An example of behavioral economics: the so-called Tom Sawyer effect

On many occasions, in economic analysis the psychological factor is overlooked. And it shouldn’t be that way, as the Stock market reactions to announcements of interest rate hikes or cuts.

In the study Tom Sawyer and the Construction of Value, available on the Boston Fed website, several experiments are explained that can be related to the branch of economics called behavioral economics.

Behavioral economics or behavioral economics is the study of how people psychological, social or cognitive factors affect the economic decisions of individuals.

Combines economics with psychology to study what happens in the markets and analyze people’s behavior, their limitations and the problems derived from these limitations. In contrast to classical economic theory, he defends the irrationality of economic agents when making financial decisions.

Although it has been something very studied in the financial markets, it did not receive an “official” accolade until 2017, when the Nobel Prize was awarded to Richard H. Thaler, one of the maximum exponents of this current.

An experiment

In the study cited above, the following experiment comes out: a teacher tells his class that he will read a poem for 15 minutes. Then he separates the class into 2 groups without contact between them and asks the following questions to each group:

Group 1: “Who is willing to pay $ 2 to listen to me?” Group 2: “Who would be willing for me to pay him 2 dollars in exchange for listening to me?”

The answer they give is logical. In group 1, only 3% would agree to pay those 2 dollars. In group 2, 59% are willing to charge $ 2.

So far everything is very normal, but the teacher then tells each group that the audition will be free and asks: “How many, knowing this condition that I neither charge nor pay for listening to me, are you willing to listen to the reading?”

The logical thing would be that approximately the same number of students in group 1 as in group 2, would be willing to hear the poem but this is not what the results reflect.

35% of the students in the group who had previously been asked for money to listen to the reading, will go to the free audition. But only 8%! of the group of those who believed they were going to charge is willing.

The Tom Sawyer effect

In the book of Mark Twain Tom Sawyer’s adventures, Tom is commissioned to paint a fence, something he hates to do. However, when a certain Ben passes by and becomes interested in what he is doing, he pretends that he cannot let anyone help him, that he is afraid of being punished if he does not do it right.

In the end, not just Ben, but many more, end up painting the fence and even paying Tom to let them do it. In this way, the same act, depending on how it is sold, can cause sadness or joy, harm or benefit.

They call this in the studio tom swayer effect. And what happened in the experiment of reading the poem? That the initial question had conditioned the human mind.

Those in group 1 had a very different concept of the value of reading the poem than those in group 2. For the former, reading is worth more because they go from having to pay for it to being free.

But for the seconds it is the other way around. From getting paid to listen to the poem to not doing it. Thus, accessing it for free supposes a loss of value in their mind, when reading should have the same value for all.

This different valuation that the human being makes of the same data depending on the information that they have provided us before has many readings applicable to financial markets.

This is especially important when you go out a data (be it the CPI or Apple’s results), which will be considered good or bad plus based on expectations than by the value of the data itself.

As the markets are so interrelated and all have the same data provided by the same information providers consulting the same analystsThis effect, already well known, can even lead us to mistrust the consensus prior to the news.

A close example

When in August the Fed minutes, it was learned that at the July meeting a majority of Fed members supported stopping monetary stimulus. Stock market reaction was downward.

A few days later in Jackson Hole, Powell said it was too early to talk about rate hikes, that inflation was temporary, and he said that the reduction in asset purchases would be at the end of the year. Stock markets reacted higher.

In the end, the day came to announce the reduction of monetary stimuli, a few dates ago. It brought stock markets down in August, but added something that was very popular: that it did not mean that interest rates were going to rise. And the reaction of the bags, which were at prices much higher than those of August, was to go to all-time highs.

The same news that when it happens, goes from being negative to positive. Of course the tom sawyer effect It happens in many other facets of life not related to financial markets, but … I will not put more examples.

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