Submitted by Nicholas Colas of DataTrek Research
Can the US and China come to a trade agreement? For Story Time Thursday we address that question with 2 behavioral finance studies. The first shows professional negotiators expect “fairness” during talks even more than laypeople. The second reveals significant cultural (US-China) differences on what constitutes a “fair” deal. Bottom line: markets like the predictability implicit in a model where companies/governments are profit/utility-maximizing agents. Behavioral finance reminds us that “fairness” can matter more.
Aside from our reminiscences of working for Steve Cohen, behavioral finance is the most popular theme for Story Time Thursday. Today we have two studies from that field that both relate to the market’s topic du jour: the ongoing trade talks between the US and China.
At the center of both analyses is the Ultimatum Game (UG), the most replicated study in the field. As a review of how it is structured and what it says about human nature here:
Two strangers walk into a room and a researcher has them call a coin toss. The winner of the toss gets a sum of money (we’ll use $100 in this example).
The winner must then offer some part of the $100 to the loser. If the loser accepts the split, both parties get to keep their shares. If the loser rejects the offer, then neither gets anything. Either way, the game is over.
In theory, the winner should offer $1 of the $100 and the loser should accept it because something is better than nothing.
In practice, countless UG studies have shown that losers almost always reject offers below $25 even though they “should” be happy to walk out with $1 - $10. The lesson of the Ultimatum Game: spite trumps classical marginal utility theory.
That’s how “normal” people play the game, but do skilled negotiators follow the same playbook? In theory, they shouldn’t since they know even a sub-25% offer is better than walking away empty-handed. But then again, since they are facing off against another professional perhaps they would expect a fairer offer from a one-shot game and reject even 30%. So which is it?
In 2014 researchers from several University of California schools published the results of a study that gave the answer. Over the course of 2 years they had 102 senior level US government officials and business leaders play an online version of the UG. Here were their results:
Elite negotiators make higher offers (average $43) than laypeople ($39).
But they also require higher offers to accept a deal: $31 versus $25 for the typical non-elite player.
The more experienced the elite bargainer, the more they offered and the higher their threshold was to make a deal.
How this relates to US-China trade talks:
Now you know why President Trump and his team were so unhappy with China’s recent attempt to walk back previously agreed terms. Mr. Trump’s Sunday tweet that sparked recent market volatility is a textbook response when seen through the lens of this study.
Unfortunately, the behavior described in the study means both sides have to cede more ground than they want. Elite negotiators expect to see better-than-average offers, not worse. And their thresholds for taking a deal are higher.
The upshot may be that a successful deal is one where both sides give up more than they have publicly portrayed. Therefore, whether US investors see a deal as a positive to the US economy will come down to what China unexpectedly agrees to as much or more than what the American side gives up.
The second Ultimatum Game study today goes to the question of cultural differences between the US and China. The work here comes from Chinese/German researchers and looked at whether older Chinese citizens who had lived under Mao played the UG differently from younger demographic cohorts. The short answer is yes, but the data in the study also highlights the cultural difference between Chinese UG players and those in the West:
All Chinese age cohorts require higher offers than the 25% (US layperson) – 31% (US elite) we noted in the prior study to accept a deal. They range from a low of 34.7% (oldest) to 42.4% (those born between 1951 and 1975). Worth noting: lead Chinese negotiator Liu He was born in 1952.
On the other side of the table, the mean offer for a Chinese UG player was also higher than average: 46 – 54% versus the 40% - 43% noted above.
The bottom line here is that while this is just one study the numbers show a marked cultural difference between Chinese and American participants.
Where this leaves us: the Ultimatum Game is a good reminder that human decision-making during negotiations follows emotional guideposts, not financial/economic ones. Professional negotiators are no different than anyone else on that point and have even loftier expectations than laypeople. Culture also plays an underappreciated role.
That is why capital markets are so completely captured by US-China negotiations: they simply do not follow the cut-and-dried rules of profit maximization. Even if both sides truly want to cut a “fair” deal, how they reach one and what even fits that term will be deeply clouded by human emotion and judgment.
The bottom line: markets may seem volatile just now, but given the unpredictability of human nature when engaged in high stakes negotiations we think we’ve gotten off pretty cheaply so far... We doubt we’re out of the woods just yet.
Elite negotiators: https://www.pnas.org/content/111/52/18536
Chinese Ultimatum Game: https://journals.plos.org/plosone/article?id=10.1371/journal.pone.0070769