Thursday, March 31, 2016

Car Shopping, Part II

Last post talked about the fast, intuitive, heuristic-driven system 1 and the slow, methodical, rational system 2 in car shopping. Marketers know this; just look at their ads:
Why do car ads look like this?
... but not like this?
The previous post explains that system 1 usually makes the real decisions. The first picture above is aimed at system 1; it's targeting the real decision-maker. System 2 may find the second picture more helpful for comparing options, but system 2 isn't the real decision maker; it mostly just rationalizes the system 1 decision.

So we know system 1 is the key to purchase decisions. But how does system 1 make its choice?

It all starts with identity. Identity is the script which our characters follow in the story of our own lives. It's how we see and understand ourselves; it underlies every interaction with those around us. When we think of ourselves as careful, ambitious, adventurous, diligent, humble, faithful, caring, assertive, witty, or honest, we think of our identity. When Buzzfeed asks "Which superhero are you?", the quiz both feeds and explores our identity. Do you see yourself as a loving parent? Diligent student? Rebelious rocker? Mysterious old man? Metaphorical chessmaster? The hero? The anti-hero? Character archetypes aren't just about fiction. They underlie our own identities, helping us to characterize and understand the world around us and our place in it.

It should be no surprise that the mid-life crisis car is driven by identity.
Obvious example is obvious.
But it's not just the mid-life crisis car. The baby mobile is just as much about identity. Even if a particular sports car were statistically safer than any minivan out there, new parents would still buy minivans. Why? Because the minivan is built into our culture as a car for parents. When people identify as parents, that identity drives them toward the sort of cars they imagine parents buy, like minivans. 
Is this example too subtle?
What about the environmentally friendly car? A bit of research will tell you that the environmental friendliness of a prius is pretty questionable. But it's not really about the environment; it's about a person's identity as an environmentally-conscientious person. It's about signalling that identity both to oneself and the rest of the world. And yeah, the gas mileage is nice, but that's not what drives the system 1 gut response. Good gas mileage is how system 2 rationalizes the decision.
Is it green? Yes. Yes it is.
Signalling and identity go hand-in-hand. People often think of signalling in terms of status, but it's not just about money or power. Signalling applies much more broadly, to group membership or personal identity. It's about how you see yourself and how you want to be seen. It's about what your car says about you. Trying to bring back some adventure after a mid-life crisis? Want to show your parental commitment? Want to demonstrate your concern for the environment? On some level, every car is an identity signal.

Human brains have evolved to be really good at identity, to the point that most of it is subconscious. System 1 handles it. We don't see a minivan and think for a minute "hmmm, lots of space, sliding doors... this must be a car for parents and kids". No. The connection is instant and intuitive. In the time it takes to make the connection, a connection is also made to our own identity, asking "Do I fit this profile?". The decision to buy, or not to buy, or to at least add it to the list, happens largely in that short span of time. Long before we finish comparing options and trim levels, considering the price vs mileage tradeoff... system 1 has decided. System 1 has decided not based on statistics and features, but based on what best fits our own identity. It's about what feels like something someone would buy, if they were the sort of person we see in ourselves. Just like trying on new clothes means trying on a new identity, buying a new car means buying a new identity.

Tuesday, March 29, 2016

Car Shopping, Part 1

Let's start with the shameless plug: I'm a data scientist at a zero-inventory car dealership called carlypso. I spend a lot of time thinking about how people buy cars.

I also spend a lot of time thinking about behavioral economics and cognition. So when I think about how people buy cars, I start by completely ignoring what people SAY goes into car buying, and instead pay attention to their behavior and the underlying processes this behavior suggests. This post is about those underlying processes.

Let's imagine someone buying a car. Car buying is a big purchase, so most buyers do a lot of research. Presumably they compare different makes, models, trim packages, option packages, colors, new vs used, mileage, warranty, safety, trunk space, seating, gas mileage, and of course price. They make a short list, compare trade-offs, test drive, and eventually make a decision. Right?

