Other People’s Heads
Diego Gambetta, an economist, studied the Mafia as an industry. He asked himself a question: why do people buy protection even where they don’t seem to need it? His answer is worth retelling in full. It’s about markets in general, not just about us.
Picture a neighbourhood with a small, steady number of thieves who have nothing to do with the Mafia. The risk of being robbed is low for any one shop, and most shopkeepers see no point in paying. But somebody starts. Maybe the jewellers: they have something to lose. Maybe the ones whose protector is a cousin or a friend. Maybe the ones who scare easily. It doesn’t matter why. What matters is what comes next.
If the protection works, the thieves walk past the protected shops and go to the unprotected ones, and the risk for those who don’t pay goes up. Paying starts to make more sense. Somebody else pays. The risk for the rest goes up again. A chain reaction. In the end, Gambetta writes, everybody buys protection simply because everybody else does.
Notice: not one shopkeeper changed his mind about the thieves. He changed his mind about his neighbours.
The Beauty Contest
In 1936 John Maynard Keynes compared the stock market to a newspaper competition that was fashionable at the time. Readers were shown a hundred photographs and asked to pick the six prettiest faces, and the prize went to the one whose choice came closest to the choice of the majority. How do you win? Not, said Keynes, by picking the faces you find pretty. Not even the faces the majority finds pretty. But the faces the majority thinks the majority will pick. The most sophisticated go on to the fourth and fifth level.
Shares, according to Keynes, work the same way. You don’t buy because the company is good, but because you think others will decide it’s good and the price will go up—and the others are thinking exactly the same about you. The price reflects expectations about expectations more than it reflects the business.
Gambetta’s shopkeepers were playing the same contest. The price of protection in the neighbourhood told you not how many thieves there were, but how many neighbours were already paying. Understanding the goods isn’t enough. You have to understand what people think other people think.
What Money Is Worth to Different People
The second thing to know about other people’s heads: the same money is worth different amounts to different people.
At the beginning of the eighteenth century the Bernoullis, Swiss mathematicians, took apart a strange game. We toss a coin until it comes up heads. Heads straight away, you get two ducats. On the second toss, four, on the third, eight, and so on, doubling every time. How much is it sensible to pay to play? On paper the expected value is infinite: each toss has less chance but twice the money, and the sum grows without limit. In real life nobody will pay more than a few ducats for a game like that.
Daniel Bernoulli explained it in 1738: each extra ducat gives less pleasure than the one before. A thousand is salvation to a poor man and small change to a rich one. People decide not by the money, but by how much that money means to them. Economists call this utility. It grows more slowly than money does.
Losing Hurts More Than Finding
In 1979 two psychologists, Daniel Kahneman and Amos Tversky, showed that people stray even further from the arithmetic. The experiments were simple. Do you want four hundred and fifty dollars for certain, or a fifty-fifty chance of winning a thousand? Most people take the sure money, even though the gamble has the higher expected value. Now the other way round: lose four hundred and fifty for certain, or a fifty-fifty chance of losing a thousand? Most people gamble.
We like to take a gain for certain. To escape a loss we’re ready to run into risk. And the loss itself weighs about twice as much in our heads as the same gain. Twenty-odd years later Kahneman got the Nobel Prize in economics for this work. A psychologist, not an economist. Tversky didn’t live to see it.
Why does this matter so much in our world? Gambetta has a thought. Even when a man isn’t sure whether he’s facing a real mafioso or an impostor, he’ll often choose to give in: when your life is at stake, you don’t usually call somebody’s bluff. That’s why pretending pays so well in our trade. When a loss threatens disaster, people pay far more for certainty than it’s worth on paper. The same mechanism makes people overpay for insurance against rare misfortunes and keep their money in a drawer rather than in shares.
Other People’s Heads at Work
How do you use this honestly?
First, remember: prices on the market are opinions about opinions. Everyone around you is buying something? Ask yourself: is it good, or is everyone buying because everyone is buying? The answer isn’t always obvious, and sometimes it’s sensible to buy along with everyone else. But you have to know which game you’re playing. Always.
Second, when you’re selling, remember utility and the fear of loss: a man with something to lose values safety above return, and a man who has already lost is ready for a desperate gamble. With the first, talk about guarantees. Don’t push the second: he’s on the edge already.
Don Vincenzo understood this without any psychologists. When we started selling oil, for a long time he couldn’t win over a single well-known cook. Then he won over one, the most respected in the district, and let him have the first batch at almost cost price. A month later five more came. They hadn’t tasted the oil. He was buying it, and that was enough. “A cook doesn’t buy oil,” the Don said. “A cook buys what the other cooks will think when they see my tin on his shelf.”