Behavioural

Economics
Sujoy Chakravarty

Centre for Economic Studies and
Planning

What is behavioural economics?

Behavioural economics is a new branch of economics that uses

theories, tools and techniques of analysis from social sciences such
as psychology or anthropology that are used to enrich the model of
human behaviour that has been used tradiBonally in neo-classical
economics.
As it stresses observed agent behaviour rather than logical
opBmizaBon algorithms, behavioural economists are oIen also
experimental economists, who conduct lab and eld experiments in
the vein of psychologists.
ObservaBons of deviaBon from theory predicBons may provide
insights into building new theories, that improve upon exisBng
ones. Eg.- herd behaviour, saBscingbehaviour, ecological raBonality,
other-regarding preferences and prospect theory

Why do we need this?

Though economic theory predicts behaviour in a large number
of economic problems, the predicBons are quite narrow in
scope.
In the real world however we see a vast number of
behavioural realizaBons:
The amount of contribuBon made to chariBes.
The proclivity towards acquiring resources through corrupt
means.
CooperaBon displayed towards teammates and co-workers
The wherewithal to take on monetary risks.
ConsumpBon and saving behaviour.

Economic Theory
Over the last century has concerned itself more with raBonal
benchmarks and less with trying to model empirically observed
behavior.
According to Smith (1989) most economists feel that
economics is an a-priori science rather than an observaBonal
one.
According to Milgrom and Roberts (1987, p. 185) no mere fact
was a match in economics for a consistent theory. Thus most
economic theorists believe that economic problems and agent
behavior therein can be fully conceptualized by thinking about
them.
Accordingly aIer the thinking has produced sucient
technical rigour, internal coherence and interpersonal
agreement, economists can then apply this to the world of
data. (Smith, 1989, p. 152)

The bo[om line

The raBonal agent thus modeled is a self-

interested maximizer always taking a decision
that maximizes his expected wealth.

But from casual empiricism

if we look around us we see serious violaBons
of this behavioural norm.
Human beings are prone to voluntary acts of
kindness someBmes moBvated by altruism.
Most people cooperate with their neighbours
in the upkeep of their neighbourhoods.
Most would trust another human being
uncondiBonally oIen suering negaBve
consequences from this trusBng behavior.

Predictably or systemically irraBonal

Are most people then irraBonal?
If that were the case shouldnt theory reect this
divergence from the norm especially as this divergence
is oIen systemaBc and not random?
Ariely (2008) refers to these divergences as predictably
irraBonal ones.
Basu (1983), Sugden (1986) and Coleman (1990) have
a[ributed social norms (especially those that inculcate
values and a sense of morality) as modiers on our
desire to maximize our material wealth.

Early glimmers of behaviourism

Adam Smith in The Theory of Moral Sen7ments
(1759) builds on the work of David Hume (A
Trea7se of Human Nature, 1739)
Here, Smith writes about an important
psychological moBvaBon that governs the way
that economic agents conduct exchange.
The parBcular moral senBment that Smith
describes at length is sympathy, i.e. the feeling
of compassion or concern for others.
This tempers self-interest in socio-economic
transacBons and leads us to sacrice narrow
proteering in order to maintain Bes of aecBon
with our fellow human beings.

So then why do we need economic

theory at all?
Economists have tradi7onally avoided
explaining behavior as less than ra7onal for
fear of developing many fragmented theories
of mistakes.Erev and Roth (1998, p. 848)
Economic theory provides a behavioural
(raBonal) benchmark of great generality
against which we may compare observed
behaviour.

The role of experiments

The eld of experimental economics (not to menBon
experimental social psychology) stands at the centre of this
debate on observed behavioural deviaBons from raBonal
theoreBcal predicBon.
The method of controlled experiments from the Iies
onwards has allowed us to test game theoreBc models as well
as individual choice models with human subjects in the
laboratory.
Observed economic behaviors are compared to raBonal
theoreBcal benchmarks, divergences from the raBonal norm
are noted and in certain cases theories are advanced to
explain these deviaBons.

A dierence in approach
A fundamental point of divergence between psychology/
cogniBve science and economics is related to the
theoreBcal underpinnings behind various results.
Most economists dont really need a precise and accurate
theory at the individual level, just as long as it is general
enough to explain some of the observed behaviour
accurately and generate an aggregate predicBon that is
more or less accurate.
So elegance and generality are generally desirable in
economic theory, whereas psychologists and cogniBve
scienBsts are interested in modeling the precise nuances of
behavior displayed by individuals.

