Take This Little Quiz on Economics Decision Making

1. A bat and a ball cost $1.10 in total.  The bat costs $1.00 more than the ball.  How much does the ball cost?
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake, there is a patch of lilypads.  Everyday, the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

This is a short test, called the Cognitive Reflection Test (CRT), developed by Shane Frederick, Assistant Professor of Management Science at Sloan School of Management, MIT.  These questions test a certain type of intelligence, what Sloan calls, "cognitive intelligence."  Each of the questons has an intuitive, albiet wrong, answer, and of course a right answer.  Do you think you got them all right? 

Is cognitive intelligence important?  Well, research shows that those with a higher level of cognitive intelligence live longer, earn more, have larger working memories, faster reaction times and are more susceptible to visual illusions.

If you have been reading this blog, you know that Behavior Economics is one of my particular interests.  I referenced it in The Psychology Behind Income Tax Refunds, and Bad Decisions in Deal or No Deal.  This was especially interesting to me because the CRT was found to have a surprisingly high correlation between individuals ability evaluate risk in decision making, and to recognize the time value of money.  Unfortunately for America's youth, most respondents did not fare well on this test.  The mean score was only 1.24 correct, with 33% getting zero right, and only 17% aceing the test.  MIT students did best, but the study does not indicate how many may have been students of Professor Frederick.  They scored a mean of 2.18, with only 7% flunking.  Because there are only three questions a "low" score is a zero, and a "high" score is perfect.  One or two correct is merely average.

They asked some follow up questions to demonstrate how a high CRT scorer makes better overall decisions.  How would you answer this one?  Would you like $3400 this month or $3800 next month?  Well, if you have credit cards with high rates to payoff, you may think that the time value works in favor of having the money now, right?  Well, not unless Visa is charging you 150% and knocking on your door with a baseball bat in hand.  The $400 lost by taking the money now represents a one month 12% return, or 141.2% annually.  60% of High CRT scorers took the $3800, while only 35% of low scorers prefered to wait a month.

Another question is a little bit tougher.  Would you rather have $100 now or $20 every year for 7 years?  28% of low scorers took the $100, while 43% of high scorers took the payments.  The "correct" answer is less clear.  The Net Present Value of the $20 payments of the next seven years is equal to $100 at an assumed rate of 9.2%.  Could you take the $100 today and earn better than 9.2% on it?  Quite possibly.  One thing we certainly learn.  The high scorers are more patient.

The CRT also seems to be a strong indicator in deciding whether a gamble was worthy or unworthy.  For example, when asked if they would take $100 for certain or take a 50% chance at $300.  This should be simple.  The expected return is an easy calculation.  $100 times 100% equals $100 expected return.  $300 times 50% equals a $150 expected return.  You should take the gamble.  Well, 75% of high CRTs flip the coin, while only 47% of low CRTs do so.  But, I want to know that I am getting paid.  I may have a higher expection by flipping the coin, but I sure could use the hundred bucks.  True, and an important concept when dealing with real life versus the hypothetical.  However, it doesn't seem to be the certainty of gain or the probabilities that are driving low CRT scorer's decision making.

A basic tenet of Behavioral Economics is a concept called Loss Aversion.  Simply, losing money feels more badly than winning money feels good.  Let's take the same question as before, but turn it upside down.  Your choice is now whether you would like to lose $100 for sure, or take a 50% chance of losing $300.  The math is the same.  The expected returns are negative $100 for the no coin flip option, and negative $150 for the coin flip.  So, math tells us to fork over the hundred bucks and call it a day.  Well, Low CRTs took the gamble at a rate of 61%, while high CRTs only did so 55% of the time.  Not a big margin, but it demonstrates that it was not the certainty that was the important factor the the low CRTs.  They chose the wrong mathematical option both times, and once it was the certain the other it was the gamble.

The correct answers to the questions at the beginning are: 1) 5 cents, 2) five minutes, 3) 47 days.  Did you answer 1) 10 cents, 2) 100 minutes, 3) 24 days?  If so, go back and reread the questions.

You can read the entire report at http://mit.edu/people/shanefre/CRT.pdf

Comments

[frankyj]

That was in smart money magazine. I initally only got number 3 right on the first try. Oops.
Try this game:
- pay me $10, flip a coin and if you win I'll pay you $100.
Would you play? Most people are like, sure.

- pay me $100,000, flip a coin and if you win I'll pay you $1,000,000.
Would you play? Most people say, hell no.

Same relative magnitude, same probability, but different answers.

[lamoneyguy]

That's an interesting one Frank. I believe it is a problem of Cognitive Framing. But I'm not an expert, so I could be wrong. The real problem is that most people don't have $100k. It's also why I think Deal or No Deal contestants should often take the deal, even when the offer is below the expected value calculations. It always is. Now change your problem to take away the loss aversion.

I give you $10 or a coin flip for $100. People would flip the coin. I give you $100k, or flip for $1mil. Many would take the 100k. Although if you made the expected values closer it would be more interesting. For example, I give you $35 or flip for $100, most would still flip. I give you $350k or flip for $1mil. Overwhelmingly, most would take the $350k. And I wouldn't argue with them. $350k is life changing. $35 is not.

[MoneyDummy]

Since I got them all right, I'm going to claim infallability whenever financial decisions need to be made. *Evil laugh*