economics related decisions. Prospect theory explains why people love certain but smaller gains and also why same people will turn into complete gamblers in a crisis situation.

Daniel Kahneman and Amos Tversky’s Prospect theory in economics

Prospect theory is one of the most important ideas of behavioral economics. It shows how people make choices when times are highly uncertain. Rationally, any person would go with the choices having the best probable outcomes in uncertain times but in real scenarios that is not the case. Real people are emotional and always have mindset of survival. That is exactly why in uncertain times, people choose anything that has complete surety, certainty of gain instead of gambling for higher gains however highly probable they may be. And when probable gains are very high than average gains people will choose higher gains even when they have very less probability. This irrational, non-economical behavior may make human decision seem illogical, inconsistent. This illogical behavior is an important part of our evolution as species which Nobel Laureate Daniel Kahneman’s Prospect theory highlights. We will throw more light on prospect theory hereon.

Expected Utility Theory

“The agent of economic theory is rational, selfish, and his tastes do not change.”

Expected utility theory lies at the foundations of economics. It allows economists to model the scenarios to understand the dynamics between the resources, their perceived value and the risks/ uncertainties involved in any transaction.

The basic idea behind expected utility theory is that for any given set of uncertain events, a rational agent considers the weighted average of all gains based on the probabilities. The rational agent makes decision based on overall gains rather than being biased towards certain high value gains or certain highly probable gains.

For those who want more details, I have written in depth on the expected utility theory.

Prospect Theory

Although expected utility is one of the fundamental concepts of economics, the assumptions on which it stands have their own limitations. So, expected utility theory is not a complete and absolute theory to understand and predict the behavior of agents in economics. The moment we are injecting the word “behavior” we must understand that humans are not a purely mechanical or mathematical thinkers – decision makers. Also, as per the expected utility theory, there can be different perception of the value for given same resource for different agents. What expected utility immediately does is to fully attach the perception of value of given gain only with the bulk of resource that agent already has and the value addition it would do to this already existing bunch of resource. There is no psychological element in this discussion which is a larger predictor of the behavior of the agents in economics.

So, you can call prospect theory as an augmentation of expected utility theory. Prospect theory is not meant to falsify the expected utility theory rather it helps EUT to evolve where its own assumptions fail to explain the behavioral decision of the agents.

Modern economists are making more efforts to incorporate the psychological aspects of decision making into the machine-like purely mathematical models of economics. This makes the predictions more realistic when human decision making is involved. Daniel Kahneman and Amos Tversky published their world-famous paper called ‘Prospect theory: An analysis of decision under risk’ in ‘Econometrica’ in 1979. This paper is one of the most cited papers in economics. Prospect theory thus became the cornerstone of behavioral economics.

Kahneman and Tversky pointed out one “theoretical blindness” imparted due to the EUT. We will see those details in depth. They pointed out certain effects based on the decision making of the subjects under different decision-making events. Collection of these effects makes the prospect theory important. The important point to keep in mind is that everyone is risk averse in reality. Nobody wants to choose the transaction where there expected utility is reduced. So, the utility function of agents is concave.

Certainty effect

People overweight outcomes that are considered certain, relative to outcomes which are merely probable.

According to EUT, people will weigh out the outcomes based on their probabilities, but Kahneman-Tversky found out that people love certainty of gains. People don’t want to get involved into gambles when they know that there another way to gain something “closely valuable” for sure.

Kahneman-Tversky presented an interesting observation in their paper, here are the exact scenarios:

Choose between

A: Gain of 2500 with probability 0.33

Gain of 2400 with probability 0.66

Gain of 0 with probability 0.01

B: Gain of 2400 with certainty

According to the EUT the utility equivalent of A can be calculated as

U(A) = (2500 x 0.33) + (2400 x 0.66) + (0 x 0.01) = 2409

And utility equivalent of B

U(B) = (2400 x 1) =2400

So, according to EUT the utility of A is higher than B. But you already have your answer ready in your mind. Same was observed by Kahneman- Tversky; 82% of the people choose event B where the gain was certain.

Does this mean that the more probable the gain the more preferred it will be?

The answer is complicated.

Kahneman- Tversky further posed a modified event,

Choose between

C: Gain of 2500 with probability 0.33

Gain of 0 with probability 0.67

D: Gain of 2400 with probability 0.34

Gain of 0 with probability 0.66

They observed that 83% of the people chose event C over event D. This was surprising because event D is mathematically more significant (probability of 0.34 in D over 0.33 in C). This shows that it’s not just about the higher certainty which drives the preferences. The moment given options are uncertain people rarely notice the extent of the uncertainty (numerical value of probability) to choose between.

Take one more example given by Kahneman-Tversky

A: Gain of 4000 with probability 0.80

B: Gain of 3000 for sure

Here 80% of people chose B.

But when presented following:

C: Gain of 4000 with probability 0.20

D: Gain of 3000 with probability 0.25

Here 65% people chose C.

What exactly is happening here?

People love sure gains over any uncertain gains. But when both or all of the presented gains are uncertain, people will choose to gamble with those giving higher gain, whatever may be the possibility. This goes against EUT which says rational people would consider both the gain and the probability while making a decision. In reality when people are uncertain, they choose to go with the uncertain but higher chances of gaining.

You will now start to notice that EUT creates an objectivity in the choices by mathematically connecting the gains with their probability. But Kahneman-Tversky observed that real people will not follow EUT, they will make decisions based on the prospects they are presented. People never look at the scenarios in economics as distinct events, they look at the current trade-offs, current prospects they a have at their disposal to choose. The choice is always relative to the prospects presented and not absolute like EUT asks for in a mathematical form. That is exactly why Prospect Theory becomes important. It’s neither about the certainty nor the value, its more about what type of options – prospects you are providing to the people.

This is one important idea in marketing. We will see that in detail as the discussion evolves.

There is an interesting observation by Kahneman-Tversky when we are observing relativity of the prospects:

Choose between

A: Gain of 6000 with probability of 0.45

B: Gain of 3000 with probability of 0.90

86% of the people chose prospect B.

If you use EUT, both prospects have same utility equivalent = (6000 x 0.45) = (3000 x 0.9) = 2700.

But people refuse to be indifferent to these prospects and choose the most certain prospect.

Now, one more – same gains but totally different probabilities,

Choose between

A: Gain of 6000 with probability of 0.001

B: Gain of 3000 with probability of 0.002

Here, 73% of the people chose prospect A.

Again, both have same utility equivalent = (6000 x 0.001) = (3000 x 0.002) = 6. According to EUT people should be indifferent to both prospects.

And interestingly they didn’t go with the one which is more certain than other. They went the one with larger gain. This is because both prospects have very slim chances of gains.

Now it should be pretty clear that people compare prospects based on what is presented to them. Even when they are risk aversive, they would prefer bigger gambles when they realize that the chances of winning are really low and there is pretty much nothing to lose.

Reflection Effect

The risk aversion in the positive domain is accompanied by risk seeking in the negative domain

Certainty increases the aversiveness of losses as well as desirability of gains.

We saw how people choose when they have information of higher certainty or higher gains. What would happen if we inform them about lower certainty or lower gains/ higher losses?

We already saw one observation from Kahneman-Tversky:

A: Gain of 4000 with probability 0.80

B: Gain of 3000 for sure

80% of people chose B because they preferred surety of gain.

Kahneman-Tversky posed exact negative of this prospect which looks like

A: Loss of 4000 with probability 0.80

B: Loss of 3000 for sure

Now, 92% of the people chose option A. They don’t want a prospect where loss is certain.

Kahneman-Tversky observed that when prospects are negated people switched sides. The risk aversion in positive prospects changed to risk seeking which goes against EUT. They called it the reflection effect.

See this already discussed prospect:

Choose between

A: Gain of 6000 with probability of 0.001

B: Gain of 3000 with probability of

73% of the people chose prospect A.

The negative of this would be:

Choose between

A: Loss of 6000 with probability of 0.001

B: Loss of 3000 with probability of 0.002

Kahneman-Tversky observed that 70% of the people chose prospect B.

When it came to losses, people chose prospect with more certainty of lower loss.

This is very interesting observation. If you still cannot wrap your mind around this, the simplification looks like this: People rarely care about the combined effect of gains/losses with the probabilities as the expected utility theory rationally establishes. People care about what current choices they have and choose those which guarantee highly certain gains even when they are low and choose lower losses when they are highly certain.

“…it appears that certainty increases the aversiveness of losses as well as the desirability of gains”

Isolation effect

In order to simplify the choices between alternatives, people often disregard components that the alternatives share, and focus on the components that distinguish them.

The core of this idea is that people don’t like complexity or our brain is always trying to take shortcuts. This is one important idea and observation on human nature which Kahneman-Tversky pointed out.

What they did is creating a two-stage game:

1^st Stage-

P: Gain of 0 with probability of 0.75

Q: Move to 2^nd stage of the game with probability of 0.25

2^nd Stage-

R: Gain of 4000 with probability of 0.8

S: Gain of 3000 for certainty

The condition here is that choices must be made before the game is played i.e., before the actual outcome becomes apparent.

Before we go to what Kahneman-Tversky observed. Let us see what EUT would prefer, what a rational person would prefer:

U(R) = The equivalent utility of gaining 4000 at the end of the game = 4000 x (probability of reaching 2^nd stage from 1^st stage) x (probability of gain of 4000) = 4000 x 0.25 x 0.8 = 800

U(S) = The equivalent utility of gaining 3000 at the end of the game = 3000 x (probability of reaching 2^nd stage from 1^st stage) x (probability of gain of 3000) = 3000 x 0.25 x 1 = 750

So, U(R) > U(S). Thus, any rational person would choose prospect R in any situation as per the EUT goes.

Pay attention here,

The added complexity due to multiple stages –

When people were presented with the above mentioned two stage scenarios, 78% of the people chose the prospect giving certain gain i.e., gain of 3000 for sure. But, according to EUT you will see that this chosen prospect has lover equivalent utility. People actually ignored (or didn’t account for) the effect of the first stage of probability which would allow them to enter the actual stage 2.

Kahneman-Tversky called this an Isolation effect where people isolate or don’t care the commonalities between presented scenarios to make the decision-making process less complicated.

Now, this 2-stage game can be reduced to single stage game as follows:

Choose between

A: Coming to current stage with 0.25 chance where there is 0.8 chance to gain 4000

(0.25 x 0.8) chance to gain 4000

Gain of 4000 with probability of 0.20

B: Coming to current stage with 0.25 chance where there is certainty to gain 3000

(0.25 x 1) chance to gain 3000

Gain of 3000 with probability of 0.25

This is a reduced form of the prospect.

If EUT is applied here

U(A) = 4000 x 0.20 = 800 and U(B) = 3000 x 0.25 = 750.

The 2-stage game and its reduced form obviously will have exactly same equivalent utilities because the reduced form just combines the chances of two stages into one resultant number. So, even though these two scenarios have same outcomes of equivalent utilities, Kahneman- Tversky observed that the ways in which these scenarios are presented affect the choices of the people.

Kahneman-Tversky had already observed that when there is significantly less difference in the amounts of gains or the probability of those respective gains in two prospects, people mostly prefer the one with higher gains. So, if we present this above mentioned 2-stage scenario to its reduced single stage scenario the results are interesting.

We have already seen what Kahneman-Tversky observed for this reduced scenario. Majority of people chose higher gain prospect even though it was relatively less probable.

Conclusion

What Kahneman-Tversky did concretely in prospect theory is to formulate the value function to mathematically explain this behavior.

The value function in prospect theory is given as follows:

The simplified idea of this value function is:

The pain of losing certain amount hurts us more that the joy of gaining the same amount.

You just like winning and dislike losing – and you almost certainly dislike losing more than you like winning.

The importance of prospect theory is that it shows what it means to be a human. Once you start collecting the pieces of certainty effect, reflection effect and isolation effect the picture that is revealed is profound insight about our tendencies to ensure survival in any case.

Certainty effect shows that people will choose certain gains even if their size is low. They just want to be at peace with increasing their existing surplus if it is sure.

This is how the coupon codes, vouchers, discount codes, discount days work in online shopping. The provider lures you into buying something you really don’t want by giving you guarantee, surety that you surely are making profit out of this deal. One smart thing that happens here is that the sense of urgency. You might have realized that these coupons are expiring immediately like virtually now. This creates an urgency to materialize the profit.

When people are in profit making environment, they will always prefer sure profit over uncertain profits and that is exactly how scammers lure people. They create this sense of surety to attract people to invest in their schemes.

No wonder why people love easy money. Once you inject the surety of gains in any venture people will literally pile up and that is how Ponzi schemes, Pyramid schemes work.

The moment this surety of gain is lost and when people realize that it is only the losses that they will have to face then immediately this same population craves for uncertainty in the losses. When people see that they anyways have to digest the losses they avoid certain losses over uncertain ones, even if the actual effect of certain losses was pretty low. This is reflection effect.

The stock market is the best example to explain the reflection effect. In the crisis times – bearish markets, history has evidences that people have gone with insanely foolish bets where chances of gains are slim to none. People end up in the cycles of betting, gambling even when the realistic indicators of market are pointing to inevitable crisis.