An example
A typical economics experiment on aitudes towards risk
would have the researcher make an assumpBon about the
form of the uBlity funcBon (say constant relaBve risk
aversion or CRRA) that the agents purportedly follow.
Using this funcBon and the choice response in the
experiment, one can calculate some measure (maybe
Arrow-Pra[) of risk aversion and then compare this across
agents, over Bme, cross-culturally etc.
If anyone quesBons the validity of using this funcBonal
form over another one, most of the Bme the answer that a
theorist or an experimental economist would give you
would be that it doesnt ma,er as long as everyones
a2tude to risk is measured using the same CRRA
specica<on.

The as-if approach to behaviour

Most psychologists and cogniBve scienBsts
would be quite unhappy with this as if way
of evaluaBon and would be more interested in
the cogniBve processes that govern the choice
made by the decision maker.
Economists on the other hand, some measure
which has good internal validity but
potenBally scanty external support.

One-size ts all
According to Camerer (1995), most economists have a one-
size-ts-all approach to studying economic problems vis--
vis psychologists.
if a task involves elicitaBon of a probability, most
psychology experiments would frame the problem in a
natural seing using a vigne[e. This would anchor the tasks
to certain specic sBmuli.
Most economists would go ahead and a[empt to elicit the
same probability using a more decontextualised device
such as a pair of dice or a bingo cage.
This is in keeping with the insBtuBon free pedagogy of
neoclassical economics where elicitaBon of a probability is
coming up with a specic staBsBcal measure rather than an
assessment of a contextualized measure of uncertainty.

Bounded raBonality
The origin of this boundedly raBonal approach is from Simons
(1955) idea of procedural raBonality whereby agents follow
reasonable heurisBcs and on average achieve close to opBmal
outcomes.
This is disBnct from substanBve raBonality, where the agent
considers the enBre set of variables to make her decision.
The idea of bounded raBonality was one of failed opBmizaBon.
Agents are unable to compute the opBmum and se[le for a second
best saBscing outcome.
The more modern idea of ecological raBonality (Gigerenzer and
Brighton, 2009) strongly opposes this idea that all heurisBcs are
examples of failed opBmizaBon.

HeurisBcs: A new look at bounded raBonality

NoBce that the idea of bounded raBonality implies that heurisBcs, which
do not a[empt to opBmize an objecBve funcBon with respect to all the
relevant variables is a result of cogniBve limitaBons which force the
decision maker to perform shoddy second best computaBons.
In contrast Gigerenzer and Brighton (2009) nd that heurisBcs are ecient
cogniBve processes that ignore informaBon.
In contrast to the widely held view that less processing reduces accuracy,
their study of heurisBcs shows that less informaBon, computaBon, and
Bme can in fact improve accuracy. Gigerenzer and Brighton specically
show that there is a trade-o between bias and variance. More variables
decrease bias but increase variance.
According to this fast and frugal or ecologically raBonal approach to
computaBon, Homo HeurisBcus has a biased mind and ignores part of
the available informaBon, yet a biased mind can handle uncertainty more
eciently and robustly than an unbiased mind relying on more resource-
intensive and general-purpose processing strategies.

What exactly is a controlled experiment in econ ?

It is a way of obtaining data on how economic agents behave (i.e.- the
acBons they take) in a game, decision problem or a market.

Subjects are recruited in a randomized way to be agents in a

stylized environment that studies a parBcular economic problem.
The interacBon is described to the parBcipaBng subjects (i.e.- the
economic agents) with the help of laboratory instrucBons that present in
detail the tasks that he or she needs to perform.
Monetary incenBves are provided in a salient way, so that agents can map
the acBon space to the payos.
In other words, the laboratory interface is a real market or game that
has agents moBvated by nancial incenBves.
Examples include a laboratory double aucBon market, an oligopoly game
or a two-player Prisoners Dilemma.

