How ‘skin in the game’ helps describe the outcomes of behavioral economics
I was listening to Nassim Taleb’s book “Skin in the Game” and following along great until the book it hit upon a nerve. That nerve was when Nassim Taleb called out the “IYI” — intellectual yet idiot persona. He has very strong opinions against research professionals, like economists, and the lack of skin in the game they have. He was also pointing to behavioral economists work on irrational behavior that it wasn’t actually true. This sort of antagonist view is great. It challenged my thinking on both sides of the argument. This post looks to unpack both sides of the argument to make sense of their various viewpoints.
What does “Skin in the game” mean
Let’s start with what Taleb describes as “skin in the game” as Taleb describes it:
What is Skin in the Game? The phrase is often mistaken for one-sided incentives: the promise of a bonus will make someone work harder for you. For the central attribute is symmetry: the balancing of incentives and disincentives, people should also penalized if something for which they are responsible goes wrong and hurts others: he or she who wants a share of the benefits needs to also share some of the risks. — Taleb’s Medium Post
Let’s unpack the statement above into its components to create the equation for skin in the game:
- Balancing incentives and disincentives — The argument here is that if you don’t have skin in the game you likely don’t have disincentives for your behavior. The “attention economy” is a great example of organizations that don’t have skin in the game. Many of these operate as affiliate sites where they have minimal retribution for their actions.
- Responsibility — The argument here is that penalties should be present if an individual shares their perspectives. This is an argument that has been made about pundits for years. Phil Tetlok (who may be an IYI) said in his book Superforecasting, “ All we have to do is get serious about keeping score.” You can imagine a world where IYIs have a running score on their predictions. My guess is that you’d find most IYIs would look more like an average MLB batting average of 0.260 (aka 1 in 4 correct responses)
One example that stood out to me in the book was around employment, especially in light of the Lyft IPO last week. His argument was that companies that hire full-time employees do so to incentivize ‘skin in the game’. The rise of the gig economy opens up a number of questions around how the dynamic will change. The key question will be whether these gig workers feel they could lose out by not contracting with the platforms, like Lyft and Uber.
“What matters isn’t what a person has or doesn’t have; it is what he or she is afraid of losing.” — Taleb from “Skin in the Game”
I have written recently about this space a lot (see the stories on this part of my blog). The core aspects of Behavioral Economics is that humans don’t make decisions based purely on economics and that the decisions are often systemically predictable.
One of the core areas of behavioral economics that align with skin in the game is the endowment effect. Here is a paper that Kahneman and Thaler worked on to describe this theory. They ran a series of experiments and received data that individuals find it difficult to switch their behavior.
rational models that ignore the status quo tend to predict “greater instability than is observed in the world” (p. 47). We have added the claim that models that ignore loss aversion predict more symmetry and reversibility than are observed in the world, ignoring potentially large differences in the magnitude of responses to gains and to losses. Responses to increases and to decreases in price, for example, might not always be mirror images of each other. The possibility of loss aversion effects suggests, more generally, that treatments of responses to changes in economic variables should routinely separate the cases of favorable and unfavorable changes. Introducing such distinctions could improve the precision of predictions at a tolerable price in increased complexity.
Unpack what this means
- Asymmetry — The changes in status quo, especially loses are valued more than respective gains. Thus by having skin in the game there is more to lose than if you had nothing. As a result, if you don’t have skin in the game you are likely to take on more risks to achieve a gain.
- Irreversible — The research that was done showed that the indifference curves that in theory should have a function to exchange various goods/services was not consistent when someone has ‘skin in the game’. Thus the indifference curve is irreversible once you have something to lose.
Can they both be right?
I’m not going to focus on whether economists are wrong due to not having skin in the game. What I’m interested in understanding is whether the notion of “skin in the game” is what causes the irrational behavior that behavioral economists claim. Thus proving that Taleb and Thaler are more alike than their public statements claim (kind of like Democrats and Republicans).
- Responsibility — this is part of Taleb’s claim. The impact of responsibility is similar to decision weights where there is a large difference between no responsibility and a small amount of responsibility. The same thing occurs at the other end between a large amount of responsibility and 100% responsibility.
- Behavior is not driven by economics — my take in reading both is that they describe behavior as being driven by forces beyond pure economics. Taleb’s claim is that skin in the game essentially impacts your probabilities for specific actions. This is really similar to the Endowment effect. Thaler/ Kahneman’s claim is that people are “irrational” (in an economic sense) with their decisions. Thaler/ Kahneman/ Tversky was targeting the traditional economics base with their work and thus I feel the “irrational” argument has been taken out of context.
- Probability and Stats — Taleb argues that the IYI behavioral economists aren’t using probabilities, though based on my reading of their papers there is a significant amount of probabilities. The decision weights above is an example. I can see the argument that the studies done were academic in nature, though in later works the IYI behavioral economists worked with many organizations to prove their theories in practice (e.g. the work on nudges and the colonoscopy example)
I believe that skin in the game is what contributes to the irrational behavior — note irrational means not economically efficient. Skin in the game is a representation of external (non-economic) forces that impact decision making. This is part of the reason why companies offer stock vesting programs vs. cash. Stock provides skin in the game to increase the friction to pursue another opportunity.
Where they differ
There is much that is aligned, but there are definitely areas where they differ. Taleb is right in his critique that many IYI’s are not held accountable or responsible for their work.
One area that Taleb could also push harder is that many of the behavioral economics studies were done outside of the real world, ie. without real ‘skin in the game’. The researchers often ask hypothetical questions and thus the responses are not always accurate, as responders don’t have skin in the game. These types of approaches are good starting points, but it is important to try real-world tests.
For product professionals, this is a constant challenge. How do you test a product concept? Below are a couple of ways that can work to get ‘skin in the game’:
- Sell a prototype version only. If you can sell a basic version of the product you can prove out value. Pioneer Square Labs (an incubator in Seattle) will often setup basic websites with minimal ad spend to test concepts. If the concept achieves desired metrics they will expand out.
- Start small so losses are minimized. This is the reason that Uber, Lyft, Yelp, Airbnb started in one market with one product.
Taleb’s and Thaler’s theories are much more closely aligned than they like to admit. Skin in the game is a key factor that drives irrational economic behavior. I will leave with a final quote from Thaler and Kahneman that shows that skin in the game can cause research to be biased.
After more than a decade of research on this topic we have become convinced that the endowment effect, status quo bias, and the aversion to losses are both robust and important. Then again, we admit that the idea is now part of our endowment, and we are naturally keener to retain it than others might be to acquire it.
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