Mullainathan et al. (2008) present a model of coarse thinking or analogy-based thinking. The essential idea behind coarse thinking is that people put situations into categories, and the values assigned to attributes in a given situation are affected by the values of corresponding attributes in other co-categorized situations. This hypothesis is tested in an experiment on financial options against the benchmark of arbitrage-free pricing. First, whether a financial option is priced in analogy with its underlying stock (transference) is tested. Second, variations in the analogy between a financial option and its underlying stock matter (framing) are tested. The results show evidence in support of both transference and framing.

A model of coarse thinking was put forward by Mullainathan et al. (2008), which is based on the notion that agents use analogies for assigning values to attributes (the attribute valued in their model is ‘quality’). The defining idea behind coarse thinking is that agents co-categorize situations that they consider to be analogous, and assessment of attributes in a given situation is affected by other situations in the same category. This is in contrast to the rational (Bayesian) thinking in which each situation is evaluated according to its own merits. Even though coarse thinking appears to be a natural way of modeling how humans process information (Kahneman and Tversky, 1982; Lakoff, 1987; Edelmen, 1992; Carpenter et al., 1994; and Zaltman, 1997), gathering empirical evidence on the issue is difficult. It is clearly difficult to isolate coarse thinking from confounding explanations. However, experimental methods appear to be particularly suited for this task due to greater control that they offer.

Mullainathan et al. (2008) use the advertising theme of Alberto Culver’s Natural Silk Shampoo as a motivating example to explain coarse thinking. The shampoo was advertised with a slogan ‘we put silk in the bottle.’ The company actually put some silk in the shampoo. However, as conceded by the company spokesman, silk does not do anything for the hair (Carpenter et al., 1994). Then, why did the company put silk in the shampoo? Mullainathan et al. (2008) write that the company was relying on the fact that consumers co-categorize shampoo with hair. This co-categorization leads consumers to value ‘silk’ in shampoo because they value ‘silky’ hair (clearly not a rational response) i.e., a positive trait from hair is transferred to shampoo by adding silk to it. Such a transfer of informational content of an attribute across co-categorized situations is termed ‘transference’. An important question is, how are categories formed in the first place? A natural response is to say that clues about category formation must come from the description of the situation under consideration. Mullainathan et al. (2008) call such inference ‘framing’. The way a situation is described or framed affects its subsequent categorization. Hence, ‘framing’ and ‘transference’ are two concepts associated with coarse thinking.

Behavioral Finance Journal, Initial Public Offering, Capital Structure Theory, Academic Literature, Mergers and Acquisitions, Financial Investors, Information Asymmetry, Institutional Investors, Discounted Cash Flow, Firm Valuation, Indian Markets, IPO Market.