Well... not really. Yes, all of that stuff happens. But that's just the most visible part of the process. One of the big lessons of the psychology of decision-making is that you usually need to look past the surface. Tversky (one of the two fathers of behavioral economics) provides a good example.
"Over the past few years, we have discreetly approached colleagues faced with a choice between job offers, and asked them to estimate the probability that they will choose one job over another.  The average confidence in the predicted choice was a modest 66%, but only 1 of the 24 respondents chose the option to which he or she initially assigned a lower probability, yielding an overall accuracy rate of 96%."
       —Dale Griffin and Amos Tversky, "The Weighing of Evidence and the Determinants of Confidence."  (Cognitive Psychology, 24, pp. 411-435.)
Think about that for a moment. A decision as big as a new job, everybody spends some time researching and carefully considering the decision. But for all that careful consideration... 23 out of 24 people went with the option they leaned toward originally. Apparently all that "research" and "careful consideration" didn't actually have much impact on the final decision. The real decision was actually made much earlier.

To explain this, we need a bit of jargon. Decision-making psychology talks about "system 1", which makes fast intuitive judgements, and "system 2", which makes slow, rational judgements. Within any individual person, both systems operate in parallel. In examples like Tversky's, system 1 has already decided. Once system 1 has decided, a host of cognitive biases steer system 2 toward the same conclusion. Even though it looks and even feels like the decision hasn't been made yet, most people will spend more time looking for evidence which supports their system 1 decision, and be more skeptical of evidence which opposes their system 1 decision. As a result, the real decision is usually made by system 1. System 2's de-facto job is to rationalize it. (This process is a major theme in a 2011 best-seller by Kahneman, the other father of behavioral economics.)

Time to take it back to cars. Tversky's job-decision example seems like a pretty direct analogy. Find 24 friends who are "deciding" on a car, and ask them what they're currently leaning toward. I bet that at least 22 times out of 24, they'll go with the same car they were still "deciding" on, from the same dealer they were still "deciding" on. Seem like a good bet?

There's a weird thing with SUVs. Ask people why they like SUVs, and one of the most common answers is "safety". Statistically, this is hogwash. The risk of rollover in an SUV is so dramatically higher than other vehicles that it makes them much more dangerous. But statistics are system 2 thinking. What about system 1? Do SUVs *feel* safer? Yes. They feel big, and tall, and durable. They feel like if there's an accident, it's the SUV that'll survive. Whether or not that's true is irrelevant. It feels safe, which is what appeals to system 1.

That doesn't mean system 1 is always wrong, though. Quite the opposite. The whole point of system 1 is that it uses heuristics which usually work well for quick judgements. The point is that people don't update those judgements much when new information comes along.

Let's look at some pictures.

Stealth IAT

Assume these two jeeps are the same year/make/model/trim, same options, same mileage, etc. They're the same price. Which one would you want? Go ahead and think about it for a second. But don't think too hard.

Ok, now what if I tell you that the car on the top needs a $3000 timing chain replacement? Think about that for a minute. How does that update your estimate? First car, or second? How much money difference is there?

Some of you are probably thinking "hmm, $3000 is a lot, but that second car obviously needs 4 new tires and probably a battery and maybe a tow and who knows what else...". Maybe you came up with a whole list of things that might be wrong with the second car, considering what's visible. But I bet you didn't stop to think what else might be wrong with a car that needs a timing chain replacement.

This is classic confirmation bias - system 1 has decided, so system 2 goes looking for reasons to support the original decision... but it doesn't do a good job looking for reasons NOT to support the decision. This is the biggest single mechanism which makes system 1 decisions so important.

At carlypso, I hear the struggle between system 1 and system 2 all the time as salespeople talk to customers. Sometimes, a customer's system 1 doesn't want to buy from us. The purchase makes sense rationally, but the customer's gut says no. The poor salesperson sits there spouting all sorts of facts and arguments and explaining why it really does make sense... but they're fighting an uphill battle. System 1 doesn't like it, so system 2 discounts all these nice reasons and generates counter-arguments, and it just goes into a drawn-out "grind", as the salespeople call it.

