Behavioral Economics How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it. Of this kind is pity or compassion, the emotion which we feel for the misery of others, when we either see it, or are made to conceive it in a very lively manner. That we often derive sorrow from the sorrow of others, is a matter of fact too obvious to require any instances to prove it; for this sentiment, like all the other original passions of human nature, is by no means confined to the virtuous and humane, though they perhaps may feel it with the most exquisite sensibility. Adam Smith, The Theory of Moral Sentiments (1759) Behavioral Economics uses insights from psychology to improve economic theory. Primary contributions from psychology often involve: 1. Preferences unaccounted for by economic theory such as fairness or status. 2. Mistakes. Early economists expressed and developed psychological concepts in their work, e.g., Smith, Bentham and Edgeworth. In the early 20th century, many economists turned away from psychological concepts. Notable exceptions were Irving Fisher, and later, John Maynard Keynes. In the latter 20th century, anomalies in behavior unexplainable by economic theory could no longer be ignored. In psychology in the 1960s, the view of the brain as an information-processing unit rather than a stimulus-response machine became dominant. Problem-solving and decision-making gained interest among psychologists—topics relevant to economics. Collaborative work revealed some explanations for anomalies, and the field of Behavioral Economics emerged in the early 1980s. In addition to traditional economic methods, behavioral economists tend to rely more heavily on experiments. Experimental economics is an empirical tool, like econometrics or cost-benefit analysis. Experiments take place in a lab setting. The experimenter sets rules, establishes rewards, and assigns tasks to the subjects. The behavior is then observed and documented. Pair up. Decide who will be player 1 and who will be player 2. Assignment: Split $10 between you. 1. Player 1 makes an offer to player 2 as to how to split the $10. 2. Player 2 accepts the offer or rejects the offer. 3. If Player 2 rejects, no one gets anything. • Ultimatum Game shows fairness counts. • Real world tests of offer rejection due to fairness concerns might be observed in: • Failures of legal cases to settle before trial • Costly divorce proceedings • Labor strikes. • In the real world, we cannot tell if rejection of offers occurs because of: Fairness or 1. Reputation building in repeated games 2. Agency problems, e.g., clients and lawyers 3. Confusion Experiment eliminates 1-3. Advantages of Experiments • Can control influences on decision-making, unlike in the complex real world. • Easier to establish causality. • Subjects can be interviewed afterwards about their understanding and thought processes. • Easier for the general public to understand than other empirical techniques such as regression. Disadvantages of Experiments • Small samples • Unrepresentative samples • Behavior may be influenced by perceived expectations of the experimenter. • Artificial environment • No meaningful monetary consequences from decisions. Anchoring Occurs when someone’s choices are linked to prominent but patently irrelevant information. Experiment: 1. College students asked how many times they had gone on a date in the past month. 2. Then they were asked how happy they had been overall. Correlation between responses = 0.66 Anchoring Experiment-Part 2: 2nd group of students were asked questions in reverse order. 1. First they were asked how happy they had been overall in the past month. 2. Then they were asked how many times they had gone on a date in the past month. Correlation between responses to 1 and 2 was close to 0. • Happiness question was anchored by the dating question for the first group. • Order of questions matters. Would you prefer: Option A: 2% yearly pay increase after a year when there has been inflation of 4% Option B: pay cut of 2% after a year when there has been zero inflation What would rationality imply? Indifference between A and B. Money illusion– Bias in the assessment of the real value of transactions induced by their nominal representation. Dynamically Inconsistent Preferences Maintaining Self-Control e.g., Diets, alcohol, drugs, smoking,… Standard economic theory assumes preferences are dynamically consistent -- an individual’s preferences over the alternatives available at some future date do not change as that date approaches or once it arrives, i.e., he/she never loses self-control. Experiments show that individuals often show present bias– a form of dynamic inconsistency involving a bias toward immediate gratification. Individuals aware they might not follow through on their plans might choose pre-commitment -- a choice that removes future options. e.g., resident rehab, weight-loss spas Economists and psychologists are working together to bring psychological factors into economic models and improve policy prescriptions. Behavioral economics models often: • have additional parameters or change the form of a relationship or parameter • ―nest‖ standard economics models • are now being tested against data. Neuroeconomics is also bringing information to bear on economic decision-making. Neuroeconomics ... imagine an ideally perfect instrument, a psychophysical machine, continually registering the height of pleasure experienced by an individual ... From moment to moment the hedonimeter varies; the delicate index now flickering with the flutter of the passions, now steadied by intellectual activity, low sunk whole hours in the neighbourhood of zero, or momentarily springing up towards infinity ... Francis Y. Edgeworth (1845-1926) Early economists lamented the inability to measure preferences directly. Economists turned to the concept of ―revealed preference‖ to enable prediction of economic decision-making, where observed choices are presumed to reveal individual preferences. The utility-maximization apparatus yields predictions without measuring preferences directly. Technical advances in neuroscience now make observation of brain activity related to preferences and choices possible. Neuroeconomics uses knowledge from neuroscience to inform economic theory about how the brain works in decision-making and strategic thinking. Neuroscience also benefits from the conceptual structure of economics. (Paul W. Glimcher et al., ―Neuroeconomics: The Consilience of Brain and Decision,‖ Science 306, 447, 2004). • Animal Behavior • Brain Imaging • Electro-encephalogram (EEG) • Positron Emission Topography (PET) • Functional Magnetic Resonance Imaging (fMRI) • Single-neuron Measurement • Psychopathology • Brain Damage in Humans • Damage occurred prior to study • Transcranial Magnetic Stimulation (TMS) • Four lobes • Frontal – Planning, cognitive control, integration of cross-brain input. • Parietal – Motor action. • Occipital – Visual processing. • Temporal – Memory, recognition, emotion. • Notable features of the brain: • Automaticity – brain processes and choices can occur without awareness. • Sense-making – the brain seeks to make sense of the individual’s behavior • Modularity – brain is organized into modules, sometimes anatomically distinct, which are tied to particular functions. • Modules can work independently or in cooperation in brain processes • Neuroscience can help to identify brain areas associated with different factors affecting decisions. Neuroscience evidence shows that when Players 2 are faced with unfair offers, particular parts of the brain are activated more than when fair offers are made: • Dorsolateral prefrontal cortex (DLPFC) – involved in cognitive processes, e.g., goal setting and executive control. • Insula cortex – activated during the experience of negative emotions, e.g., pain, distress, anger and disgust. • Anterior cingulate (ACC) – area which detects cognitive conflict. Fig.2. Activation related to the presentation of an unfair offer. (A) Map of the t statistic for the contrast [unfair human offer – fair human offer] showing activation of bilateral anterior insula and anterior cingulate cortex. Areas in orange showed greater activation following unfair as compared with fair offers (P < 0.001). (B) Map of the t statistic for the contrast [unfair human offer – fair human offer] showing activation of right dorsolateral prefrontal cortex. A. G. Sanfey et al., Science 300, 1755 -1758 (2003) Sanfey et al. (2003) conclude that their results are consistent with ―the idea that the areas of anterior insula and DLPFC represent the twin demands of the Ultimatum Game task, the emotional goal of resisting unfairness and the cognitive goal of accumulating money... ― The ultimate decision-maker is the brain. Neuroeconomics and behavioral economics can help us understand how the brain works and what neural and psychological variables affect economic choices. Economic models informed by NE and BE can make better predictions and policy recommendations.