Behavioral Economics (PowerPoint download) by linxiaoqin


									          Behavioral Economics
• 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
  units etc.
 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
  perceived losses.
• 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
  of Christmas-
• 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
  worse off?
• 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
Current consumption



                       U=15 utils
                      U=10 utils
• Welfare programs expand an individual’s
  choice set.
• 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.
              Time inconsistency
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

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