The important thing to appreciate from prospect theory is to know when and where to stop in crisis situations.

“…people become risk seeking when all their options are bad”

If you have lost this game in poker or any gamble, you always feel that I will play the next game and definitely (somehow) will recover my losses (even when I know that James Bond is sitting on my table).

You will be more relaxed if you were told in advance that you will make less money of $10000 and you will be more stressed, feel pain if you make $12000 and government cuts $2000 for some taxation at the last moment. The gain is same but the “prospects” are different.

People can be confused to choose the loss-making options even when they are completely informed. When decision making is multi-stage so that there are some common things between them, people usually neglect those shared attributes even if they are significant and move on to the differences to finalize the choice even if these differences are not significant. This is isolation effect.

Many electronics companies while creating their pricing strategies intentionally create shared features and smartly just add one low-cost additional feature in the top model to sell it at foolishly, unjustifiably higher cost. People are ready to pay higher prices for that low cost (for the manufacturer/ marketeer) because it makes that model better. (You know who I am talking about.)

For me, the isolation effect has a huge philosophical implication.

Kahneman-Tversky have attributed the behaviors pointed out by Prospect theory to the tendency for survival. If you want to survive and are living in an already good situation then you would not want to disturb the current resources you have, that is why you don’t prefer uncertain gains, you are more than happy if the gains are certain even if they are small in size because they are not disturbing the already materialized gains.

In same way when conditions to survive are hostile you would take that every chance to increase your resources, however slim the chances may be. This is some kind of indication of hope. Important thing about Prospect theory is that Kahneman-Tversky pointed out that this exact risk-taking tendency in negative environment can push people into the spiral of continuous losses.

We are naturally evolved in this way.

The isolation effect outlines our tendency to eliminate common/ shared attributes of given resource to make a choice. The key thing to appreciate here is that while neglecting these commonalities we are never conscious of how significant they are in our life. You must appreciate that when I am writing this, sharing this, when you are reading this, we have more than enough resources to sustain a basic life. We are living better life than most of the world population but still we are not satisfied because we have already isolated that which we have with us. The isolation effect thus points out to our tendency to lose the feeling of gratitude for everything we have right now.

We rarely appreciate things which we already have or things we are sure that we would never loose. Many times, people realize the worth of things as really significant – as truly valuable when they are lost.

Being alive and having the ability to experience – to appreciate this life is what common to all of us, this is precious than anything else in this world, rest is just the bonus. We should not let the practice of comparison isolate this preciousness.

References and further reading:

Kahneman, Daniel., and Amos Tversky. “Prospect theory: An analysis of decision under risk.” Econometrica 47.2 (1979): 363-391
Thinking fast and slow – Daniel Kahneman
Risk and Rationality in Uncertainty – On Expected Utility Theory
Connecting money with sentiments – Behavioral Economics

Risk and Rationality in Uncertainty

We have many philosophical ideas about how money is not everything in life but deep down, everyone knows how money constitutes to a bigger portion of who we are. Although money can’t buy everything, the unexplainable value it holds behind presence of almost everything in our lives will never go unnoticed. We know that this importance of money/ resources/ assets is highly dependent on how much of those we have right now and how much of those may get lost in an uncertain event. This perception of value drives our decision making in risky situations. The Expected Utility Theory (EUT) in economics deals with the modelling of such scenarios. The mathematical formalization of the perception of wealth and our risk profile is facilitated by this fundamental theory. EUT lies at the foundation of actuarial science/ insurance, financial risk management, decision making under budget restrictions, asset management, and investment management.

EXPECTED UTILITY THEORY

We live in an uncertain world. Timing events where too many interactions are happening could be risky especially when it comes to money or the basic resources for sustenance. In crisis situations, our survival instincts have always kicked in to ensure preservation of life and the resources required to ensure its longevity. They need not to be always rational, they are just meant to save life somehow, that is why most of the acts of survival seem extraordinary. Interesting thing to understand here is that when such extraordinary survival instincts kick in as a mass effect the whole mass effect becomes irrational, unexplainable, incoherent. There is no sane explanation to justify these mass events. When such events badly affect the resources responsible for basic life of every being, it can be catastrophic. Huge sudden falls in stock market are good indicators of such disasters, crises. Insurance on the other hand could prepare person to handle the disasters in a preventive way. Stock market and insurance are one of the best examples to understand how people assess risk and maintain/ reject rationality while making important decisions. We will see what formal ideas from economics lie behind these events of uncertainty.

Expected Utility Theory (EUT) in Economics

Expected utility theory lays the foundation of how a rational person would make decision in an uncertainty where valuable resources like money are involved. The whole idea is based on the quantification of that uncertainty and connecting that uncertainty with the individual gains from individual uncertain event. Expected utility also creates a formal structure of how person perceives risk in given scenario. This helps to quantify the value generated from any economic event.

Origin – St. Petersburg Paradox

Daniel Bernoulli is credited to establish the expected utility theory which is one of the foundations of economics. The theory emerged from the St. Petersburg Paradox which goes like this:

You have $2 and we toss a coin. Heads, the amount you have now is doubled and tails then the game stops and you leave with whatever amount you have right now. The game continues till its always heads in series and stops when the coin shows tails.

The question is how much will you be willing to pay to enter this bet?

The probability of heads and tails is 50-50% which is ½ . If it is a series of heads (heads followed by heads) then the events are dependent on each other, so the probability of this event is intertwined with the probability of the previous one. If there happens a game where you start with $2 and every time heads comes, and the money goes on doubling the equation of gain would be:

As this math goes, a person should pay infinite amount as he will be gaining infinite amount from such game. ‘E’ value here is identified as expected value. Even if one such possible game would happen in reality, people won’t pay infinite amount in reality to enter this bet.

Bernoulli resolved this paradox by creating the concept of Expected utility. People will pay not what actual value it delivers (as in the $s of money); they will pay according to how actually it will be useful to them, ‘utilizable’ to them – that is where the utility and thus expected utility comes in picture.

Expected utility is calculated by the amount one would gain and the chances of gaining that amount. The expected utility thus is sum of all the gains connected with the probabilities of gaining them.

Daniel Bernoulli
The determination of the value of an item must not be based on its price, but rather on the utility it yields.

1^st Tenet of EUT: Expectation

The overall utility of a prospect, is the expected utility of its outcomes.

In very simple words, for a given scenario you will weigh the chances of its constituent events and connect them with their respective gains. The sum of the all connections of each gain with their chance of realization is the usefulness – utility of that scenario.

Mathematically,

Expectation:

In our example we need to assume something that is the usability of the money – utility.

We assume $10 has utility of 1 unit. (This is just an assumption to understand the concept. When multiple objects are involved, their utilities will be different.)

So, the expected utility of this scenario is:

E = ((1000/10)x0.2) + ((50/10)x0.65) + (10000)x0.15) =

20 + 3.25 + 150 = 173.25 units

So, the expected utility – the usefulness of this event is 173.25 units.

The unit of value which we assumed in this calculation is sometimes called ‘utils’ – the basic unit of utility. It will change based on how one perceives the value in given scenario.

You will realize that the expected utility is the weighted average of utility of events and their individual probabilities.

Four Axioms of Utility Theory

Later John von Neumann and Oskar Morgenstern expanded the concept of EUT with the idea of rationality. The agents involved in such uncertain economic exchanges are ‘econs’-the rational beings.

They have clear preferences among the options provided in every economic decision which comes under the idea of “completeness”. If out of the given set they select multiple options at a time, then it is said that they are ‘indifferent’ to these options. Whatever might be the internal distribution of constituent they might have. It’s about the final utility they perceive. When presented with choices, a rational person has clear preferences for those choices.

For all given uncertain events there is a hierarchy of preferences. If A is preferred over B and B is preferred over C, then A is always preferred over C. Which goes as transitivity.

Suppose we have been presented three events where event A is preferred over B and B is preferred over C. Now if one introduces a new event N which is slightly less preferred than B and more preferred over C then event B and N would be indifferent. In simple words, the choices between options would never directly jump, they will align as per the preferences in line.

So, A>B>C and B>N>C then A>B>C and A>N>C mean the same.

This is continuity. Graphically, the utility function is always a smooth curve.

Why do A>B>C and A>N>C mean the same even when the calculated numeric value would differ? It is because utility is never an absolute value it is just used to arrange the preferences by quantifying them. Ground rules used to define usability from the given resources i.e., the utility function of given scenario will be different for different scenarios and different sets of people. This is simplification of the concept called ordinality of utility. You can rank utility but not say that event A is this many percent better than event B.

When you have set the preferences of A over B and if you are offered another totally different/ irrelevant event M with new utility. You would still prefer A over B. Introduction of M will not affect the preferences as if A and B are independent of M. This is called ‘independence‘ in EUT.

So, completeness, transitivity, continuity and independence are the four axioms of EUT. Note that they are not ‘complete’ representation of reality. It’s just that they bring in simplicity to treat given scenarios and evaluate them. That is why you will find contradictions to these axioms. (Maybe a topic for another time.) The axioms are there to create a formal mathematical structure to draw useful inferences.

2^nd Tenet of Expected Utility Theory: Asset Integration

In EUT, asset integration is an idea based on the assumption that all people making economic decisions are rational. So, in uncertainty or risky scenarios a rational person will look at the overall gains instead of focusing on one certain gain and neglecting other unsure gains. A rational person will look at the risks of scenarios in a collective way and decide to enter only if the expected utility improves his assets’ position. A rational person will only enter the given scenario if the collective utility is better than the individual utility of its sub-events or sub-gains.

A rational person will not focus on an individual more probable gain even when his overall gains are becoming low.

3^rd Tenet of Expected Utility Theory: Risk

The beautiful insight EUT creates is about the mathematical formalization of risk profile. For that we will understand some ideas in advance.

Utility function – it is a mathematical relation between how one sees the value of given object/ resource. The value of resources is different for different people. A crude example would be how a beggar values money for one time meal compared to a filthy rich person. The value of $25 would be different for different people based on the conditions they are in.

This is where marginal utility comes in picture.

Marginal utility talks about what difference it makes in your perception of the value of a given thing if one would give you more of that in the next event. Roughly speaking the more we have something, the less we value it, so marginal utility is always diminishing. If I already have 10 packets of chocolates which are enough for the day to me, the next 11^th packet of chocolate won’t make that much difference in my current excitement of having 10 packets. (Please note that we are talking about rationality here, although nobody is rational when it comes to chocolates.) A rational version of me would trade that 11^th packet for something else with a person who hasn’t received even a single packet. A person who has no chocolate would perceive that single packet with higher value than how I perceived it (provided that he loves chocolates).

Alfred Marshall – the British Economist brought the concept of
‘Marginal Utility’ through his book ‘Principles of Economics’ in 1890.

So, utility function is a mathematical transformation of objects in given event to a unitary value so that the results can be easily compared with each other because the transformation converts everything to single unit system. These single unit of value is called ‘util’.

Utility function can be any possible mathematical relation. Generally, it is expected to be simple to not invite the complexities in modeling of given economic scenario. It should be simple enough to draw realistic conclusions.

An understanding of utility function gives insight into how the person evaluates risk with respect to the resources they hold.

Consider a scenario:

Event 1 – You enter a lottery where there is 50% chance that you will win $100 and 50% chance that you win nothing.

Event 2 – You are given $50 for sure, unconditionally just for playing the lottery.

Assume we have three differently thinking people to make choices in this scenario. Different thinking means how they assess the risk of entering the lottery which has some uncertainty and the surety of winning $50. Difference in assessment of risk means difference in the perception of utility. It further means that the utility function will be characteristic to each person.

Person 1 has the following utility function:

So, for Person 1 the utility of certainty (7.07 utils) is higher than the uncertainty (5 utils). He is happy to walk away with sure $50 gain instead of betting for $100 lottery.

Person 1 doesn’t want to take risk by entering the Event 1 of betting when he is sure about gain of $50 in Event 2. This is risk-averse behavior. The utility function mathematically models that risk averse behavior. Utility function is concave in risk aversion.

Now comes Person 2 with the following utility function:

You will see that the utility of certain and uncertain choices is the same. It means that it doesn’t matter for this guy if he enters the lottery having uncertainty or gets $50 for sure. This is risk-neutral behavior. The person 2 doesn’t care about certainty or uncertainty. He values both events the same. As mathematically both have similar utilities. Person 2 is indifferent to both events.

Now see the Person 3 with following utility function:

This guy has a radical view, he perceives the worth of entering the lottery (5000 utils) better than gaining $50 for sure (2500 utils). This guy is gambler! He finds it more interesting to enter the bet instead of gaining $50 for sure. He is happy to take the risk in uncertainty.

Looking at these three people you should note that the scenarios/ events they are presented are exactly the same. The only thing which is different is how they see the value in lottery and the sure gain.

So, the first person demonstrates risk averse behavior. He wants surety of gain rather than gambling for higher but unsure gain.

The second person demonstrates risk neutral behavior. Bet or no bet he doesn’t care. Just be done with it.

