• So far, we have assumed utility maximizing behavior or profit
maximizing behavior on the part of economic agents.
• Economic agents make mistakes. Do we learn from those
mistakes? Mistakes do not necessarily violate the assumption of
utility or profit maximization.
• However, if we continue to make the same mistakes, or, if people
make mistakes in the same way, then the assumptions of utility
maximization or profit maximization may be suspect.
• Behavioral economics is an attempt by some researchers to
redefine economic decision-making with a psychological foundation.
• Behavioral economics accounts for behavior like procrastination,
self control, envy, revenge, love, the madness of crowds,
bandwagon effects, snob effects, etc.
Some researchers in behavioral
economics and behavioral finance
• Daniel Kahneman (economist) and Amos Tversky
(psychologist) – Econometrica (1979) “Prospect Theory:
An Analysis of Decision under Risk” in Kent Library
• Richard Thaler (economist)- The Winner`s Curse:
Paradoxes and Anomalies of Economic Life - in Kent
Library..Nudge, In Kent Library.
• Robert Shiller (financial economist)-Irrational
Exuberance -in Kent Library
• Matthew Rabin-(economist) “Incorporating Fairness into
Game Theory and Economics” The American Economic
Review, 1993. In Kent Library
Some perceived regularities in decision-making that seem
to be inconsistent with utility maximization.
• Framing Effects-frame is the combination of beliefs,
values, attitudes, mental models, and so on which we
use to perceive a situation. We effectively look through
this frame in the way we would look through tinted
spectacles. The frame significantly effects how we infer
meaning and hence, understand the situation.
• Kahneman and Tversky defined a decision frame as ‘the
decision-maker’s conception of the act, outcomes and
contingencies associated with a particular choice.’
• Tversky and Kahneman told people to assume there was disease
affecting 600 people and they had two choices:
• Program A, where 200 of the 600 people will be saved .
• Program B, where there is 33% chance that all 600 people will be
saved, and 66% chance that nobody will be saved. Expected value
of program B is 200 lives saved (and 400 people will die).
• The majority of people selected A, showing a preference for
certainty or risk aversion.
• They then offered them another two choices:
• Program C, where 400 people will die, 200 people live.
• Program D, where there is a 33% chance that nobody will die, and
66% chance that all 600 people will die. Expected value of D is 200
people live and 400 people die. Same as program B.
• Most people now selected D, seeking to avoid the loss of 400
• Notice how the framing makes the difference. Prospects A and C
are the same, and B and D are the same.
• Framing the prospect as a gain makes people risk averse. Framing
the prospect as a loss makes people risk takers.
• Anchoring effects-Initial impressions become reference
points that anchor subsequent thoughts and judgments.
• Salesperson has three items for sale-expensive, medium
high priced, and cheap. Show the customer the
expensive item first, which acts as an anchor. Makes it
easier to sell the medium high priced item.
• Dramatic or easy-to-recall events often become strong
anchors. For example, the vividness of the horrible
events of September 11 caused many to view airline
travel as too risky, but many experts believe that travel
has never been safer.
• The endowment effect-Once people
possess an item they frequently will not
accept a money amount greater than the
amount the individual originally paid for the
item. An example: Some people won’t
throw away junk, but store it in storage
Endowment effect often arises because of loss aversion.
• Loss Aversion: The disutility of giving up an object is
greater than the utility associated with acquiring it.
• People are often reluctant to sell a stock that has
performed poorly until it is back to the price it was
originally bought at.
• Battered women often return to jerks who beat them.
• You want to sell your house which you bought for
$105,000. However, given current market conditions,
your house is only worth $100,000. You receive an offer
for $100,000. Interest rates are 7%. You turn down the
offer. You correctly assume you will receive an offer for
$106,000 one year from today.
• Status Quo Bias: One implication of loss
aversion is that individuals have a strong
tendency to remain at the status quo,
because the disadvantages (or disutility) of
leaving it loom larger than advantages
• An implication of the endowment effect is
that people treat opportunity costs
differently than out-of-pocket expenses.
• Foregone gains are less painful than
• Fairness and the Pareto Principle
• The Pareto principle: if a trade makes at least
one person better off and no one worse off then
the trade is Pareto improving.
• Experiment: two individuals have to decide how
to distribute a given amount of money between
themselves. If they can agree, they get to divide
the money as to their agreement.
• Person D (the dictator) makes a proposal.
Person C (the citizen) either agrees or disagrees.
If C agrees with the proposal then the proceeds
are divided. If C disagrees, then C and D get
• Prospect theory vs. Expected utility theory
• Expected utility theory suggests that individuals can
determine expected values of risky prospects and make
choices consistent with utility maximization.
• Prospect theory-people are not good intuitive
statisticians. Likely outcomes are estimated to be less
probable than they really are; and outcomes that are
quite unlikely are typically estimated to be more probable
than they are. Furthermore, people often behave as if
extremely unlikely, but still possible, outcomes have no
chance whatsoever of occurring.
Linda is 31 years old, single, outspoken, and very bright. She majored
in philosophy. As a student, she was deeply concerned with issues of
discrimination and social justice and she participated in anti-nuclear
demonstrations. Which of the following statements are more
• A. Linda is a teacher in an elementary school.
