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EC 310: Behavioural Economics

Dr Matthew Levy

London School of Economics

Lent Term 2017-18

Lecture 1: Contracting and Self-Control

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Plan for this Term

• Naivete in Intertemporal Choice


• Finish (paritally naive) present bias
• Projection Bias

• Heuristics and Biases


• Limited Inference in Games
• Behavioural IO and Finance
• Behavioural Public Policy – Happiness, Nudges, Welfare,
etc.

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Paying not to go to the gym


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Paying Not to Go to the Gym
• Among most common New Year’s resolutions: exercise
more
• Nearly 17,000 health clubs in the US, revenues over
$11.6bn
• 32.8m Americans members of health clubs (which is not
the same as actually going)
• DellaVigna and Malmendier (2006) is one of the first in a
mini-literature on the incentives to exercise
• What can we learn from observing people’s choices from a
menu of gym contracts and their actual exercise
decisions?
• New: how do firms respond to biased consumers?

• Challenge: unlike previous natural/field experiments, now


relying on observational data.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Paying Not to Go to the Gym
• DellaVigna and Malmendier observe gym attendance for
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

members of 3 Boston-area health clubs.


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• Customers choose from a menu of three possible


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

contracts:
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

1 Monthly flat-rate contract: pay a fixed membership fee of


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

$70–$85 per month for unlimited visits. Contracts


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
automatically renew, unless customer cancels in-person or
by sending in a form.
2 Annual flat-rate contract: pay a fixed membership fee of
10 times the monthly fee. Contracts automatically renew,
unless customer cancels in-person or by sending in a form. 1

3 Pay-per-visit contract: either pay $12 per visit, or purchase


a 10-visit carnet for $100
• Observe visits for customers choosing one of the flat-rate
contracts
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

3
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Paying Not to Go to the Gym
• Prediction 1: if customers are time-consistent and have
rational expectations, the average cost per visit when
choosing a flat-rate contract should be lower than the
pay-per-visit rate
• But the punchline of the paper is in the title... people pay
not to go toTable
the4: Distribution
gym: of Attendance and Price per Attendance at Enrollment
Sample: First spell and no subsidy, all clubs
First contract monthly, Months 1-6 First contract annual, Year 1
(monthly fee >= $70) (annual fee >= $700)

Average Price per Average Price per


attendance attendance attendance attendance
per month per month
(1) (2) (3) (4)
Distribution of measures
10th percentile 0.33 7.59 0.23 6.05
20th percentile 1.00 10.17 0.86 8.67
25th percentile 1.50 11.39 1.23 10.65
Median 3.91 20.89 3.58 20.34
75th percentile 7.00 58.39 6.58 59.82
90th percentile 10.75 107.50 11.00 119.64
95th percentile 12.83 170.00 13.25 239.28

Fig 1
N = 912 Fig 1 Full LSE logo in colour N = 912 N = 145 N = 145
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

Notes: The number of observations is denoted by N. An enrollment spell starts whenever an individual enrolls (or re-enrolls) in the club and ends whenever the
individual quits or is censored. The sample “First spell” consists of the first enrollment spell. The sample “First spell and no subsidy” restricts the sample “First
spell” to those spells in which the average adjusted monthly fee is at least $70 if the spell starts with a monthly contract and at least $58 if the spell starts with an
annual contract. The spells in column “First Contract Monthly, months 1-6” start with a monthly contract. The spells in column “First Contract Annual, year 1” start 4
with an annual contract. The variable "Price per attendance" is defined as the ratio of the average price over the average attendance over the firsy period (6
Fig 2 LSE logo – clear space
Fig 2
x x months for the monthly contract, one year for the annual contract).
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.

Table 5: ThisAverage Attendance


applies to the reproduction of the logo
in Monthly and Annual Contracts
OF E CONOMICS AND
at any size

POLITICAL SCIENCE
The clear space is indicated by the blue line.
Nothing must enter this area.
(Sorting)
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square
Average attendance during the n-th month since enrollment
Sample: First spell, all clubs
Month 2 Month 3 Month 4
Paying Not to Go to the Gym
LSE logo
Monthly contract 5.500
(0.0658)
N = 6380
4.998
0.069
N = 5783
4.592
0.070
N = 5390

• Timing:
Annual contract in period 0, the5.583
agent chooses
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
5.797 5.151
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
a contract from a
(0.1865) 0.191 0.188

menu. In periods 1, 2, ... she chooses whether to attend


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
N = 874 N = 858 N = 839

the gym or not


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
Notes: Standard errors in parentheses. The number of observations is denoted by N. An enrollment spell starts whenever an
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
individual enrolls (or re-enrolls) in the club and ends whenever the individual quits or is censored. The sample “First spell”
around the logo is shown above, and defines an area into which nothing should intrude.