Findings from experimental studies

Game theory people are not as hyper-raBonal as predicted by
theory. Though self interest is an important moBvator for decisions
made, it is by no means the only one. People display preferences
for altruism, reciprocity, spite and mutualism. E.g.- cooperaBon in
prisoners dilemma, egalitarian shares in bargaining games. Culture
and norms play a role in shaping agent behaviour.
Individual decision making Humans are prone to systemic biases
making their behaviour diverge considerably from the model of the
expected uBlity maximizer. E.g.- endowment eect, reecBon
eect. These are oIen to do with the procedures humans use to
aggregate payos.
Since most real world problems involve both individual decision
making as well as interacBve components we see procedural as well
as preferenBal divergences from theory.

OUTCOMES
Prices, allocations

Pre-1960 institution free theory

Post 1960 institutions matter

Post 1980 culture and demographics

CHOICE
BEHAVIOUR

matter.

ENVIRONMENT
Agent values, costs,
endowment,
technology

CULTURE and
DEMOGRAPHICS
Social Norms

INSTITUTIONS
Language of the market
Rules of communication and
contract
Extensive form structure

Figure 1: Institutions, culture, environment and behaviour in economics (extended from Smith, 1989)

Prisoners and tragedies

The meta analysed cooperaBon in 2 X 2 prisoners dilemma
experiments show cooperaBon rates of greater than 50 %
Public goods games show cooperaBon rates of 20-40 %
ContribuBon to public goods is dependent on cultural norms
with some populaBons showing very high cooperaBon and
others close to Nash equilibrium behaviour (Henrich, et al.,
2001, 2005)
Chakravarty et al. (2013) nd very high rates of cooperaBon
(40-50 %) among high alBtude village communiBes in Kumaon.

Altruism and warm glow

Altruism Increase in uBlity from giving to an other with no
explicit or implicit reciprocity.
Warm glow Increase in uBlity from the act of giving with no
concern regarding the recipient.
In dictator games a meta give rate of 27 % is seen (Engel, 2011)
Dictator giving is sensiBve to contexts, framing, reference
points and social environments.
Banerjee and Chakravarty (2014) nd that framing and implied
property rights over the endowment determine dictator
outcomes.

Trust and reciprocity

A trust or investment game is one where a proposer chooses

whether to keep his endowment E or send x, keeping (E-x). The
respondent obtains 3x (original investment trebled) and decides the
amount [0, 3x] to send back to the proposer.
An ulBmatum bargaining game is one where a proposer decides what
part (x) of his endowment (E) he will give to the respondent. If the
respondent accepts then the split is (E-x, x) if not then neither get
anything (0, 0)
What are the Nash equilibria of the above games?
For TG, in giving x the proposer displays altruism and forward looking
reciprocity and in returning y, the respondent displays strong
reciprocity.
For UBG, the respondent vetoes only at the cost of making zero
payo.
How did experimental subjects behave ?

Trust and reciprocity

Berg at al. (1986) nd that a substanBal number of subjects do not send zero,
i.e.- are trusBng and a signicant amount of trust is reciprocated.

UlBmatum bargaining [Bowles, 2004]

Game

Results

Interpreta<on

Cita<on

Standard

Modal oer =
Oers < 20 % rejected

Reciprocity by
respondent

Guth, Schmi[berger and

Schwarze (1982)

Randomized Oers

Few rejecBons of low

oers.

Proposer not
responsible

Blount (1995)

Roles chosen by
quiz

Many low oers, very few

rejecBons

Proposer is
deserving

Homan, McCabe, Shachat and

Smith (1994)

Exchange game

Many low oers, very few

rejecBons.

SituaBonal
framing

Homan, McCabe, Shachat and

Smith (1994)

No fair oers
possible, only
[(8,2), (10,0)]

Low oers not rejected

Proposers
intenBons
ma[er

Falk, Fehr and Fischbacher

(2003)

Punishment by
third party

Most observers punish

low oers by proposer

Generalized
fairness norms

Fehr and Fischbacher (2001)

Standard: Au/Gnau

Oers > are common

high and low oers are
rejected w/ equal freq.

Endogenous
situaBon
dependent prefs

Henrich, Bowles, Boyd,

Camerer, Fehr, GinBs and
McElreath (2001)

Standard:Machigue
nga

Many low oers, very few

rejecBons

Endogenous
situaBon
dependent prefs

Henrich (2000)

A theory of other-regarding or social

preferences
Says that an agent is not merely interested in increasing his
own payo from a game, but also concerned about the other
agents payo, i.e.- he is inequality averse.
Thus Ui = Ui(own, | own other|), increasing in both
arguments.
Fehr and Schmidt 1999, Falk and Fischbacher, 1998; Fehr and
Schmidt, 1999; Bolton and Ockenfels, 1999; Rabin, 1993;
Charness and Rabin, 1999; Levine, 1998 all have models of
social preferences.
Some of these models use reciprocity/reputaBon and are not
staBc.