The third person demonstrates risk loving behavior. He wants the thrill of uncertainty in betting, so he sees more value in uncertainty of lottery.

This is how Expected Utility Theory can be implemented to mathematically model how different sets of people/fund managers will make decisions based on the risk profile. The relation between expected utility (which is the weighted average of gains) and utility function (which shows how one values the gain) can show us the risk profile.

In the graphs shown, blue lines show utility function and the orange lines show expected utility. The orange line in our case connects the utility of $100 and $0 which is Event 1. This orange line connects any points on utility curve and it will give the expected utility value for that scenario of uncertain gain. In simple words, it’s the line of weighted average exactly like the definition of expected utility. This line is used to find out the certainty equivalent (CE). A certainty equivalent is the utility of an uncertain gain if it was certain.

Almost all the time, people are risk averse. People want to avoid uncertainty about higher gains when they are presented with some lower but sure gain. This is where marginal utility becomes important. (This point deserves broad explanation which we will cover another time under Prospect Theory)

Marginal Utility

In risk averse people, you will see that the utility function starts to flatten out once the value gained increases. The more value someone already has the less he values the next addition of bunch into the preexisting bulk. Remember the chocolate box example?

One with 10 boxes of chocolate perceives one additional box with less value, whereas some with no chocolate will see it as a precious one as he has nothing right now. The perceived value of the additional next lot goes on reducing. This is known as diminishing marginal utility. Marginal utility is always diminishing.

So, a safe playing person would stop entering the next gamble because he now has enough. The next uncertainty in gambling has less value for him.

EUT in actuarial

Now it is obvious that only a risk averse person would go for conservative approach in uncertainty. This also means that risk aversion will also invite preventive measure against loss of certain assets, resources. Insurance thus comes into the picture. EUT here helps to mathematically formalize the probability of the risks which would compromise current gains, the perceived value of asset/ property/ resource and losses one can bear. We can now calculate the premium for the insurance against uncertainty of loss of something.

So, we will look into a scenario where risk aversion exists thus marginal utility is always diminishing.

We have the utility function of a man has a property giving revenue of $100K/year as:

u(x)=ln x

Now will see the risk scenario. Suppose this person does a fire audit of his property and the auditing agency finds out that there is 50% chance that he will suffer a loss of $60K/year due to fire hazard and 50% chance that nothing will happen.

After rephrasing, the gains from the property would look this:

50% chance that the income is $40K/year and 50% chance that income is $100K/ year.

Using the tenets of EUT the mathematical expression becomes:

Now, what we are doing differently here is to find out what this expected utility in uncertainty means when there is complete effect of loss with some chance and gain of some chance. In earlier examples we had second event of certainty against which we compared to understand the risk profile. Now it’s reverse calculation, we know the risk profile, we know the perceived overall value i.e., EUT of the property. Now we will find the certainty equivalent (CE) using the risk profile which can be explained by the utility function of the person.

How much is this 11.05 utils in terms of money from the property for this guy? We can find this from utility function of the person.

ln(x)=11.05, thus x=$63245.55

Now, think the fire hazard as a lottery where you gain $63245.55 money as per EUT calculation. Whether the fire will happen or not, the possible overall earning from this property would be $63245.55.

Now, if the property without any fire hazard was giving me $100k and the insurer guarantees me that same earning for the losses due to hazard. How much maximum amount should I pay to the insurance agency?

I will pay only that much amount which falls short to the $100k when compared to perceived earning calculated from the combined effect of certainty and uncertainty as given by EUT.

My earing due to uncertainty is $63.2k/year, I would receive $100 for a fine year so in order to continue that $100k even for a worse year I would pay insurance agency = $100000 – $63245 = $36754.45.

Anything I am paying above $36754.45/ year for insurance premium is loss for me. I would not go above this amount to insure my property which guarantees income of $100k per year. This is how the insurance premium is decided.

Conclusion:

We have many philosophical ideas about how money is not everything in life but deep down everyone knows that money constitutes a bigger portion of who we are. Although money can’t buy everything, the unexplainable value it holds behind presence of almost everything in our lives will never go unnoticed. We know that this importance of money/ resources/ assets is highly dependent on how much of these we have right now and how much of those may get lost. This perception of value drives our decision making in risky situations. The mathematical formalization of the perception of wealth, our risk profile is facilitated by expected utility theory. Although this theory has its own limitations it lies at the foundation of the economics.

For further reading:

Von Neumann, John, and Oskar Morgenstern. “Theory of games and economic behavior: 60th anniversary commemorative edition.” Theory of games and economic behavior. Princeton university press, 2007
Kahneman, Daniel., and Amos Tversky. “Prospect theory: An analysis of decision under risk.” Econometrica 47.2 (1979): 363-391
Thinking fast and slow – Daniel Kahneman
Connecting money with sentiments – Behavioral Economics
Settling accounts with the losses – On Prospect Theory

Ideological Legacy of The Rock Star Scientist

The dream that Dr. APJ Abdul Kalam had for developed India is the reality in which we are living today. It wouldn’t be possible if he hadn’t devised a result-oriented action plan for the Nation. It is sad that we never celebrate such great bright minds the way we celebrate film/ TV stars or sportsmen, especially in this golden era of social media. The incorporation of e-governance, e-judiciary, Information Communication Technology (ICT), Providing Urban-amenities to Rural Areas (PURA) were some of his key agendas for developed India and same is the reality we are living in. Today’s youth must appreciate that we are just enjoying the fruits of his well-formed result-oriented action plans created on his ‘Vision 2020’. This is to remember the ideologies of Dr. Kalam from his book ‘Turning Points’.

Turning Points – Remembering Dr. APJ Abdul Kalam’s legacy on his birthday

Unity in diversity lies at the heart of India as the biggest democracy in the world. This diversity also brings in various challenges from geographical, cultural, economic, governance and many more local perspectives. Bear in mind that despite having multitudes of such challenges the constitution has ensured that the machines are well oiled and keep running properly. To handle a nation with such diversity is a challenge in itself. Try convincing small group of people on an idea you have and you will realize how difficult it is to make others appreciate your vision. You will realize that people rarely resonate with completely new, unconventional ideas. The person must carry an aura to convince others for the path he is laying down. The person must carry a clear and pious vision for the masses.

Vision elevates the nation

-Dr. APJ Abdul Kalam, Turning Points

A vision must be pious because the moment people discover malice, a vision no more remains ‘the’ vision; it becomes a propaganda. Polarization is created and chaos ensues. That is one of the challenges with democratic society.

Only a self-inspired person, a person who is pure at heart, a person who can empathize with the masses, a person with emotional and intellectual intelligence and most importantly a person with humility can truly inspire people towards a common goal of the upliftment of the whole nation. Such people are blessing to the society and they appear once or maybe twice in a century. They are rare and leave an everlasting mark on society.

Dr. APJ Abdul Kalam, The Missile Man, The People’s President, and a teacher at heart was one such personality India had. Dr. Kalam was India’s 11^th president. Even though he is not physically among us his ideas and his vision are with us and will keep on inspiring every Indian rather every human. He is my source of inspiration since my childhood; I will take this opportunity to unfold certain aspects of his personality hereon. This is me remembering Dr. APJ Abdul Kalam on his birthday 15^th October.

Dr. Kalam wrote a book called ‘Turning Points – A Journey through challenges’ where he highlights the key events which shaped his tenure during the presidency and what really drove him to have a sense of accountability towards the people of India. If you look at the life achievements of Dr. Kalam, you will realize that overcoming challenges in spite of having multiple failures and worst conditions was his forte. His systematic logical thinking combined with result-oriented actions was the key reason for such achievements. You must also appreciate that he was not just a scientist with logical foolproof plan for results; he was a pure empath who understood what people of the nation actually wanted. He knew the pain of the masses and also made successful efforts to resolve many fundamental issues. Please understand that the position of The President in Indian Constitution although is the highest position, there are very few examples where the elected President created a significant impact on whole nation physically and ideologically. Most of the times, Prime Ministers are known to be the key drivers of the nation’s future in Indian Democracy.

You will appreciate what exactly caused Dr. Kalam to have a focused mindset towards making India a developed nation by 2020. Although we are still in developing phase, the rate is slow but we wouldn’t be here if Dr. Kalam had not envisioned the ‘Vision 2020’. The book Turning Points thus gives a glimpse into what made him to devise an action plan in making India a developed nation.

You will be surprised to know that we are literally living in the accomplished visions of Dr. Kalam and there are many those will be achieved in near future.

The Modern India

Dr. Kalam was the key originator and proponent of many facilities and policies we Indians are enjoying today. It is only because of his vision and action plans we are enjoying certain life changing benefits in our routine lives.

Dr. Kalam was responsible for successful inception of Indian space program led by Prof. Vikram Sarabhai. The SLV program (Satellite Launch Vehicle), the IGMDP (Integrated Guided Missile Development Program), Indigenous hovercraft development called ‘Nandi’, Project Smiling Buddha in Pokhran for nuclear weapon development are some of the professional achievements of Dr. Kalam.

The concepts of e-governance, e-judiciary, court hearings through video conferences, pushing for the evolution of National Litigation Pendency Clearance Mission, meetings through video conferences, incorporation of Information Communication Technology, creating more policies to become energy independent, to become stronger in defense technologies, boosting the innovation funnel throughout the country, empowering the states while leveraging their specialties in cultures and traditions, making India a Nuclear superpower, developing and promoting an indigenous nuclear power program, pushing for increased plantations and facilities in biodiesel production, pushing for solar energy production and required policies, creating an annual target driven action plans for each ministry and states to have a focused development approach, creating an action plan to work on industry relevant skill development and more exposure to higher education in science and technology, creating more opportunities for the research in the fields of nanotechnology are some of the visions Dr. Kalam had for the people of the nation. This is just a short glance into what he planned and achieved in his tenure. We are just enjoying the fruits of his well-formed result-oriented action plans.

The book Turning Point will give readers a peek into the thought process and key motivations behind Dr. Kalam’s vision for making India a developed nation.

Dream Big

Appointment in ICSR – Indian Committee for Space Research (ICSR later became ISRO – Indian Space Research Organization)

The key moment which changed Dr. Kalam’s thought process was during his interview with Prof. Vikram Sarabhai. Dr. Kalam worked in the development of the hovercraft after which he had this interview. You will notice that Dr. Kalam was very impressed by the first-hand confidence that Prof. Sarabhai had in him because he explored the capabilities Dr. Kalam had without questioning his competencies. Dr. Kalam always told youth to dream bigger. That idea came from this exact moment. Dr. Kalam realized that what Prof. Sarabhai had dreamt was way bigger than the dreams of Dr. Kalam.

This moment inspired Dr. Kalam to dream even bigger which he always kept reiterating in his interactions with youth.

Urge for cross implementation of technologies

Appointment in DRDO missile program

India’s first satellite Rohini RS-1 was launched by SLV. Dr. Kalam was Project Director for this program. He presented how this satellite launch vehicle put Rohini in the orbit to Dr. Ramanna who was a nuclear physicist and director of DRDO (Defense Research and Development Organization). Dr. Ramanna offered Dr. Kalam the position of DRDO. Dr. Kalam accepted this position because he wanted to implement the space technology developed from SLV program into missile development program.

You must appreciate that the missile technologies developed in-house for missiles like Agni, Akash, Prithvi, Trishul and Nag were possible because of Dr. Kalam’s approach to interdisciplinary knowledge implementation for indigenous technology development on faster speeds.

His same approach to create intersections in various unconnected fields through technology got reflected during his presidential tenure. The implementation of electronic technology for e-governance, e-judiciary are result of that. He always believed that such intersections of technologies boost the speed of growth.

Indigenous technology is the way to self-reliance and defense

Dr. Kalam wanted to return to his passion for teaching and interacting with youth while he was Scientific Adviser to the Defense secretary. P V Narsimha Rao, then Prime Minister also Defense Minister asked him to continue as the defense minister and Kalam agreed because he was handling multiple important programs. P V Narsimha Rao’s long-term vision for indigenous defense program inspired Dr. Kalam.

I think Kalam called this moment as the turning point because if he would have been associated with teaching at that time his future would have been totally different from becoming the President. This moment is also important because it created a concrete foundation in Dr. Kalam’s mind to create a long-term vision for nation which will rely on indigenous technologies.

During his Presidential International visits Dr. Kalam always pushed for the use of indigenous ICT, BPO frameworks, pharmaceutical manufacturing technologies. This moment might be the key inspiration behind Dr. Kalam’s thought process.

Nation first, politics later

Dr. Kalam was offered a Cabinet position under Vajpayee Government in 1998 when he was handling the Missile Program (Development of Agni Missile) and Project Smiling Buddha (Pokhran Nuclear Test). Any other normal person would have accepted the better and beneficial offer of Cabinet Minister but keeping Nation first Dr. Kalam decided to decline this offer and focused on the Indigenous Missile Program and Nuclear Weapon Program which further upon their success made India’s global presence stronger.

Drive to Envision, Urgency to take Actions, and Having Courage to do the Impossible

Dr. Kalam stands out as one of the rarest statesmen who focused on practicality of vision and action plan for their execution; there is a reason for that attitude.