• B. Linda works as a bank teller.
• C. Linda is active in the feminist movement.
• D. Linda works in a bookstore.
• E. Linda is a member of the League of women voters.
• F. Linda takes yoga classes.
• G. Linda is an insurance salesperson.
• H. Linda works in a bookstore, takes yoga classes, and
is active in the feminist movement.
• Perceptual Contrasting Effects-When we make decisions,
we tend to do it by contrasting between the decision item
and reference items. When two things appear close to
one another, we will tend to evaluate them against one
another more than against a fixed standard.
• When you meet two other people, you are likely to
compare each against the other on several dimensions
to decide whom you prefer. This may include physical
beauty, similarity of interests, and various personality
• A simple physical way of illustrating perceptual contrast
is to put one hand into hot water and the other into cold
water, then move both hands to lukewarm water. The
cold hand will feel hot and the hot hand will feel cold.
• To make something look good, first show something of
inferior quality. Or, to get someone to buy something
expensive, first show them something even more
• Self control and gift giving-The economics
• Some economists (but not me) would
argue that there is a deadweight loss to
Christmas. People prefer money so they
can buy what they want, rather than the
gift which frequently has a lower marginal
utility value than money.
• Consider the dilemma of a couple who enjoy drinking a
bottle of wine with dinner. They might decide that they
can afford to spend only $10 a night on wine and so limit
their purchases to wines that cost $10 a bottle on
average, with no bottle costing more than $20.
• This policy might not be optimal in the sense that an
occasional $30 bottle of champagne would be worth
more than $30 to them, but they don't trust themselves to
resist the temptation to increase their wine budget
unreasonably if they break the $20 barrier.
• An implication is that this couple would greatly enjoy gifts
of wine that are above their usual budget constraint.
• Instead the mental accounting analysis suggests that the
best gifts are somewhat more luxurious than the
recipient normally buys, consistent with the conventional
advice (of non-economists), which is to buy people
something they want, but wouldn't buy for themselves.
Other self-control problems
• If we expand the choice set (the budget
set) that individuals face are they better or
• Is it appropriate to give gifts of food to a
person who is trying to diet and lose
• Should we offer an alcoholic a drink?
• Should we take a compulsive gamble to a
casino to see a show?
Public Policy and Self-Control
• Programs such as food stamps and other
welfare programs expand the choice set of
individuals who receive those benefits.
• Does it make them better off?
• Many poor individuals have the worst
problems with self-control.
• They have very high discount rates and
care about the present more than the
• Welfare programs expand an individual’s
• If the person is already at B because they
irrationally (or irresponsibly) make
decisions, then an expansion of their
budget set might allow them to be even
more irrational and move toward C.
1.Hyperbolic discounting-people generally prefer
smaller, sooner payoffs to larger, later payoffs when
the smaller payoffs would be imminent; but when
the same payoffs are distant in time, people tend to
prefer the larger, even though the time lag from the
smaller to the larger would be the same as before.
2.When given a choice, some people would prefer
$50 today to $100 one year from now, but would
choose $100 six years from now versus $50 five
years from now.
3.”Eat, drink, and be merry, for tomorrow you may
4. Lots of people want the IRS to withhold more than they owe
in taxes so they get a big refund check. This behavior
amounts to giving the IRS an interest free loan.
5. School teachers who work 9 months are given the option of
receiving their salary over 9 months or over 12 months.
Many choose the 12 monthly checks because they don’t
“trust” themselves. They lose interest income.
6. Before you choose a college think of the reputation the
college has: is it a diploma mill or does it require hard
Most people prefer the college to have a good reputation,
but once they arrive, they often prefer easy classes.
• Availability bias-Kahneman and Tversky-People seem to
judge the odds of a given event occurring based on how
readily an example comes to mind.
• Acquiring information is costly and people look for
• Imagine a situation in which gifts are being distributed in
red and blue boxes. You don't know what the boxes
contain, but everyone is asking for a red box. Therefore,
you ask for a red box too, assuming they must know
something you don't and because you want to appear "in
the know" too.
• This case is rational herding or kind of like the band-
wagon effect. Now, consider that everyone was thinking
just like you, and that the chain began only because a
prominent individual was seen picking a red box.
• When asked to rate the probability of a
variety of causes of death people tend to
rate "newsworthy" events as more likely.
• People often rate the chance of death by
plane crash higher after plane crashes,
and death by natural disaster as too likely
only because these events are reported
more often than common causes of death.
• Confirmation bias-People look for examples and
anecdotes that confirm their prior beliefs.
• Example: I think that my dreams and
nightmares foretell the future. I have a dream
and the next day it comes true confirming my
prior belief. However, I ignore all the times my
dreams don’t come true.
• After people buy a new car they eagerly read the
advertisements for that car - the ads, of course,
confirm that their purchase was a good one.
A Non-exhaustive summary of behavioral effects
• Framing Effects
• Endowment Effect
• Fairness and the Pareto Principle
• Prospect Theory
• Perceptual Contrasting Effects
• Self-control and gift giving
• Time Inconsistency
• Availability bias
• Confirmation bias