• Define a contract as a triple (T, L, p), where:


consists of the first enrollment spell. The spells in row “Monthly Contract” start with a monthly contract. The spells in row “Annual
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures areContract” start with an annual contract. The sample in month n includes spells that are ongoing, not frozen, and not miscoded.
the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• The contract lasts for T periods (e.g. single visit, 30 days,


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

365 days)
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• The agent pays a lump-sum fee L in period 1


• The agent pays a fee p32in each period t during which she
attends the gym
• Big assumption: the agent treats spending money as a
1

utility cost in the period in which she spends it


• In every period t ≥ 1, the (intrinsic) costs and benefits of
going to gym are:
• A fixed utility gain of b in period (t + 1)
• A stochastic utility cost of c ∼ F (c) in period t
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Paying Not to Go to the Gym
• When does a β β̂δ agent think she will go to the gym?

−c + β̂δb − p ≥ 0
⇒ c ≤ β̂δb − p

• What is self-0’s expected utility from day t?


∫ β̂δb−p
βδ t
(−c + δb − p)dF (c)
−∞

• What is self-0’s expected utility from contract (T, L, p)?


[ ∫ ]
1− δT β̂δb−p
βδ −L + (δb − p − c)dF (c)
1−δ −∞

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

6
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Paying Not to Go to the Gym
• So when does a β β̂δ agent prefer a flat-rate contract
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

(T, L, 0) to a pay-per-use contract (T, 0, p)?


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• Using last expression from previous slide, rearrange to


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

find:
around the logo is shown above, and defines an area into which nothing should intrude.

 
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

∫ β̂δb−p ∫ β̂δb 
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

 
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
1 − δT 
L≤  pdF (c) + (δb − c)dF (c)

1−δ | −∞ {z }
β̂δb−p
} | {z
low-cost days intermediate-cost days

• On low-cost days
1
(c ≤ β̂δb − p), the agent thinks she will
always go to the gym. The flat-rate contract simply saves
her p
• On intermediate-cost days, the agent thinks she will go
only under the flat-rate contract. But the value to her is
only δb − c ≤ p
• On high-cost days (c > β̂δb), the agent thinks she will never
Fig 1 Full LSE logo in colour

go.
Fig 1
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Paying Not to Go to the Gym
• Previous expression uses unobservable integrals. Can be
used to write a weaker bound that is tied only to CDF:
commitment value
}| { z }| ]{
face value
(1 − δ) z [
L ≤ p · F (βδb) + (1 − β̂)δb · F (β̂δb) − F (β̂δb − p)
1 − δT [ ]
+ p · F (β̂δb) − F (βδb)
| {z }
overoptimism

• If the agent is time-consistent, then left only with first


term: pay only p times expected number of visits
• If the agent is fully sophisticated, left with first two terms:
pay extra to correct (1 − β̂)δb mis-alignment of future
preferences
• If the agent is fully naive, then left with first and third
Fig 1
terms: over-pay because of overoptimism Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Paying Not to Go to the Gym
• Thus the “paying not to go to the gym” evidence could
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

mean either that consumers are very naive, or that they


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

are very sophisticated


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• If naive, they are over-paying because they think they will


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

go much more often than they actually do (“fictitious


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

surplus”)
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
• If sophisticated, they are not over-paying but instead value
The abbreviated version is the square block with the letters LSE (fig 4).

the commitment of a flat-fee contract (“commitment value”)

• How to distinguish between these two cases?


1 Low subsequent attendance? (i.e. F (βδb) < L/p)
• Week 1 Survey:
1

• How many times per month do you exercise? x̄ =


• Weighing the costs and benefits, how many times do you
think you should exercise? x̄ =
(T-test: )
2 Consider firm’s decision and contract choice.
3 Consider a second decision.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Contract Design and Self-Control
• Set T = 1 for simplicity
• Firm’s problem:
( ∫ βδb−p )
max δ L − K + (p − a)dF (c)
(L,p) −∞
( ∫ )
β̂δb−p
s.t. βδ −L + (δb − p − c)dF (c) ≥ βδ ū (IR)
−∞

• Since IR will bind in optimal contract, we can substitute in:


 
 
 ∫
βδb−p ∫
β̂δb−p 
 
max δ 
−K − ū + (δb − a − c)dF (c) + (δb − p − c)dF (c) 

p  
 −∞
| {z }
βδb−p 
| {z }
social surplus from attendance fictitious surplus from overoptimism

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Contract Design and Self-Control
• Require technical assumption for FOC to yield maximum
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

“Asymptotically bounded peaks”: ∃(M, z) ∈ R2 such that


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

f (y ′′ ) ≤ M f (y ′ ) for all |y ′′ | > |y ′ | > z


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• i.e. no sharp peaks in tails