When Dr. Kalam was Principal Scientific Adviser (PSA) for Government of India when he paved the foundation of action plans and their implementation for Vision 2020. During this tenure as PSA, Dr. Kalam had a helicopter accident where for the sheer luck of the nation he was unharmed.

Even after going through such accident, he was immediately ready to connect with the locals and the youth where he asked them to recite his hymn. This shows the artistic side of Dr. Kalam. Dr. Kalam was known for inspiring poetry showing the importance of the power of youth.

Courage to think different,

Courage to invent,

Courage to travel on an unexplored path,

Courage to discover the impossible,

Courage to combat the problems and succeed,

Are the unique qualities of youth.

As a youth of my nation,

I will work and work with courage to achieve success in all the missions

Dr. APJ Abdul Kalam, Turning Points

This near-death experience gave him a totally new perspective towards the life in front of him. It created a sense of urgency for him which pushed him to write the famous book ‘Ignited Minds’. This sense of urgency inspired him to push more for PURA (Providing Urban-amenities to Rural Areas) project. Many independent village ecosystems, governance technologies, tech policies, benefit transfers which are now available in rural areas are the fruits of this PURA program.

I have always believed that cowards never make history, history is created by people with courage and wisdom. Courage is individual, wisdom comes with experience.

Dr. APJ Abdul Kalam, Turning Points

Empowerment and Independence of the Nation

Dr. Kalam believed in the power of self-reliance and improvement in the agility between different functions of government and also between individual states. You will be surprised to know that he was the statesman who brought the idea of e-governance in the Office of the President and implemented it effectively. It later spread horizontally to the e-governance and digitization of documents that we see today. It took time because of multiple reasons but you must appreciate his vision and future outlook behind it. His dream then is now our reality.

In similar sense, Dr. Kalam created action plans for individual states based on three parameters:

The contribution to the vision for developed India
The heritage of particular state
The core competency of that state

This shows how agile and practical Dr. Kalam’s thinking was. He knew how to play with the strengths of each state and also cared for their legacy thereby preserving the cultural importance of diversity in our country.

Dr. Kalam is also one of the statesmen behind the upliftment of the judicial system. He pushed for the National Litigation Pendency Clearance Mission. This mission is the origin for the e-judiciary, court hearings through video conferencing, use of ICT in litigation, age analysis of pending cases, fast track courts which we are seeing today.

Duty Towards Nation

Dr. Kalam always created a sense of duty towards nation in the hearts of the youth and his action always reflected the same attitude. Many of his lectures were named as ‘What Can I Give To The Nation?’

Dr. Kalam’s way to guide the youth to answer this question is based on the importance of values in human life. He gave huge importance to each and every public address he would give. He revised his public addresses multiple times to ensure that the message is crisp and inspiring.

You must appreciate that human values were the core of his speeches. The ideology of ‘being a better human is the best you can offer to the nation’ is what inspired youth to follow their own dream thereby also benefiting the nation in greater sense. Dr. Kalam’s speeches always had this element of ‘call for action’ that is exactly why the question – ‘What can I give to the Nation?’ is simple yet meaningful. It made the youth to look inside them for the betterment of the nation altogether. These are the skills of a seasoned inspirational personality, they make you look inside to create a better future outside for everyone, it creates a sense of duty, accountability and also satisfaction for life well spent.

And this same sense of duty and accountability Dr. Kalam wanted to inject into the Indian Parliament and Indian Politics. He had action plans to do that too.

When politics degrades itself to political adventurism the nation would be on the calamitous road to inevitable disaster and ruination. Let us not risk it.

Dr. APJ Abdul Kalam, Turning Points

Dr. Kalam was well aware of the gaps between the lives of the common people and the events in the parliament, They were completely inconsistent and were not helping (even today they rarely help)

People are yearning for lifestyle change by preserving the cultural heritage, values, and ethos of the Indian civilization.

Dr. APJ Abdul Kalam, Turning Points

Dr. Kalam asked the parliament members to focus on key aspects of development of their own state instead of engaging into the propaganda-based politics. Dr. Kalam was one of the few proponents of the Development Politics. You might think that this word is somewhat recent concept but Dr. Kalam was the originator of the action plan and policies for development-based politics.

He gave five points to the members of parliaments to work upon:

Agriculture and food processing
Education and health care
Infrastructure
Information and communication technologies
Self-reliance in critical technologies

You must appreciate that the world we are living in is the result of action-based plans and their results based on these ideas.

Dr. Kalam pushed for the indicator of National Prosperity Index (NPI) instead of GDP (Gross domestic Product). The idea was that GDP growth indicates net domestic product but it doesn’t reflect how this growth is affecting the quality of life in rural and urban area. Thus, associating GDP with other indicators can actually help to gauge the realistic growth of the nation.

NPI (National Prosperity Index) = 
annual growth rate of GDP + 
improvement of quality of life of the people particularly those below poverty line + 
the adoption of a value system derived from our civilizational heritage in every walk of life which is unique to India

This shows that Dr. Kalam had the sense of importance of the cultural heritage in the growth of nation. The urge to push for the upliftment of quality of life is intentional to reduce the gap between the riches and the poor.

Strong Inner Compass – Value-based character development

Dr. Kalam even though was an intelligent scientist and had many professional achievements, he was down to earth. Intellectual humility was his second name. His thoughts also showed how he valued the sense of service, honesty and compassion right from the childhood.

Dr. Kalam shares an event from his childhood where he received beating from his father for the very first time in spite of being the youngest and the most loved child. The reason was to accept the gift from others for being elected as the President of the Panchayat of Rameshwaram.

Dr. Kalam quotes his father’s words from Hadith-

“When the Almighty appoints a person to a position, He takes care of his provision. If a person takes anything beyond that, it is an illegal gain.”

That thing remained with Kalam forever. The last things that Dr. Kalam possessed were 2,500 books, a wrist watch, six shirts, four trousers, three suits and a pair of shoes. He donated his pension to the development programs for rural areas. He didn’t have any TV, fridge, AC.

Dr. Kalam was a spiritual person. You will see from his whole life journey he never submitted to a single side of the religion – he was always on the side of divinity. This shows his openness to find the real truth of what it means to be a human being. Humanity was at the core whenever he was discussing any religious topic.

“Kalam sees no conflict between science and religion. When I asked him if he believed in the Day of Judgement and rewards or penalties, we might have to pay in life hereafter, he replied evasively, ‘Heaven and hell are in mind’…”

“No rationalist can dispute Kalam’s vision of divinity. Some define God as truth; others as love, Kalam’s concept of godliness is compassion…”

Khushwant Singh, Author and columnist for Hindustan Times

Sacrifices make any great pursuit ‘great’

Dr. Kalam was devastated after the crash of an Air Surveillance Platform which led to death of all its 8 occupants. He realized in this very incident that many people without any personal gain give away their lives to the service of the nation and their sacrifices goes unnoticed in the chaos of all the politics. This should never happen. You can sympathize with the pain of the relatives of these heroes but you would never be able to return the service they provided to the nation. Everyone must be aware of that.

This shows the sensitive side of Dr. Kalam. He was a strong proponent of dreaming big, having courage to do the impossible but this event shows that he was also aware of what sacrifices people make to achieve the impossible, these sacrifices, this service are bigger than anything and should not go unrecognized. He wanted the people of the nation to appreciate the same.

Religion is a personal thing and so are the culture, faith, language and heritage

Dr. Kalam visited the places affected by the Gujarat Riots. His intent was to understand the ground reality and he knew that his mere presence will speed up the relief efforts. Bear in mind that visiting such sensitive areas for a President is a highly risky task.

Dr. Kalam was disheartened by the events, he expressed the reason behind that-

“…in our land, with its heritage of a highly evolved civilization and where great men were born and stood tall as role models for the entire world, communal riots with their attendant tragedy are an aberration that should never happen.”

“Each individual has the fundamental right to practice his religious, cultural and language faith. We cannot do anything to disturb that.”

Dr. APJ Abdul Kalam, Turning Points

Building bridges to share each other’s competencies for mutual growth

Dr. Kalam is also known globally for his speech in the European Parliament. He focused on mutual growth plan for European Union and India. His poem ‘Message From Mother Earth’ won hearts of all the members of the European Parliament. Dr. Kalam’s visiting day in 2005 – 26 May to Switzerland is celebrated as Science day there. Dr. Kalam proposed to implement the electronic network to connect African nations using the IT power of India under Pan African e-network Project.

Whenever Dr. Kalam visited any country, he made sure that both countries help each other to generate mutual benefits and deepen the relationship. Dr. Kalam was always open to understand what greatness lies in others.

In meeting people, we are transformed too, though we stay the same.

Dr. APJ Abdul Kalam, Turning Points

Real development starts from the bottom – PURA

Dr. Kalam highlighted one key observation about the developed nations. Even though their rural regions, villages in developed nations look just like our meaning not exactly, not physically meaning that the ways people carry their lives. The villages in developed countries don’t have high rising towers, big houses, big restaurants and hotels. What they exactly have are the basic amenities like power, education, transport and easy access to government to live comfortably. This inspired Dr. Kalam to work on the mission for the upliftment of rural areas of India under project PURA.

The word itself is self-explanatory.

It stands for Providing Urban-amenities to Rural Areas.

The key idea behind PURA was to solve the problems of emerging due to fast Urbanization of towns and fast migration from the villages. Towns get overwhelmed due to overpopulation and villages are empty because there is no quality of life.

If you see the other side, villages are pollution free which urban people want. Urban areas have better opportunities for earning and sustenance which rural people want.

PURA focused on addressing these exact issues on rural level.

Following were the key headers of the PURA project:

Physical connectivity – roads and transport
Electronic connectivity – for local knowledge preservation and transfer
Knowledge connectivity – for skills sharing and efficiency boosting of multiple rural areas thereby creating spare time to do better things and improve quality of life
Earning capacity – once these three connections are improved, people can work on increasing the earning capacity.

In the end we, are all humans

Dr. Kalam also made efforts to made the Mughal Gardens in the Presidential office to become a center of discussions. He tried to improve the flora and fauna there. He coordinated between DRDO scientists who had developed high-altitude agriculture before to develop several (12) gardens in Rashtrapati Bhavan. Later biodiversity park was also developed there. This showed his connect with nature.

Dr. Kalam was reluctant on approving the capital punishment believing that it is not a human’s job to decide the fate of the life of other person, but as a duty he had to do that. Dr. Kalam made sure about the total background of the convicted person and tried to understand what will be the life of the people dependent on such convicts. Wherever he found the offenses to be too inhumane he approved the capital punishments. You must appreciate that being the President he could have approved every capital punishment but his core value system, that human side was always active. He knew that in the end the convict is also a human.

We are the creations of God. I am not sure a human system or a human being is competent to take away a life based on artificial and created evidence.

Dr. APJ Abdul Kalam, Turning Points

Parliament functions are the heart of democracy

Dr. Kalam was the main proponent of the need for improvement in parliamentary Functions.

Constant vigilance is the price of liberty. It is important that democratic processes and functioning, however satisfactory they may appear on the surface, cannot be, and should not be frozen in time.

Dr. APJ Abdul Kalam, Turning Points

He made every practical effort and created a result-oriented action plan for giving the boost in the efficiency of the parliament. Some of them are implemented, we hope others are still under consideration.

Dr. Kalam had created a development matrix between the Cabinet Ministries and the Members of Parliament which created and intersection of resources, action plans, targets and results for each state. He made sure that his presidential powers are put in effect for the betterment of Parliament and thereby the people for which it stands.

These are few takeaways from Dr. Kalam’s 21^st book – Turning Points. There are many details which show a deeper insight into the personality of Dr. Kalam. Everyone should read it. This book shows all aspects of a perfect human being. The vision that Dr. Kalam had for the developed India is the vision in which we are living today. It wouldn’t have been possible if he hadn’t devised a result-oriented action plan. Although there are many things which are yet to be achieved and speed sometimes is not that fast. Dr. Kalam was also concerned about the speed of these developments. But at least we know where to go – the right direction. It would be impossible without his vision.

In the times of the golden era of social media celebrities, film stars, TV stars, sportsmen always are at the focal point of attention. We rarely celebrate scientists on such platforms.

It is sad that we never celebrate the bright minds especially the scientists the way we celebrate film stars or sportsmen. Dr. Kalam is a rock-star if you compare with others. Not only from Science and technology point of view, Dr. Kalam was People’s President, an ideal teacher every student dream of, a kind human, a divine spiritual leader, man of values and virtues and the best of all the humans the nation, the world would ever see again.

We are just living in his dream which became the reality today. It was only because he dreamt of the Vision 2020 with a realistic action plan to execute it and make it ‘our reality’. We owe it all to Dr. Kalam. There would rarely be any leader, any human like him in future. The world will remember him forever for his contributions.

