The maths behind gut decisions

First carefully weigh up the costs and benefits and then make a rational decision. This may be the way we want it to be. But in reality, invisible emotions, experiences, prejudices and even altruisms also influence our decisions.

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In a nutshell

Human decision-making behaviour is far more complex than the traditional economic model of homo economicus, the benefit maximiser, suggests. Who would have thought, for example, that people who are able to determine their own salary do not in fact pay themselves the maximum but a rather moderate amount? That television affects our choice of junior staff or our income and consumption requirements? Or that people with an economic background actually behave differently when making financial decisions? Behavioural economists at the Halle Institute for Economic Research (IWH) are investigating what such irrational factors mean for a society's economic processes, using the (social) psychology toolbox and devising experiments and studies to identify and close the gaps in the homo economicus model.

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The world of work is one area where such deviations from the benefit-maximising ideal image are the rule rather than the exception. Companies need productive staff to be successful. In order to maintain or even improve this productivity, however, it is not enough for a firm to focus solely on the remuneration of its workforce according to the motto: the more, the better. Other factors, such as meaningful work or the feeling of being treated fairly, also affect workforce productivity levels.

For example, if employees learn at a later, that a task they have already performed was meaningless, they will make less of an effort with future work. This means that meaningless work not only evokes negative emotions at the time, such as disappointment and replaceability, but also influences future motivation, as IWH behavioural economist, Sabrina Jeworrek and her co-authors discovered with the help of a large-scale experiment. This discovery should not be confused with another, however: employees also definitely want information about their companies' setbacks. If, for example, a campaign has failed in the past, it makes sense to inform the workforce of this and not to conceal this fact. As employees will not be demotivated by this setback, as you might expect – on the contrary. They will try harder next time if they are able to regard the task as a meaningful challenge.
In another study, Jeworrek discovered that employees are less productive if they believe that their employer is treating their colleagues unfairly – even if they themselves are unaffected by this. For this experiment, 195 test subjects were hired for two assignments in a call centre. A section of the workforce was arbitrarily dismissed on grounds of cost savings. "We wanted the situation to be as anti-social and unfair as possible," says Jeworrek. And not only did productivity fall, the test subjects also took longer breaks and left work earlier.

The self-employed do not have the problem of colleagues being unfairly treated. Nevertheless,their behaviour is also affected by hidden factors. Whether they are gripped by entrepreneurial spirit also depends on which TV programmes they watched in their youth, for example. Or whether they have sufficient financial market knowledge. You see,econometric findings suggest that greater financial literacy leads to increased self-employment. So, if politicians want more entrepreneurial activity in Germany, the prevalence of positive role models, the inclusion of a basic grasp of economics in the curriculum and financial information would be a major starting point. As soon as a person becomes self-employed, their character also changes: if a person is self-employed they are more willing to take risks – and also more likely to remain self-employed.

And even the unemployed are influenced by context: IWH economist Steffen Müller discovered that parental unemployment affects children, for example. What is particularly interesting is that boys and girls react differently to parental unemployment. If their father was unemployed, both sons and daughters are more likely to be unemployed in future, but daughters experience a counter-reaction that sons do not: they invest more in their education.

Regardless of whether a person is employed, self-employed or unemployed, their subjective wellbeing heavily depends on how they perceive their position within their social group. This can also affect basic personal attitudes, for example, towards foreigners: if a person compares their income with that of their friends and feels financially inferior, this will have a negative impact on their sympathy towards foreigners – even if this person is actually a higher-earner.

People do not always act and make decisions rationally; they are fallible. Subconscious factors determine the direction of our decisions, and many of these factors are beyond our control. However, being aware of the mechanisms behind this can help us to understand people and their role in the economy, identifying and promoting their potential.

Publications on "Behaviour"

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Do Banks Value Borrowers' Environmental Record? Evidence from Financial Contracts

I-Ju Chen Iftekhar Hasan Chih-Yung Lin Tra Ngoc Vy Nguyen

in: Journal of Business Ethics, forthcoming

Abstract

Banks play a unique role in society. They not only maximize profits but also consider the interests of stakeholders. We investigate whether banks consider firms’ pollution records in their lending decisions. The evidence shows that banks offer significantly higher loan spreads, higher total borrowing costs, shorter loan maturities, and greater collateral to firms with higher levels of chemical pollution. The costly effects are stronger for borrowers with greater risk and weaker corporate governance. Further, the results show that banks with higher social responsibility account for their borrowers’ environmental performance and charge higher loan spreads to those with poor performance. These results support the idea that banks with higher social responsibility can promote the practice of business ethics in firms.

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Firm Social Networks, Trust, and Security Issuances

Ming Fang Iftekhar Hasan Zenu Sharma An Yan

in: European Journal of Finance, forthcoming

Abstract

We observe that public firms are more likely to issue seasoned stocks rather than bonds when theirs boards are more socially-connected. These connected issuers experience better announcement-period stock returns and attract more institutional investors. This social-connection effect is stronger for firms with severe information asymmetry, higher risk of being undersubscribed, and more visible to investors. Our conjecture is this social-network effect is driven by trust in issuing firms. Given stocks are more sensitive to trust, these trusted firms are more likely to issue stocks than bonds. Trustworthiness plays an important role in firms’ security issuances in capital markets.

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Gender, Credit, and Firm Outcomes

Manthos D. Delis Iftekhar Hasan Maria Iosifidi Steven Ongena

in: Journal of Financial and Quantitative Analysis, forthcoming

Abstract

Small and micro enterprises are usually majority-owned by entrepreneurs. Using a unique sample of loan applications from such firms, we study the role of owners’ gender in bank credit decisions and post-credit-decision firm outcomes. We find that, ceteris paribus, female entrepreneurs are more prudent loan applicants than are males, since they are less likely to apply for credit or to default after loan origination. The relatively more aggressive behavior of male applicants pays off, however, in terms of higher average firm performance after loan origination.

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Social Capital, Trusting, and Trustworthiness: Evidence from Peer-to-Peer Lending

Iftekhar Hasan Qing He Haitian Lu

in: Journal of Financial and Quantitative Analysis, forthcoming

Abstract

How does social capital affect trust? Evidence from a Chinese peer-to-peer lending platform shows regional social capital affects the trustee’s trustworthiness and the trustor’s trust propensity. Ceteris paribus, borrowers from higher social capital regions receive larger bid from individual lenders, have higher funding success, larger loan size, and lower default rates, especially for low-quality borrowers. Lenders from higher social capital regions take higher risks and have higher default rates, especially for inexperienced lenders. Cross-regional transactions are most (least) likely to be realized between parties from high (low) social capital regions.

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CEO Network Centrality and the Likelihood of Financial Reporting Fraud

Salim Chahine Yiwei Fang Iftekhar Hasan Mohamad Mazboudi

in: Abacus, forthcoming

Abstract

This paper investigates the association between CEO’s relative position in the social network and the likelihood of being involved in corporate fraud. Tracing a large sample of US publicly listed firms, we find that CEO network centrality is inversely related to the likelihood of fraudulent financial reporting. We also document a significant spillover effect of financial reporting behaviour from the dominant (most central) CEO to other CEOs in the same social network, suggesting that the ethical corporate behaviour of CEOs is, on average, influenced by that of their dominant CEO in the network. We further find that the role of CEO network centrality in reducing fraud risk is more prominent in firms with lower auditor quality. Overall, our results suggest that network centrality is an important CEO trait that promotes ethical financial reporting behaviour within social networks.

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