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

• Then FOC yields:


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

 
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

∂Π(p)  ( )

= δ(a−p) f (βδb−p)−(1− β̂) δbf (β̂δb−p)− F (β̂δb−p)−F (βδb−p) 

∂p | {z } | {z } | {z } | {z }
>0 ≥0 >0
≥0
1

• If agent is time-consistent, p∗ = a
• If agent is sophisticated, p∗ = a − (1 − β)δb
• If agent is fully naive, p∗ = a − [F (δb−p)−F (βδb−p)]
f (βδb−p)
• So below marginal cost pricing (for investment good) is
consistent with any type of present bias.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Procrastination on Cancellation

• Consider an agent who no longer wants to go to the gym,


but must pay a cost in order to cancel.
• In period t, if the agent is still enrolled and does not cancel
their contract, they pay £f and remain subscribed.
• If they do cancel the contract, then they additionally pay a
utility cost ct ∼ Ft (c), but have no decisions or costs in
subsequent periods.
• Assume ct is revealed at the start of each period, so that
self-t knows its value but self-(t − 1) does not
• Further, assume Ft (c) = F (c) for all t, so that the
disenrollment cost is stationary

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Procrastination on Cancellation
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• We will solve for the unique stationary perception-perfect


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

cutoff strategy:
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• All selves believe all future selves will disenrol whenever


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
c < c̃
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• All selves will actually disenrol whenever c < c∗


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• As before, the quasi-hyperbolic model means one extra


step when solving for a stationary strategy.

• Thus we have a three-step solution:


1
1 Derive a closed-form solution for long-run value of a
strategy, V (ct , c̃)
2 Use V (ct , c̃) to derive current value of strategy, W̃ (ct , c̃),
and consistent beliefs c̃
3 Use c̃ to derive perception-perfect cutoff strategy c∗

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Procrastination on Cancellation
• The value of the β, β̂, δ model is making this process
convenient:
1 Let V be the (exponentially discounted) perceived
continuation cost function – i.e., the value to self-(t-1) of
letting the game continue on to self-t:
{
−ct − f, if ct ≤ c̃
V (ct , c̃) =
−f + δ E(V (ct+1 , c̃)), else

2 Let W be the current-period payoff function:


{
−ct − f, if disenrol
W (ct , c̃) =
−f + βδ E(V (ct+1 , c̃)), if do nothing
3 And let W̃ be the perceived cost function for future selves:
{
−cτ − f, if disenrol
W̃ (cτ , c̃) =
−f + β̂δ E(V (cτ +1 , c̃)), if do nothing

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Procrastination on Cancellation
• Using the recursive structure of V ():
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

( ) ( )
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

E E E
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

[V (ct , c̃)] = P r(ct ≤ c̃) -f − [ct |ct ≤ c̃] +P r(ct > c̃) -f +δ [V (ct+1 , c̃)]
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

E[V (ct, c̃)] = E[V (ct+1, c̃)]


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• But now we use stationarity:


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• Assume for simplicity that δ = 1, and that ct ∼ U [0, c̄]:


The abbreviated version is the square block with the letters LSE (fig 4).

• Then P r(ct ≤ c) = c/c̄


• And E[ct |ct ≤ c] = c/2

• Then our expression simplifies to: 1

c̄ c
V = −f −
c 2
• First term: higher c will incur f for fewer periods; second
term: will incur a higher cost in expectation
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

15
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Procrastination on Cancellation
• Now that we have a closed-form solution, solve for
consistent beliefs c̃.
• Is there a fixed point that an agent believes would make
her future self indifferent between immediately
disenrolling and continuing using the same cost as the
cutoff?
−c̃ − f = −f + β̂V (c̃)
• Solving through, find:

f c̄
c̃ =
1/β̂ − 1/2
• These will be the beliefs that support our stationary
equilibrium
• Note that ∂c̃ > 0. How does this relate to pessimism
∂ β̂
effect?
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Procrastination on Cancellation
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. • Now that we have beliefs, we want each self to
Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

best-respond.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• This too takes the form of a cutoff: cancel iff ct ≤ c∗ , where:


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

E
The abbreviated version is the square block with the letters LSE (fig 4).

−c∗ − f = −f + β [V (ct+1 , c̃)]


c̄ c̃
⇒ c∗ = β(f − )
c̃ 2
1

• Fixing β̂, comparative static w.r.t β?