Entrepreneurship and Poverty

We are surrounded by many entrepreneurs which go unnoticed and have nothing to do with the keywords like technology, unicorn, angel investors. A high chunk of these unnoticed entrepreneurs are poor entrepreneurs, almost a billion around the world. Nobel laureate economists Abhijit Banerjee and Esther Duflo studied such poor entrepreneurs which has created deep insights and answered many questions. Providing supporting capital – microcredit to such poor entrepreneurs is not the final answer to this riddle.

Paying close attention to the larger fraction of the poor entrepreneurs

Monthly Revenue of a ‘Chai-wala’

It is very common discussion among group of youngsters to roughly estimate revenue of their “Snacks n’ Tea” seller while enjoying that short break. The discussion ends when the earnings estimate from that seller’s business reaches to a figure which is far bigger than what these “highly qualified” youngsters actually earn thereby inspiring them to think about pursuing their own business, start-up. What actually happens after such short surge of inspiration is also a common knowledge. Very few of such people actually work on entrepreneurship, their business idea and again very few of these truly taste the success. Social media, mainstream media have also positively affected and boosted the startup mentality, entrepreneur mentality among the youngsters through TV-series, reality shows, success stories, popular talk shows, podcasts and nonetheless video platforms like YouTube. The “F.I.R.E. culture” (Financially independent, Retire early) is also one wave of thought which inspires such entrepreneurs to create something of value, turn it into a business and sell it at higher valuation to gain financial independence early in life. (Although, FIRE is not limited to financial freedom through entrepreneurship only). Following their passion and working over it to create a start-up and then becoming a wealthy person is also one famous new career route for today’s youngsters.

In short, for our generation, entrepreneurship holds the key to financial independence thereby key to the freedom (materialistic freedom to be more specific) – life living on their own terms, without any terms and conditions.

When looked through “the pop-cultural” lens towards entrepreneurship one will see all the glamour, money, popularity, angel investors, “unicorn startup” funds and success stories. In reality there are very few practical examples in these enterprises which successfully fit to all such criterion, which really have created value in the society; most of them are actually just publicized bubbles rather black holes sucking in the attention, time and money of the investors.

The Reality of Entrepreneurship Around the World

Start-ups represent only the early developmental part of an entrepreneurship. Even though they represent such an early and small part of the concept of entrepreneurship, start-up stands as the biggest lamp, biggest fire attracting the youth like moths.

Here are some interesting facts:

9 out of 10 startups fail

7.5 out of 10 venture-backed startups fail

2 out of 10 new businesses fail in the first year of operations

Only 1% of startups become unicorn firms like Uber, Airbnb, Slack, Stripe, and Docker

The success percentage for first-time founders is 18%

20% start-ups fail before the end of their 1^st year, and almost 70% start-ups end by their 10^th year.

These facts are not presented to demean the value of stat-ups or to negatively criticize start-ups thereby idea of entrepreneurship (although there are some people who also try to capitalize their failure in both the good and bad ways). When you will look at the complementary positive data on start-ups you will realize that the successful start-ups even being low in numbers created value to the society in totally different ways, they changed the ways of working and doing things through the exploitation of technology.

The glamour while portraying the concept of entrepreneurship is actually overshadowing the key idea behind it which is “ingenuity”.

Poor Entrepreneurs

What is the definition of an entrepreneur? The dictionary definition goes like this- “a person who sets up a business or businesses, taking on financial risks in the hope of profit.” Literally, a person who runs an enterprise. Now look at the pictures above, can you tell which one of these is an entrepreneur?

This will make us realize that how the glamour built around the word entrepreneur is actually a mirage. The basic idea in entrepreneurship is the risk taking for the gaining profit. We are surrounded by such small entrepreneurs in our day-to-day life, most of these are poor entrepreneurs. World renowned Nobel laureate economists Abhijit Banerjee and Esther Duflo have contributed to uncover the reality of such poor entrepreneurs and many questions associated with such poverty.

Why should one be interested in poor entrepreneurs?

According to the data collected by Abhijit Banerjee and his team roughly 12% of the population in rich countries calls themselves as self-employed i.e., entrepreneurs. The interesting thing is that the poor countries have far higher percentage of self-employed people. Nearly 70% people call themselves entrepreneurs – self-employed in poor countries. These are the people who are mostly single person entrepreneurs like tailors, bricklayers, auto-drivers, street-vendors, shopkeepers.

“…most income groups in poor countries seem to be more entrepreneurial than their counterparts in the developed world-the poor no less so than others… ”
Abhijit Banerjee and Esther Duflo, Poor Economics – rethinking poverty and the ways to end it

Looks like bigger chunk of the entrepreneurial population of the world is not really glamorous and full of revenues, capital and resources. The intention to focus on this information is not to degrade entrepreneurship, rather it is to understand why the percentage of entrepreneurship is huge in poor countries where availability of resources and capital is already hitting rock bottom low? How do they manage such ventures in low margins? Do these entrepreneurial ventures bring them out of the poverty? If yes then, how? If not then why?

If entrepreneurship is supposed to give people freedom to operate on their own conditions, freedom to be their own boss, freedom to take control over their own lives, bring their ideas into the society then why poor countries where the entrepreneurial fraction is huge are not coming out of poverty? Why most of such poor entrepreneurs remain poor even after embarking on the journey of self-employment?

Trust me the answer is not related to ‘lower rates of returns’ only!

Ingenuity of the Poor Entrepreneurs

Let us understand the challenges faced by the poor entrepreneurs listed as below:

Being poor, they are inherently low on capital (obviously)
They have low or no access to formal financing institutions like banks, insurance companies
As they have no access to formal finance, they approach local moneylenders and borrow with high rates of interest
They have very low risk-taking capacity because any investment other than that for sustenance is a survival challenge
They have very crude social support in terms of materialistic and emotional levels. They are surrounded by people having same difficult lives. They rarely have good connections with people who will trust them, people who will have access to better conditions capital-wise or relation-wise

Even after having these challenges, the fraction of entrepreneurs in poor countries is surprisingly high. How is this possible?

As Abhijit Banerjee explains, the poor entrepreneurs have clever ideas to run their businesses even at low capital. The unavailability of resources, material/ capital means forces them to find out new creative ways to make living. You will see many such innovative entrepreneurs around who try to make living by using some really interesting ideas e.g., the human hair collectors roaming around town to exchange with utensils/toys, the scrap collectors who collect specific types of waste only and sell them to bigger scrap dealers in bulk, there are some dust collectors in the gold markets of many cities in India where poor people collect road dust around the gold shops and try to extract tiny amount of gold from such collected dust to sell it.

But how many of these innovative, creative and ventures with true ingenuity actually turn into a unicorn or a big company? In simple words, one knows how costly are the hair extensions/ wigs are then why the hair collectors are not getting rich with their business? If gold is that precious then why these dust collectors are not getting rich with this gold dust collection ventures?

This is where the insights created by Abhijit Banerjee play a very vital role. In his book “Poor Economics – rethinking poverty and ways to end it” co-authored by Esther Duflo, he has given very important insights into the world of poor people, the challenges they face and ways to uplift them.

Let us deep dive into the key concepts to understand the economics of such entrepreneurs.

Representation of the Poverty

Figure 1 The S-shaped curve and the poverty trap
Source: Poor Economics – rethinking poverty and the ways to end it by Abhijit Banerjee and Esther Duflo

Economists use the diagram shown above to indicate the relation between income of today and the income a person will earn in the future. You will see an S -shaped curve forming. The red zone indicates the poverty trap zone where a poor person starts from A1 earns a meager amount which is not enough to sustain making the net income negative thereby proceeding to A2 which is backward directed/ decline in income. This reduced income restricts his/her freedom to choose (as the words go “beggars cannot be choosers”), risk-taking ability, reduction in available capital thereby scarcity of capital disposable to meet the daily basic requirements. So, the ventures in which poor people are engaged are down-valuing ventures according to this representation – which is used to represent “The Poverty Trap”. For those who think that the ventures of poor people always end up in losses thereby degrading their existing states, this curve in red zone represents that vicious cycle.

Most of the economists think that poverty is not a vicious cycle. By providing minimum enough capital/ resources to the lowermost group, their lives can be kick-started where the ventures will give net positive incomes, thereby gradually increasing their income over the time. That is why the world around us is explained by blue shaded part of the diagram, known as inverted L-shaped curve.

Figure 2 The inverted L-shaped curve
Source: Poor Economics – rethinking poverty and the ways to end it by Abhijit Banerjee and Esther Duflo

Please note one interesting detail in this diagram which we will bring further in our discussion. The initial slope of the curve is steep indicating substantial valuation increase in income but as the curve proceeds slope of the curve ends into flat thereby indicating less or no increase in valuation of the income over the longer period.

In very simple words, a venture can only sustain over the time if there is some net gain over the time (always remaining net positive, even if it becomes smaller and stagnant over time). Very few people and actually no one would engage in a venture where they see their future valuation, future earnings dropping over the long-time horizon. That why most of the economist accept Figure 2 to represent the incomes of today and tomorrow for anyone.

Asking the Right Questions

Now that we have realized that it will take very small amount of effort and capital to uplift the poor entrepreneurs why doesn’t that help them immediately? Abhijit Banerjee in his studies asked some important questions which reveal why just giving poor enough money won’t solve the complete problem. Abhijit Banerjee clarifies that it is the inherent nature of the enterprises/ businesses, societal conditions and even the mindset of the poor entrepreneurs that makes them stagnant in their ventures. Even if they are running their small businesses successfully, they will always make just enough to sustain in long time horizon, very few will be the outliers which come out of this stagnancy.

Abhijit Banerjee pointed out that most of the poor entrepreneurs repay their loans on high interest rates. The high returns rates are attributed to the lending from informal financiers like local money lenders, relatives. If poor entrepreneurs are successfully repaying such high interest loans while sustaining through the business, then that means that their overall rate/ fraction of earning for the capital invested is also very high.

So, why don’t they become relatively wealthy even after running business with high rate of overall returns?

Here we can take support of the inverted L-shaped curve for poor entrepreneurs and build on that further.

Figure 3 Diminishing marginal returns in poor enterprises
Figure created from the explanation in the book Poor Economics – rethinking poverty and the ways to end it by Abhijit Banerjee and Esther Duflo

Abhijit Banerjee explained the reasons for the stagnancy in poor enterprises in practical ways based on his field research. He explains the important behavior of marginal returns in terms of the poor enterprises. Marginal returns are the what left after an entrepreneur pays off everything – like payment on tools, payment of the wages to the workers, payment of the things bought to sell. Marginal return is take-home money after the business is done.

Now let us see the inverted L-shaped curve in figure 3 for poor enterprises. At the start of the business the marginal returns (shown as the height of the vertical blue arrow) are very high for the extra capital invested (shown as the length of the black horizontal arrow). The early investments in the business yields higher returns – higher marginal returns.

But, as the curve proceeds, due to the inherent nature of the businesses poor entrepreneurs are involved in as the capital investment goes on increasing, for every unit increase in such investment the marginal returns go on reducing and diminish further.

You can see in the figure 3, there are four different instances of extra capital investment in the poor enterprises. The L-shaped curve increases rapidly at early investment stage but as the capital investment goes on increasing the curve quickly flattens out, indicating the stagnancy.

In poor enterprises any new unit capital investment will give diminished marginal returns over the time

This behavior can be explained by the example of local fruits and vegetable vendors. First a person starts out with very few 2 or 3 vegetables (potato, tomato, onions for example). Being the commodity vegetables, they are sold very easily, fast and margins are also pretty good for the amount invested to buy them in wholesale. So, with those good returns he/she now buys different vegetables and now provide more options to his/ her customers. Now you will realize that not everyone buys every vegetable he/she has to offer, the sell of potato, tomato, onions may still remain good. But in order to expand he/she cannot depend on selling those only, and as he/ she expands into new varieties there comes the uncertainty of not everyone buying it. Perishable nature of these products is also one problem over which he/she has no control. The overall return may increase by incorporating more variety of items or by buying a cart to access many customers but for every new investment further done to grow this business, the guarantee of higher returns is very low.

So, the vegetable/ fruit vendor realizes this at a stage in his/her business that buying only those items which would sell, items which will not perish immediately with limited customer accessibility through cart is the only option to survive. You have to understand the limitations created by the nature of the businesses poor entrepreneurs are invested in.

That is exactly why only giving money to poor entrepreneurs won’t bring them out of the poverty. The businesses they can perform stagnate very rapidly.

Now, someone should ask the question for the case of the vegetable/ fruit vendor.

The questions could be asked as follows,

The vendor should buy a vehicle so that he will contact more customers, why doesn’t he / she do so?
The vendor should go to the wholesale market to buy the vegetables and fruits even at low rates to increase his margins, what stops him/ her?
The vendor should rent a place in cold storage to maintain his items fresh till they are sold to the end customer, what is the hurdle?

Now, let us assume ourselves as this vendor and try to answer these questions.

If the sell is stagnant even with a cart, why should one put exceedingly high amount in a vehicle purchase. This will be a big capital step. As the accessibility to formal lending is difficult, it brings capital in but the returns will be very low due to the borrowing at higher rates of interest.
In order to buy at wholesale low rates connections with the wholesale tycoons are vital. Such connections are based on mutual benefits which the poor entrepreneurs hardly have access to.
Cold storage rentals are significantly high for the amounts they earn so that goes there.