Norms and culture

A very important intellectual direcBon that emerged out of the
anomalies observed in laboratory experiments was the study of
the eect of culture and demographics on economic behaviour
through the formaBon and enactment of social norms.
Sen (1973) alludes to social norms when he discusses the
prevalence of cooperaBve acBon in the Prisoners Dilemma
game.
Arrow (1982) clearly states that The model of laissez-faire
world of total self-interest would not survive for ten minutes;
its actual working depends on an intricate network of
reciprocal obligaBons, even among compeBng rms and
individuals.

Preference reversals
Problem 1: Choose Between the following two risky bets, A or B:
A. 2,500 with probability of .33,
2,400 with probability of .66,
0 with a probability of .01
B. 2,400 with certainty

----------------------------------------------------------------
Problem 2: Choose between the following risky bets C or D:
C: 2,500 with probability .33, 0 with probability .67
D: 2,400 with probability .34, 0 with probability .66.

N = 72 A [18%] and B [82 %]

Majority display preferences of this type:
U(2,400) > .33U(2,500) + .66U(2,400) --- (I)

N = 72 C [83%] and D [17%]

Thus most people displayed preferences of the form:

.33U(2,500) > .34U(2,400) --- (II)
(I) and (II) are opposite to each other. This was rst documented by
Maurice Allais (1953)

Loss domain
Problem 3:
A: 4000 with prob = 0.8
0 with prob = 0.2
B: 3000 with certainty
Problem 4:
C: - 4000 with prob = 0.8
0 with prob = 0.2
D: - 3000 with certainty

The reecBon eect

Preferences are risk averse over gains and risk preferring over loss
domains. We are also loss averse, i.e.- a[ach a greater weight to a
loss as compared to a gain.
Chakravarty and Roy (2009) documents this over both risky and
ambiguous preferences.

Prospect theory
Formulated by Kahneman and Tversky(1979). Its salient points:
People overweight the importance of unlikely events and
correspondingly overweight near certain events.
People respond to framing, i.e.-equivalent outcomes are treated
dierently depending on the manner in which the outcomes or the
decision seing are described.
Provides a conceptual framework for dealing with situaBon-
dependence. If the uBlity funcBon is to explain behaviour its
arguments should be changes in states or events rather than the
states themselves. Thus, the value individuals place on states
depends on the rela7onship of the state to the status quo (ini7al
wealth, state enjoyed by peers, etc).

Equity Premium Puzzle

Given the return of stocks and bonds over the last century, an unreasonably
high level of risk aversion would be necessary to explain why investors are
willing to hold bonds at all (Mehra and Presco[ (1985)).
Benartzi and Thaler (1995) combined two behavioral conceptsloss aversion
(Kahneman and Tversky (1979)) and mental accounBng (Thaler (1985))to
provide a theoreBcal foundaBon for the observed equity premium puzzle.
Thaler et al. (1997), Gneezy and Po[ers (1997), and Gneezy, Kapteyn, and
Po[ers (2003) have all observed individual behavior consistent with the
Myopic Loss Aversion (MLA) conjecture.
Individuals are loss averse and oIen have myopic (short term) ways in which
they evaluate their por~olios. Both of these traits make them choose bonds
over equiBes.
It is assumed that with an increase in evaluaBon periods (i.e.- less myopic
decision making) may make people hold less of their wealth in bonds.

Equity-premium puzzle experiments

Haigh and List (JoF, 2005) conduct an experiment in lo[ery
choices and show that MLA is important in decisions made not
just by students but also by 54 professional futures and opBons
pit traders from the Chicago Board of Trade.
The traders display more MLA than the students.

Anchoring and reference points

Anchoring eects-IniBal 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 rst,
which acts as an anchor. Makes it easier to sell the medium
high priced item.
DramaBc or easy-to-recall events oIen 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.
When NYSE trading begins traders are more careful but over
the day their behaviour becomes more risk preferring and by
closing Bme they are almost risk neutral. Why is this
happening?