But other times, a customer's system 1 does want to buy from us. Those are the easy sales. Even if they want a really specific car and it's tough to get exactly the right one at a good price, those are the good cases. The customer wants to buy the car; all we need to do is help their system 2 to rationalize it.

This post has mostly explained that system 1 is the real decider, and system 2 usually rationalizes system 1's decision. Next post will lay out my current thinking on how system 1 chooses a car.

Saturday, March 26, 2016

Theory of Extreme Wealth

Most people operate in reasonably efficient labor markets, the sort you might learn about in econ 101. There's a range of incomes, and the range is governed mostly by supply and demand. Basic manual labor has the highest supply and the lowest price. Work requiring more skill or education commands steadily higher prices. Both supply and demand are abundant enough that markets are liquid, and employer-employee relationships are reasonably fluid.

This realm of "ordinary" earnings does a good job up to the upper middle class, somewhere on the order of $100k annual earnings. Doctors have the highest earnings within the ordinary realm, thanks to very limited supply and very large demand. Similarly, engineers, statisticians, programmers, and other technical occupations command relatively high prices within the ordinary realm. But all of these occupations have an earnings cap, of sorts. Doctors or engineers rarely make more than $200k/yr unless they move into management or entrepreneurship.

Beyond the realm of ordinary income, typical market behavior starts to break down. For entrepreneurs or upper management of large companies, there is no simple market. What is the "demand" for entrepreneurs? What is the "supply" for upper management? In either case, we could try to define some rough measure of supply and demand, but there is certainly no efficient, liquid market for such occupations. Understanding higher levels of wealth requires venturing beyond econ 101 and into game theory. So how can we more effectively understand income at the extreme upper end of the spectrum?

What do all of the following have in common?
    - Upper management
    - Entrepreneurs
    - Investment bankers
    - M&A lawyers (mergers and acquisitions)
    - Real estate developers
    - Lobbyists
    - ...
Obviously, these are jobs with at least the potential for high wealth and status. But what unifies them from a game theoretic perspective?

All of these occupations solve "coordination games". These are problems in which everyone involved can gain by following some plan, but only if everyone else follows it too. Real estate developers are a good example. Future tenants are happy to commit if they know the building will actually be built, builders and architects will commit if the project is funded, bankers will provide funding if future tenants are lined up, and a handful of other parties are also involved. The real estate developer plays the role of coordinator, getting everyone on the same page so that the new building actually gets built.

Similar stories apply to managers, entrepreneurs, investment bankers, etc. Even within these occupations, larger and more complex coordination problems typically correspond to higher pay. Upper management and entrepreneurs tend to make more money at companies with more employees and more complex business relationships. IPOs, for instance, significantly increase coordination complexity, since managers must coordinate stockholders and the board. Pay for managers at public companies is correspondingly higher. Similar coordination complexity applies in a merger or acquisition, with corresponding large bonuses for the parties involved. Same for real estate developers, for whom larger projects mean more buyers, builders, bankers, and regulators. Same for lobbyists, for whom larger projects mean more lawmakers and bureaucrats spanning multiple departments.

Coordination also serves as an interesting delineator of class. Upper management, investment bankers, large entrepreneurs, etc. are all typical occupations of America's elites. As Michael Church has posited, the elite class is characterized largely by their social networks (original source is gone, but you can read a bit at SSC). The main asset of a labor-class person is their skills and physical output, the main asset of a gentry-class person is their education and ideas, and the main asset of an elite-class person is their network. But why is an elite's network so important? Picture it. An investment banker is trying to arrange a merger deal between two companies. Coordinating the two is a lot easier if the banker already knows at least some key people in both companies. The more people they know, and the closer those people are, the easier it is to coordinate. If your main business is solving coordination games, then being friends with the people you need to coordinate makes the job a lot easier. Coordination problems are the reason why elite networks matter in the first place.

The moral of the story is that, if you're after extreme wealth, "networking" is important but not the main goal. Rather, the goal is to solve big, complicated, highly lucrative coordination problems, and knowing the right people is often a useful means to that ends.