You must understand that these are not some contrived examples created to prove certain points. These are real life challenges and questions faced by poor entrepreneurs. It is only because of such challenges the poor entrepreneurs have that creative mindset, low cost, less capital-intensive problem-solving mindset. This also the reason economists found that poor entrepreneurs have very low number of people involved per business, they cannot afford to employ others due to the stagnancy.

As the study done by Abhijit Banerjee indicates, even if you provide some extra marginal income to the poor entrepreneurs so that they can access such options where extra capital is required, they will still choose to not invest that extra amount in the business because they know that for that extra investment the returns will not be that high over the longer period. (Abhijit Banerjee experimented with such extra capital provisions to poor entrepreneurs in Sri Lanka through lottery system, these entrepreneurs chose to invest that extra money in their livelihoods instead of businesses)

The Big Gap to Fill

Now you should understand that even when extra capital is provided, that extra capital definitely won’t go into the growth of the poor enterprises. The question now comes that why poor entrepreneurs don’t have wide mindset? Why can’t they think big? Looks like the horizons and the mindset of poor entrepreneurs are so narrow that they are scared of risk taking. For the exact reasons the micro-financing institutions have tried to disseminate finance education, entrepreneurial education to the poor entrepreneur they lent money. But economists found that it is the inherent nature of the enterprises that poor can and are involved in, which makes them to think so.

Abhijit Banerjee here clarifies what exactly is the difference between the poor entrepreneurs and the rich entrepreneurs. For that let us look at the figure 4

Figure 4 Combining technologies and S-shaped curve of entrepreneurship
Source: Poor Economics – rethinking poverty and the ways to end it by Abhijit Banerjee and Esther Duflo

You must appreciate the beauty with which Abhijit Banerjee has explained the difference between poor and rich entrepreneurs. Any incorporation of production technology in an enterprise will improve the productivity. Buying machinery, tools, infrastructures can largely boost the business performance. This boost due to production technology is shown as curve QR.

What does the curve OP represent?

As you have already seen, curve OP starts with no to less capital investment and flatten out immediately. It is the curve of poor entrepreneurship.

Now you must understand that in order to gain marginally/ exceptionally high returns one needs to start with high up-front capital in hand (Indicated as capital OQ). The big tech startups, the big supermarket chains start exactly from here where there are high chances of success (This is also why rich start-ups or any non-poor start-ups demand high funding).

In the case of high marginal returns in poor enterprises in their early stages of development we can easily think that high marginal returns should create the foundation of a successful long-term business. These high margins will allow the person to invest more in the same business, to employ more people to expand the workforce, to purchase new machinery, new tools. But these high marginal returns could never fill that capital gap for poor. This is what majorly differentiates between poor and rich entrepreneurs.

So, one has to really appreciate the gap lying between poor and rich entrepreneurs. This gap of capital to create production technology is too large for poor entrepreneurs and for the business they run. It is not just their narrow mindset, rather they are so close to the harsh reality that they prefer not to follow such seemingly “imaginary” paths.

Conclusion

Entrepreneurship for our young generation seems like a glamorous venture with big money, new technologies, new ideas, new technologies, “angel” investors and “unicorn” start-ups but we always forget that we are surrounded by many entrepreneurs which go unnoticed and have less to nothing to do with the keywords explained here.

A high chunk of these unnoticed entrepreneurs are poor entrepreneurs. They are part of our lives in a big way – you can think of the vendors of every small thing you use in your whole day.

Most of the people in poor countries are self-employed or entrepreneurs. This proportion is far less in developed nations.

Poor entrepreneurs seem to make high returns in their business but most of those high returns go to the repayment of the loans at high interest rates due to the inaccessibility to formal financial institutes which can lend at relatively lesser rates of interest. These businesses are very small and unprofitable over the time even though the rates of returns are exceptionally high.

Providing capital and opportunities to poor to start their business is not the solution to their improvement. Even after such provisions they will engage in the enterprises which rapidly stagnate over the time.

In order to come out of such stagnation they will need to fill that huge gap capital to incorporate production technologies which is impossible without the involvement of anti-poverty policies which will create opportunities and involvement of big formal institutes to provide no risk capital.

“The idea of the entrepreneurial poor is helping to secure a place within the overall anti-poverty policy disclosure where big business and high finance feel comfortable getting involved.”
C. K Prahlad, taken from the book Poor Economics by Abhijit Banerjee and Esther Dulfo

Poor entrepreneurs have less risk-taking ability, no to less business connections, no credit/ loan capability when compared to their rich entrepreneur counterparts. They have to fill that huge gap of up-front capital which could have brought new production technology, employed more skilled labor. Filling this high capital gap is impossible for poor entrepreneurs. That is exactly why a smart, ingenuous street vendor even while having the best and the original ideas cannot expand his/ her business into big industries, companies and malls.

When we are understanding that poor enterprises rarely promote multiple employment/ connected employments, we should understand that supporting the poor entrepreneurship won’t drastically improve the employment rates of the nation, especially the poor nations. This is also why creation of good jobs is very important.

References:

Poor Economics – rethinking poverty and the ways to end it by Abhijit Banerjee and Esther Duflo
MIT OpenCourseWare – 22. Entrepreneurs and workers – Lecture by Abhijit Banerjee
106 Must-Know Startup Statistics for 2023
90% Of Startups Fail: Here’s What You Need To Know About The 10%
News reference – Sifting through sludge for a sprinkle of gold – The Times of India

Game Theory – Minding our decisions

“All stable processes we shall predict.

All unstable processes we shall control.”

– Jon von Neumann

Human relationships are more of multiple complex interactions. The interactions with living or non-living bodies create some actions and these actions have some favorable or unfavorable outcomes. The word “relationship” here is not used just as in parents, siblings, in-laws or acquaintances but as a connection to everything around us, mostly living things. The awareness of our actions and their consequences- that visualization of cascade is one of the major parts of our knowledge building, relationship development, behavior management, personality development.

As a sane creature (most of the time) we try to calculate the consequences of our actions, have a thought about it and then decide our strategy while acting on something. This is what some people call the motivation or habit or trait of that person, that character. Important thing to understand is that every action always has multiple outcomes which brings the complexity in the expected outcomes of the scenarios. Different people have different motivations/ habits/ traits so they react and decide in different way adding further complexity to the scenario.

Take a simple example:

Many a times when you are trying to call your friend this happens. You call him, his phone rings but he doesn’t pick up. Then he notices the missed call and tries to call you while you are already calling him. The call remains engaged from both sides. Then you both wait for exactly the same time oping that the one on other side will call.

This goes for some time, and after some trial and error your call gets connected.

What should be an optimal strategy for such simple scenarios?

There is a rigorous field of mathematics and economics (not limited to these only and rather a wide field) which can deal with such problems and far more complex problems in our day-to-day interactions.

“Game theory is the study of mathematical models of strategic interactions among rational agents.”

Simply put, game theory can give answers to have the best strategy for the interactions which can be business interactions, economical interactions, national interactions, war strategies or competitor strategies. The idea of Game theory was developed by famous mathematician Jon von Neumann and economist Osker Morgenstern. Let us dive in deeper.

Basic Definitions in Game Theory

Game– A game is any situation in which players (the participants- the agents) make strategic decisions—i.e., decisions that take into account each other’s actions and responses.

Agents– The participants, the players of the game.

Rational Agents– This is the most important idea in Game theory where the rationality of agent is the idea of welfare of the agent. The agent will always try to achieve its own welfare. In economics this is known as maximizing the utility.

A rational agent always tries to maximize its utility.

Strategy– Rule or plan of action for playing the game.

Payoff/ Outcome– The value of utility, extent of welfare from certain strategy. It is numerical, quantified measure of the benefit from a strategy.

Optimal Strategy– A strategy which maximizes the utility of an agent.

Please note that the clear definition of utility, rational agent, optimal strategy defines the boundaries of the problems in Game theory thereby making it mold-able into the mathematical models (although mathematical models can consider the factors beyond boundaries but it will make the problem unnecessarily complicated). Mathematical models as in the mathematical equations which can be solved using general techniques to get the maximized outcome for the agents.

Please note that the word “Game” in game theory can be any situation which requires strategic decision making involving more than one agent. The game can be simple like Stone-Paper-Scissors, Tic-Tac-Toe or a Chess game to more complex game like launching a new smart phone in the market or taking over a company or setting up a war with a nation or even winning the general elections of the country.

The Prisoner’s Dilemma

The Prisoner’s Dilemma is the most common and famous example to understand the basics of Game Theory. Consider a scenario:

Two persons are arrested by Police under the crime of armed robbery. The Police know that they have committed this robbery together but they don’t have enough proof to justify that. They can only charge the persons under the theft of the car used for robbery due to lack of evidences. Police think that if both persons confess the armed robbery, then they can easily jail them under the proper charges of armed robbery. So, they lock each of them in separate cell and ask them to either confess or deny the crime.

The police inspector tells each one of them separately in their cell the following:

If only one of you confesses the crime and the other doesn’t, then the one who confesses will be freed but the another one refusing will be sentenced for 10 years. If you both confess, you’ll each get 5 years. If neither of you confess, then you’ll each get two years for the car theft.

Now, if we see the overall scenario, the best thing for both the prisoners is to deny the crime and set themselves free at first, but if you think properly of all the consequences and the information available to both the prisoners, that is not the best strategy.

The common information of three possible cases given to both the prisoners by the policeman is known as Information Set in Game theory.

So, the outcomes of such scenario can be arranged in a table to form a matrix which is also known as the Normal Form in game theory.

If we assign a number to each the payoff of each strategy,

0 for the worst case- 10 years of jail
2 for 5 years of jail
3 for 2 years of jail
4 for becoming free, no jail

then the normal form can be given as follows:

It becomes very easy to see as an agent of this game- the prisoner will try to maximize his utility by refusing the crime thereby setting him free. But the catch here is that he doesn’t know what another prisoner has done- whether he confessed or refused the crime.

Now, we need to understand that the final outcome is not dependent on only one prisoner decision. Hence, the decision making of second prisoner will affect the decision making of first prisoner. Let us see from the perspective of Prisoner 1:

Refusing should be the best idea, but if Prisoner 1 refuses and the Prisoner 2 confesses then it will lead to 10 years of imprisonment (zero utility) for Player 1 more risky operation as he is not sure about Prisoner 2’s decision.
If Prisoner 1 confesses the crime, then there are two possibilities:
- Prisoner 2 also confesses thereby both will get 5 years of sentence (utility of two)
- Prisoner 2 denies thereby prisoner 1 getting freed and Prisoner 2 gets sentenced for 10 years (utility of 4 for prisoner 1 and zero for prisoner 2)

So, confessing becomes the best strategy for both the prisoners when they are in an isolated cell.

Which is why the optimal strategy for both the prisoners of this game is to confess. In any possible decision by another prisoner, it will give the best possible outcome.

The one thing important to notice here is that they both could have refused simultaneously. Because, if they both refuse it would have maximized the utility of both (2 years of jail for both, utility of 3 for both). The thing is that the risk associated with refusing is more than the risk associated with confessing. Thus, even if the utility is highest in some cases the interaction of other players forces a player to choose optimal strategy which will yield the best irrespective of other players decisions.

The Nash Equilibrium

Mathematician John Nash took the Game theory developed by Neumann and Morgenstern and provided mathematical background for finding the strategy where the solution will be optimal irrespective of the decision made by the other players. For that we need to understand the two types of games – Cooperative and non-cooperative games

If the prisoners in above examples are supposed to have a word with each other before presenting their opinion to the police they surely would have understood that refusing will benefit them both, which when exploited is a collusion – a foul play, here in the prisoner’s game it is exploited.

But as we know in reality, even if they are given a meet to discuss before presenting their opinion there is still that risk of changing the statement at the last minute (!) thereby making the game a non-cooperative game. Nash Equilibrium exists in such non-cooperative games.

A cooperative game represents the game where players agree to work towards a common goal. It’s like splitting your restaurant bill with your friends. Here the main focus remains on the contribution from each player, like Coalition of Countries to reduce carbon footprint, to stop Global Warming. Shapley value is used in cooperative games instead of Nash Equilibrium. Shapley value distributes the payoff based on the contribution a player makes in the game.

Shapley value simply decides the fairness of payoff for each player in cooperative game whereas Nash equilibrium decides the best decision to maximize the payoff in a non-cooperative game.

“In non-cooperative games there exists an equilibrium at which no side has any rational incentive to change the chosen strategy even after running through all the choices available to the opponent”

In short, Nash Equilibrium is like a law which needs no punishment to enforce to the rational people, because the people understand that breaking that law will not benefit them.

It is like following a traffic signal properly. If all will rush at the crossing all will be late in their journey maybe possible deaths due to accidents. Following the time-based signal will give opportunity to everyone, thereby zeroing the risk of accidents and saving the travel time. (And still some people break the signal, hence the word “rational agent” is of highest importance in Game theory!)