Framing and preferences

Tversky and Kahneman (1981) told people to

assume there was disease aecBng 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.
They then oered 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.

Asian Disease Problem

The majority of people selected A, showing a preference
for certainty or risk aversion.
Most people now selected D, seeking to avoid the loss of
400 people.
NoBce how the framing makes the dierence. 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.

Status quo bias and endowment eect

The endowment eect is peoples tendency to value
something more highly when they own it than when they
dont
Example: experiment in which median owner value for mugs
was roughly twice the median non-owner valuaBon
Some economists think this reects something fundamental
about the nature of preferences
IncorporaBng the endowment eect into standard theory
implies an indierence curve kinked at the consumers iniBal
consumpBon bundle
Smooth changes in price yield abrupt changes in consumpBon

Endowment Eect
Half the parBcipants were given mugs available at the campus bookstore
for $6
The other half were allowed to examine the mugs
Each student who had a mug was asked to name the lowest sale price
Each student who did not have a mug was asked to name the highest
purchase price
Supply and demand curves were constructed and the equilibrium price
was obtained
Trade followed
There were four rounds of this

Bias Toward the Status Quo:

Default Eect
When confronted with many alternaBves, people someBmes
avoid making a choice and end up with the opBon that is
assigned as a default
Example: Experiment showing that more subjects kept $1.50
parBcipaBon fee rather than trading it for a more valuable
prize when the list of prizes to choose from was lengthened
Possible explanaBon is that psychological costs of decision-
making rise as number of alternaBves rises, increasing
number of people who accept the default
ReBrement saving example illustrates the default eect when
the stakes are high

13-40

Default eect: reBrement

Prior to April 1, 1998, the default opBon was
nonparBcipaBon in the reBrement plan
AIer April 1, 1998, all employees were by default enrolled
in a plan that invested 3% of salary in money market
mutual funds
Only the default opBon changed

Dynamic inconsistency
Hyperbolic discounBng-people generally prefer smaller,
sooner payos to larger, later payos when the smaller
payos would be imminent; but when the same payos
are distant in Bme, people tend to prefer the larger, even
though the Bme lag from the smaller to the larger would
be the same as before.
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 ve years from now.

Examples
Lots of people want the IT dept. 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.
School teachers who work 9 months are given the
opBon of receiving their salary over 9 months or over
12 months. Many choose the 12 monthly checks
because they dont trust themselves. They lose
interest income.
Before you choose a college think of the reputaBon
the college has: is it a diploma mill or does it require
hard work?
Most people prefer the college to have a good
reputaBon, but once they arrive, they oIen prefer
easy classes.

Poverty and cogniBon

Recent work by Shar and Mullainathan (2013) Poverty and all
its related concerns require so much mental energy that the
poor have less remaining brainpower to devote to other areas
of life.
As a result, people of limited means are more likely to make
mistakes and bad decisions that may be amplied by and
perpetuate their nancial woes.
Their work could explain a conundrum of public policy: If you
give an individual Rs. 1000, why does he not invest it (his
marginal uBlity of a Rupee is high) and instead buy alcohol?
Chakravarty and Warglien (unpublished, 2013) demonstrate
that poor people may be much more myopic in their evaluaBon
of Bme.

Minor temptaBons
Ariely and his colleagues gave thousands of people 20 number
problems. When they tackled the problems and handed in the answer
sheet, people got an average of four correct responses.
When they tackled the problems, shredded their answers sheets and
self-reported the scores, they told the researches they got six correct
responses. They cheated a li[le, but not a lot.
He put cans of Coke and plates with dollar bills in the kitchens of
college dorms. People walked away with the Cokes, but not the dollar
bills, which would have felt more like stealing.
He had one blind colleague and one sighted colleague take taxi rides.
The drivers cheated the sighted colleague by taking long routes much
more oIen than they cheated the blind one, even though she would
have been easier to mislead. They would have felt guilty cheaBng a
blind woman.

So
Given that these minor moral transgressions are in of
themselves largely innocuous there is no real reason for us to
correct them.
However if everyone in the populaBon performs them, can we
end up with harmful social outcomes?
How can we prevent these ?
Dan Ariely (2012) The (Honest) Truth About Dishonesty.