John Nash – a mathematician received Nobel Prize in economics for his work of Nash Equilibrium. The development of mathematical tools further for game theory revolutionized the economics. The movie on his life called “A Beautiful Mind” depicts his original thought process in a beautiful way.

“I can observe the game theory is applied very much in economics. Generally, it would be wise to get into the mathematics as much as seems reasonable because the economists who use more mathematics are somehow more respected than those who use less. That’s the trend.”

– John Forbes Nash Jr.

Assumptions of Game Theory

All players are utility maximizing rational agents that have full information about the games, rules and the outcomes/ payoffs. (So that the mathematical models will fit)
Players are not allowed to communicate – no coalition in a bad way – no collusion- no foul play (hence the reason Governments also establish anti-collusion, antitrust laws, anti-monopoly laws in real world)
Possible outcomes are known in advance and cannot be changed (Deterministic models, hence the reason many equity traders try to find some trends in the equity indices based on certain assumptions)
The number of players can be infinite but most of the games will contextualize in terms of two players only (thereby simplifying the model).

Strategies of Game theory

Pure and mixed strategies:
- PURE- Players follow same strategy in the game- All the companies may increase the product prices of their products to increase the profit. (Actually, it not that simple)
- MIXED- Different players follow different strategy in the game. (One company will try to sell less but expensive units, the another one will try to market the best-in-class after-sales services)
Dominant and dominated strategies:
- A dominant strategy leads to the best of all alternative payoffs
- a dominated strategy leads to the worst of all alternative payoffs
- Say, there are two companies A and B both have two products – consumer and professional. The market has 80 % of consumers and 20 % of professionals. What can A and B do.
- Company A and B both will enter both the consumer and professional market hence each will get 50% of the share from total market (half of consumer i.e., 40% consumer and half of professional i.e., 10% of professional market to each company), thereby maximizing the utility which is Dominant Strategy
- Company A and B both will enter only professional market (which is already 20% of whole market- smaller market share) so both will get only 10% each of the total market thereby getting the least amount of market share which is Dominated strategy
- Only company A can enter in consumer market and company B can enter professional market thus one will get complete consumer market and the another will get complete professional market. Reverse is also possible here.
- The example i) here is called as Strictly Dominant Strategy, example ii) is called as Strictly Dominated strategy.
Maximin strategy – A strategy which will maximize the profit, the utility in the game
Minimax strategy- A strategy which will minimize the loss in the game

Game Theory for Life- The Concept of Finite and Infinite Game

The applications of Game theory are uncountable in real world. The complexity of real-life problems projects an impression as if Game theory has just started developing like a new born baby. The problems Game theory can solve and the promises it provides can add great value to humanity.

In order to understand the depths of the contributions of the Game Theory, we must understand the idea of Finite and Infinite Game.

The finite game has known players, fixed rules, has an end point where there is one winner and there in one loser- a zero sum game. Like the game of chess, the game has two players, all the rules are fixed and cannot be changed by some external influence, either one of the kings gets the checkmate or the match becomes draw- no win or no lose- the game ends.

The infinite game is an eternal game- it goes on. The resources are infinite, the rules keep on changing, the players come and go. The infinite game is similar to what our life is. If one knows how to win an infinite game, then he/she can also win a life.

Simon Sinek has a beautiful book called “The Infinite Game” where he has explained how to win at an infinite game and thereby possibly at life. The insight from the idea of an infinite game is that the main goal of the game is to keep it playing. As the resources are infinite, players are infinite, rules are changeable- there is no endpoint for such game which will justify the worth of the winner. There is no winner.

Most of the games in economics, finance may seem finite games for once but deep down, when explored further are the infinite games, our life is the best example of it. Simon Sinek has given many lectures, talks about the mindset for infinite game which are beautiful. They are beautiful because they reflect the philosophical nature of Game theory and its synergy to human decision making which is not rational all the times. Simon Sinek highlights on five headers while discussing the infinite games.

Just cause- A Specific vision for the future which is yet to exist. It is powerful enough to motivate people, make sacrifice for it.
Trusting teams- Creating room for improvements, improvements will lead to evolution, development. This will truly lift the human spirit. It is about the creation of psychologically safe environment where people can demonstrate who they are and improve over it to last longer in the game.
Worthy rival- As the game is infinite- won’t end, the rival should always inspire one to elevate the game thereby strengthening both the sides. If the rival is not strong- worthy the game will end to some part but still new player will enter and perpetuate the game, thus the sustenance demands worthy rival.
Existential Flexibility- Disruption for more effective development leading to evolution
Courage to lead- Given the uncertainty of the outcome, a risk-taking attitude for the unknown but good future dependent upon the just cause is important to live through the infinite game.

Such ideas given for the infinite game can help build better organizations, better teams, better institutions.

“An infinite mindset embraces abundance whereas a finite mindset operates with a scarcity mentality. In the Infinite Game we accept that “being the best” is a fool’s errand and that multiple players can do well at the same time.”

– Simon Sinek, The Infinite Game

The Game theory itself represents an institution which has proved to become useful in not only economics but also in philosophy of humanity.

(We can deduce the optimal strategy for the engaging phone call game using Game theory. The optimal strategy is to do what both sides were doing before initiating the call. Thus, the one who tried calling first should continue calling whereas the one receiving the call should wait for the call rather than calling back! Please assume the rationality of your friend, willingness of your friend to accept the call, strong signal strength for the game!)

References and Further Readings:

The Infinite Game by Simon Sinek
Ross, Don, “Game Theory”, The Stanford Encyclopedia of Philosophy (Fall 2021 Edition), Edward N. Zalta (ed.)
Game Theory: Definition, Role in Economics, and Examples by investpedia.com
What game theory teaches us about war | Simon Sinek – TED Archive
The Infinite Game for New York Times
Strategic Dominance: A Guide to Dominant and Dominated Strategies by effectivology.com
Photo of Jon von Neumann from Wikimedia and www.lanl.gov
Photo of John Nash from Wikimedia and Peter Badge
Photo of Simon Sinek from Wikimedia
Memes from

Happiness, Inequality and Gini Coefficient

Almost half of the population of the world lives in rural regions and mostly in a state of poverty. Such inequalities in human development have been one of the primary reasons for unrest and, in some parts of the world, even violence.

– Dr. A P J Abdul Kalam

Recently, World Happiness Report for the year of 2022 was released and it was very shocking for many Indians that out of 146 countries surveyed, India stood at the position of 136 in terms of the happiest countries in the world. The countries like Myanmar, Sri Lanka, Pakistan, Yemen have still secured better ranks in terms of the happiness index despite having completely opposite socioeconomic imagery in the world. This was the moment when I understood the importance of the key performance parameters of any country.

India didn’t perform well on the list of happiest countries (actually 11th from bottom). When a child secures lower marks in the class then he/she tries to find the bad things that the class topper shows to explain and convince his/her mind and especially parents. In the same naïve sense, I looked towards the neighboring relatively upper ranking countries which have performed better than India. They are far behind India in terms of economy, social environment, quality of life, per capita income, population of youth. Then I realized the parameters on which this was being ranked. The key factors to decide the happiness were GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity and perception of corruption.

The overall purpose of such socioeconomic surveys and the gap between conclusions drawn from them and the reality people perceive are always good topics for debates, discussions. The World Happiness Report itself is a good example for this. We will see one such simple concept which might give you some insight into the such indicators in the economics.

One of the key factors in deciding the happiness of the nations was the income inequality in the respective countries. Many times, the income inequality has also been linked to the social stability by some psychologist. Jordan Peterson- for example discusses that it is not the countries with less income where the crime rates, riots thereby social instability is high, rather the social instability is high where countries have larger gap between the incomes of poorest of poor and richest of rich. This income inequality and not ‘per capita income’ is strongly linked to the social stability thereby roughly speaking ‘the happiness of people’.

Gini coefficient has explored his domain in a very simple yet effective way, there are some advantages and some disadvantages to it, but it is an interesting concept to understand. When any news articles say that the valley between rich and poor is increasing, they are actually pointing towards the increasing Gini coefficient. You can find the Gini Coefficient for almost all countries on the website of OECD (Organisation for Economic Co-operation and Development).

But, first let us understand Gini Coefficient and Lorenz Curve.

Lorenz Curve

Lorenz curve (Figure 1) is used to graphically represent the distribution of the income within the population. First of all, each member of population is arranged in to the increasing order of income, cumulative income and cumulative member count is considered for the Lorenz curve. The X-axis indicates the cumulative population and Y-axis indicates the cumulative income; it can be taken as percentage also. Lorenz cure will now indicate the fraction of income earned for the respective fraction of population.

What comes after establishing Lorenz Curve is interesting. When we take sum of all the income of nation and divide it by the population earning it, we get average income. But soon it was found that average income is not sufficient enough to compare the economic well-being of any nation.

Let us take an example:

Here we have considered five countries with population of 25 people! (bear with the example for the sake of understanding)

You can see that the average population of each country is 25. By looking at average income of each group one might say that the economic condition of each country is same – that is 4 unit per person, but that might not be the real case. One has to look closely at the data points in each country where importance of Lorenz Curve and Gini Coefficient gets highlighted.

If you compare the incomes in each groups there is specific pattern in the incomes of people. Here, Gini coefficient helps in a better way.

Figure 2. Countries with same average income may not have same income inequality

We need to plot Lorenz curve for each group and segregate the area A and area B as shown in figure 3.

The Gini Coefficient (GC) is defined as follows using Lorenz Curve, here A and B both are areas highlighted in the figure 3:

Figure 3. Area A and Area B from Lorenz Curve for Gini Coefficient calculation

The value of Gini coefficient always lies between 0 to 1. Higher the Gini Coefficient higher is the income inequality.

The lorenz curve and Gini coefficient for our example of Group A, B, C, D, E, F is as given in figure 4.

Figure 4. Lorenz curve and Gini coefficient from data in figure 2

GC=0, Perfect income equality

Now, if one looks at Group A- the income of each member is 4 units thus the Gini coefficient here is 0 indicating the ideal condition of equal income- perfect equality. In reality perfect inequality is not possible as income/wealth is not evenly and exactly distributed all over the nation.

GC=1, Complete income inequality

If one looks at Group F- the average income of the group is still 4 units but the complete income of the group is concentrated to only one person of the group which is the ideal inequality, here the Gini Coefficient is 1 indicating complete income inequality.

These are the ideal condition to compare with the real conditions.

Now let us look at the Groups B, C, D, E. Here, the average income in each group is same as 4 units, but if you start plotting them in the form of Lorenz curve, you will notice the difference in the income distribution throughout each group. The income distribution in each group is not same even though the average income is the same.

If we find the Gini Coefficient for each group, the values are given as GC_B=0.16, GC_C=0.42, GC_D=0.53, GC_E=0.82.

In short, the Gini Coefficient gives much more important information than per capita income.

Poor Countries have Gini Coefficient values scattered all over the range on as low as 0.25 to as high as 0.71. Generally, it is observed from the historical data that the countries with Gini coefficient higher than 0.40 indicate highly socioeconomic instability.

The main advantage of Gini coefficient is that it highlights how much wealth is owned by the fraction of people for a given country.

It is also interesting to notice that the country with rising GDP and rising Gini Coefficient indicate increasing poverty in the country.

Gini coefficient does not consider the size of the economy because all the income and all the population are compressed to the scale of 100% thus any two economies can be easily compared on some common parameters using respective Gini Coefficients.

The main power of Gini Coefficient is that just a simple number can give you the idea of overall income distribution in the country.

There are some ‘lost in the calculation’ details in Gini Coefficient that one needs to understand before commenting on any nation’s economy just by looking at its Gini Coefficient.

It is observed that the countries with relatively larger population and cultural diversity will yield higher Gini Coefficient than its each individual state and relatively smaller coparing countries.

Gini coefficient does not consider the dependence of basic necessities with the income. Some countries have systems like food stamps or food ration which may not be counted as monetary incomes, thus it becomes important to understand the culture and lifestyle, availability of basic facilities while comparing countries based on Gini Coefficients.

The Gini Coefficient will yield different values for the same country if base data varies as income of individual or income of household. As we know, all of the population of the country is not earning population; there are some children, young adults, elders, even young men and women who are not earning population. Hence, it becomes more practical to consider the Gini Coefficient based on the household income and considering the weightage of each family member behind that income. This will give more practical Gini Coefficients. There are three famous ways to calculate Gini based on this idea called as Per Household Member Scale, Modified OECD (Organization for Economic Co-operation and Development) Scale and Square Root Scale.

Per household scale distributes the income of the family equally irrespective of their earning potential and age. Modified OECD Scale distributes the income in the family members as per their earning potential and age- the main earning person will have more weightage that the children dependent on him/her in this scale. Square root scale simply divides the income of family into the square root of family members count. These all scale will yield different Gini Coefficients and are used to derive specific meanings for the economy.

During many studies it is also found that the Gini Coefficients of given group are less sensitive to top 10% and bottom 10% population. Gini coefficients are more sensitive to the middle fraction of populations and wealth associated to it.

Though Gini coefficient has its limitations, but it is still the most simple and effective way to visualize and compare the income/ wealth inequality of any nation.

Economists have attempted to eliminate these limitations by incorporating various other indicators or techniques like Atkins Index, Coefficient of variation, Decile Ratios, Generalized Entropy Index, Kakwani progressivity index, Robin Hood index, Sen poverty measure, proportion of the total income earned.

Featured Image credit- billy cedeno – pixabay.com

Connecting money with sentiments – Behavioral Economics

Behavioral economics established that humans are humans, they have emotions. They make mistakes and misbehave.

Human beings are the epitome of what evolution has done with the earth. Starting from the stone age to the age of AI, we had a long journey of continuous adaptation. The development of various tools like weapons for hunting to the machinery for industrial development to the ginormous simulation engines to simulate space missions are to name the few. The common thing between all these tools is that these tools are made from the resources available around us. From developing the hunting spear from the stone and a stick of a tree to making the computer chips from the silicon from sand and stones, we have mastered the use of resources around us. This became possible only because of the development in our abilities to manage our resources, our techniques of handling the available materials which we can closely connect to economics. Barter system used for trading things, development of metal currency, then paper currency and now the cryptocurrency – the journey is phenomenal. Economics deals with how we manage the resources and we all are clear that these resources have one agreed medium of transaction called currency, money.

Most of the people perceive economics as a boring subject, where you develop some theories and mathematical models to predict money trends. The models may agree with some datasets, may break down at some points implying that the field is full of biases and assumptions which are far away from reality and understanding of common public. There is this joke about economists:

– Why did God create economists?
– In order to make weather forecasters look good.

Though the joke is really good, many great economists have really shaped our perception of money thereby resources and prediction of the interactions on personal, social and global levels. Today we will be discussing one such stream of idea which revolutionized the perception of new economics though the idea was already present deep down in the older and starting ideas of economics and psychology. Before that we will need some foundation to start with.

Classical Economics

Adam Smith also known as father of Economics has this book called “the wealth of nations” responsible for the development of Classical economics. Classical economics has following ideas:

Competitive advantage – success of any industry depends on how efficiently it uses its resources

Free market – defining the prices of goods by negotiation between buyers and sellers in an open platform without any intervention of government and without any monopolies leading to equilibrium between supply and demand thereby establishing fair price

Division of labor– Defining and separation of tasks will lead to specialization thereby leading to the efficient use of resources to optimize people to enhance their skills and economic interdependence.

Then came the Neoclassical economics in 1900s which brought new school of thought which aligns with “the rational behavior theory” stating that people think rationally while making economic decisions. Hence, they are ready to pay the price of a thing/ resource based on the value it brings to them.

In simple words, the classical economics believes that the price of any product is dependent its cost of production. Whereas, neoclassical economics believes that the price of product is dependent upon the utility to the customers not its cost of production.

The conventional nature of economics – the problem

For many years the main idea behind the theories in the economics is that the people are rational while making any decision related to money. Every person exposed to a product/service has well defined preferences and unbiased ideas and expectations. These unbiased ideas make people to choose whatever is the best for them.

These ideas in the conventional economics lead the economists to formulate and study economics mathematically as inspired from the physicists. Physicists theorized an idea and based on the mathematical principles developed models which can predict the nature and behavior of objects- from a ball to the motion of planets around the sun. Hence, in economics you will find many complicated mathematical equations and wild correlations (a correlation is degree of dependence of two datasets). One funny representation is as follows, somebody found out that the there is strong positive correlation between the pool drowning deaths and movie releases of Nicolas cage. So does that mean that people were so fed up with nick’s movies so that they preferred drowning over his films. Definitely No! I am a fan here.

Source: https://www.tylervigen.com/spurious-correlations

Here is one more:

There was this funny correlation that the skirt length was related to the stock market movement called ‘the Hemline theory’. A theory saying that stocks prices move in the same direction as the hemlines of women’s dresses. For example, short skirts (1920s and 1960s) indicating bullish and long skirts (1930s and 1940s) indicating bearish markets.(!)

These are some of the reasons why the economists and their models remained part of funny discussions. This was one of the reasons why many economical models were applicable to limited datasets. The problem is not about the flaws in these ideas, the problem is that many big financial, political, life altering decisions were made based on such theories and models.

I mean these models were not completely wrong; nothing is perfect, there is always room for improvement.

Quest for establishing the correlation between human behavior and economic theories-

When economists were in the establishment of mathematical foundations of the subject causing their economics to reflect the equations and theorems, the psychologist directed their studies more towards experimental approach for the development of psychology. Their theories were more of verbal and theme based, that is also the reason why you can find psychology as a set of vocabulary itself.

Psychologists in some sense developed the ideas about how we interact with others and materials, resources around us. What affects out decision making when we interact with each other and things in our surroundings.

Some of the famous Psychologist had already tried to establish the connection between the ‘machine-like’ economic theories which strictly followed some equations and the real emotions, sentiments that make these economic models unfit with the reality. Their ideas helped us to find the reason why money does not strictly follow the strict optimized and high output giving trends. The reason does not lie in the money, it lies in the nature/ sentiments of the people who drive the money, the people who sometimes choose other things over money.

Richard Thaler, Daniel Kahneman, Amos Tversky, George Katona, Herbert A. Simon these are some of the notable names which have strongly influenced the ideas of behavioral economics.

The dawn (rather awakening) of the behavioral economics

The basic idea of behavioral economics establishes that we humans make mistakes and most of our decisions are emotion and influence driven. People are not always rational. After are we are humans. Humans are flawed (!) hence don’t follow machine-like strategies. People love to mis-behave; they love breaking the rules.

Expected utility and Prospect theory-

According to expected utility theory in conventional economics, people will choose gambles which give highest outputs whatever may be at stakes. It says that, people take money related decisions based on the maximum future value it will bring to them, whatever will be the conditions. It’s like a person buying a lottery ticket.

If a person buys a $1,000 lottery ticket with $10 and the probability of winning is 10% then he thinks that the utility or value it will bring to him will be $1000 x 10/100=$100.

But you know how lotteries work. If the same ticket has winning probability of 0.5% the expected value becomes $1,000 x 0.5/100=$1,000 x 5/1000= $5, which is already less than the money it takes to buy that ticket. Here the expected utility is far less so the person won’t buy the ticket.

The value of the lottery ticket became high due to the higher winning probabilities as the expected utility of that ticket is $200 over ticket price of $10.

In simple words, expected utility theory says that people take the chances and decide the value based on the its probability. More the probability of winning more it will be favored.

Kahneman and Tversky created ‘Prospect theory‘ which challenges the Expected utility theory. According to prospect theory it is not just about more probability and less probability of winning, it is also about the situation in which decision maker is; this called as a reference point. Other than winning or losing, a new condition is created which we can call as a reference condition. If the same lottery buying person is given the choice of

A. Getting $100 immediately

B. Having 10% chance of winning the same $1000 thereby 90% chance of gaining nothing

The same person will choose to get $100 immediately and walk off. Here the person did not choose the expected value of $100 rather, the person chose the instant benefit that he got, the person saw less risk in option A although the person may have won $1000 from the lottery, but chose to avoid the risk.

This is also famously known as ‘Loss Aversion’.

In simple words, losing $100 hurts more than winning $100. We as a human always try to avoid higher risks options and make ourselves safer. We always try to make the decisions closer to the reference points created by out experiences, assumptions. We try to “break even”.

Exponential discounting and hyperbolic discounting

According to exponential discounting (in classical economics), the value of any gain declines equally with time period it is delayed.

Here are two cases:

P. Getting $100 today over getting $110 after a week

Q. Getting $100 in 10 weeks or getting $110 in 11 weeks

A rational person will behave like an adult and will chose to wait for 7 days to get $10 more- just like a sincere (!) person. Whatever is the case- either P or Q the wait is same (waiting for 7 days) and gain is same (gain of extra $10) both the Case P and Case Q have same discounting rates, same rate of losing the value. This is exponential discounting

But what would you have done when provided with case P and case Q?

Behavioral studies show that people always go for instant benefit and chose $100 today in case Q whereas they are also ready to wait for one extra week if they are provided with only second case (Q) where the time-frame of gain is expanded. Means, people are selfish! They want this and that too. We always seek immediate rewards, instant gratification. No doubt social media is the living proof of this.

Social Preferences

The behavioral economics says that people not only just care about what they are getting, they also care about what they are getting compared to others. (That might be the reason, your HR department instructs you not to ask for the salary details of your subordinates, colleagues, seniors!)

Consider a game where one person out of two people is said to divide $100 between them and they both will get those $100 if and only if the second person agrees to whatever share she/he receives otherwise, they both won’t receive anything. The rational choice for the second person is to accept whatever she/he would receive. Whether she/he gets $1 that too is acceptable because she/he had nothing ($0) before. Having something should be better than having nothing.

But in reality, and discovered from real life observations- people always try to reason with overall situations. People compare their gains with the gains of others, thus the above said second person in reality will only agree only if they both break even otherwise, she/he won’t accept the offer knowing that they both won’t get the money. This is really observed in studies and is funny.

Conventional economics considers people as a rational choice making machine. They always know what they are doing. It’s like for every human being is an economic optimization machine what economists call ‘Homo economicus’. Here people always make rational decisions, thus follow specific mathematical models based on a set of variables. Also, there is one idea called Becker conjecture which says that the people in the top management (politicians, leaders, chief directors, executives) always know what they are doing, they are always accurate on the probabilities of the outcomes. They always behave optimally.

In contrast, Behavioral economics established that humans are humans, they have emotions. They make mistakes and misbehave. They are not ‘Homo economicus’ implied as always thriving for optimizations. They are humans – ‘Homo sapiens’ implied as imperfect and prone to mistakes. There is no such human behavior where everything will cause to balance leading to establish equilibrium. There is always evolution when it comes to being human. They learn from their mistakes change themselves, adapt and evolve instead of being stagnant as in equilibrium.

(There are many interesting concepts in Behavioral economics like impact of Game theory, Supposedly Irrelevant Factors (SIFs), Difference between Equilibrium and Evolution, Roots of Behavioral economics in Classical economics, the endowment effect, social utility and those will be the topics for another day!)

References and further reading:

Misbehaving: the making of behavioral economics by John F Chaves (Psychiatry)
Behavioral Economics: Past, Present and Future by Richard Thaler (American Economic Reveiw)
Behavioral economics: Reunifying psychology and economics by Colin Camerer (Proceedings of the National Academy of Sciences (PNAS))
Behavioral Economics Comes of Age: A Review Essay on “Advances in Behavioral Economics” by Wolfgang Pesendorfer (Journal of Economic Literature)
Adam Smith– Wikipedia
Richard Thaler– Wikipedia
Daniel Kahneman– Wikipedia
Amos Tversky– Wikipedia
George Katona– Wikipedia
Herbert A. Simon– Wikipedia

PS: One should really try to compare the concepts discussed here with the characters Walter White (As Classical economics) and Jesse Pinkman (As Behavioral economics) from Breaking Bad. You will get the idea, plus it will be fun!

Daniel Kahneman and Amos Tversky’s Prospect theory in economics

Expected Utility Theory

Prospect Theory

Certainty effect

Reflection Effect

Isolation effect

Conclusion

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EXPECTED UTILITY THEORY

Expected Utility Theory (EUT) in Economics

Origin – St. Petersburg Paradox

1st Tenet of EUT: Expectation

Four Axioms of Utility Theory

2nd Tenet of Expected Utility Theory: Asset Integration

3rd Tenet of Expected Utility Theory: Risk

Marginal Utility

EUT in actuarial

Conclusion:

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Turning Points – Remembering Dr. APJ Abdul Kalam’s legacy on his birthday

The Modern India

Appointment in ICSR – Indian Committee for Space Research (ICSR later became ISRO – Indian Space Research Organization)

Appointment in DRDO missile program

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Paying close attention to the larger fraction of the poor entrepreneurs

Monthly Revenue of a ‘Chai-wala’

The Reality of Entrepreneurship Around the World

Poor Entrepreneurs

Ingenuity of the Poor Entrepreneurs

Representation of the Poverty

Asking the Right Questions

The Big Gap to Fill

Conclusion

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“Game theory is the study of mathematical models of strategic interactions among rational agents.”

Basic Definitions in Game Theory

A rational agent always tries to maximize its utility.

The Prisoner’s Dilemma

The Nash Equilibrium

Assumptions of Game Theory

Strategies of Game theory

Game Theory for Life- The Concept of Finite and Infinite Game

You can share this:

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– Why did God create economists?– In order to make weather forecasters look good.

Classical Economics

The conventional nature of economics – the problem

Quest for establishing the correlation between human behavior and economic theories-

The dawn (rather awakening) of the behavioral economics

PS: One should really try to compare the concepts discussed here with the characters Walter White (As Classical economics) and Jesse Pinkman (As Behavioral economics) from Breaking Bad. You will get the idea, plus it will be fun!

You can share this:

1^st Tenet of EUT: Expectation

2^nd Tenet of Expected Utility Theory: Asset Integration

3^rd Tenet of Expected Utility Theory: Risk

– Why did God create economists?
– In order to make weather forecasters look good.