• Fixing β, comparative static w.r.t. β̂?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Procrastination on Cancellation
• This is how DellaVigna and Malmendier attempt to
distinguish between sophisticated and naive behaviour
• Use the actual attendance behaviour to calibrate the daily
Figure 3. Calibration of expected delay in cancellation
cost parameters: c ∼ N (15, 4), δ = 0.9995

Figure 3a. Simulated expected number of days before a monthly member switches to payment per visit.
• Sophisticates may delay
Assumptions: Cost k~N(15,4), daily savingsbriefly;
s=1 and dailynaifs
average delay is 2.3 months (70 days) (Finding 4).
may
discount factor procrastinate
delta=.9995. The observed

Fig 1
arbitrarily long for β < 0.65 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Procrastination on Cancellation
• Calculate a conservative measure of cancellation lag:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

number of full months between last visit and contract


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

termination
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print. Figure 3b. Simulated probability that cancellation delays last more than 120 days. Assumptions as in
E.g.3a.ifThe
• Figure final attendance
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
observed
around the logo is shown above, and defines an area into which nothing should intrude. is 10
share of agents with delay
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
March
over 120 days is 20and cancellation
percent (Finding 4). is 5
April, only count as 1 full month
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

• No lag counted if agent does


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
28
not attend for months, then
Also you can use either the abbreviated or full version of the logo.

attends one final time to cancel


The abbreviated version is the square block with the letters LSE (fig 4).

• Even with this conservative measure, average lag is 2.31


full months ($187). Lag is over four months for 20 percent
of sample
• Calibrationally implausible with sophisticated agents; 1

DellaVigna and Malmendier conclude naive present bias


• We will return to the gym in a couple of weeks with some
direct evidence of naivete
• Next week: projection bias
• Week 3: projection bias, present bias, and habits/addiction
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Naiveté: One last example
• MT10 applications showed scope for interventions to
overcome procrastination
• But interventions/contracts can make agents strictly
worse off, too.

• Consider an agent facing an infinite sequence of tempting


choices
• ct ∈ {0, 1} for t = 1, 2, ...
• Quasi-linear utility u(ct , ct−1 ) = ct · u − ct−1 · d
• Assume that δd > u > βδd

• Note that for any beliefs, ŝ(β̂, s) the only


perception-perfect strategy would be s = (1, 1, ...), so any
(β, β̂, δ) agent will always yield to temptation regardless

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

20
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Naiveté: One last example
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Suppose a mad economist offered the following contract:


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

1 Pay q · s immediately, for some c ≥ 0, q > 0


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

2 In all future periods, the price of the tempting good is


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

raised by s (i.e. u(ct , ct−1 ) = ct · (u − s) − ct−1 · d


The abbreviated version is the square block with the letters LSE (fig 4).

• A time-consistent agent, or a fully naive agent, would think


this was completely insane.
• A sophisticate or partially naive agent may value the 1

commitment provided by such a contract.

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

21
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Naiveté: One last example
• The agent will only want the contract if she thinks her
future selves will indulge, i.e. u − β̂δd ≥ 0 (equivalently
β̂ ≤ b for some b ∈ (β, 1))
• Given the upfront cost, the agent wants to purchase the
smallest s that will cause their future selves to behave:

(u − s) ≤ β̂δd ⇒ s∗ = u − β̂δd
• Would this be worth the cost?
βδ
u − βδd − (u − β̂δd)q ≥ u + (u − d)
( ) 1 − δ
d−u
βδ − d ≥ q(u − β̂δd)
| {z } | 1 − δ | {z }
{z } ≥0
≥0 ≥0

• Thus if β > 0, δ > 0, and u − β̂δd, there is a q̄β̂ > 0 such that
Fig 1
the agent would strictly prefer this contract for all q < q̄β̂ Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

22
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Naiveté: One last example
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Suppose a partially naive agent actually did purchase this


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

commitment device
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• It won’t work, since


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

(u − s∗ ) − βδd = u − (u − β̂δd) − βδd


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

= (β̂ − β)δd > 0

• She is made worse off in two separate ways:


1 In every future period, she gives in to the now-costlier
1
temptation
2 She paid the up-front cost s∗ q for the commitment device

• A fully sophisticated agent, however, is made weakly


better off (strictly if q < q̄β )

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

23
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Final Thoughts
• When is it possible to distinguish sophisticated from naive
behavior?

• What types of interventions:


• Are pareto-improving?
• Improve welfare of some types, decrease welfare of
others?
• Will firms find profit-maximizing?

• When will (partially) naive agents demand


welfare-improving contracts?

• When is it possible to conclude that an intervention is


helpful/harmful?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

24
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Lecture 2: Projection Bias


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Mis-Prediction of Future Preferences
• We broke apart our analysis of present-biased
preferences into two phenomena:
• Dynamic inconsistency (β < 1)
• Naivete (β̂ > β)
• Dynamic consistency is a feature imposed by exponential
discounting, but was seldom imposed by earlier, more
general, economic models.
• Naivete represented a more serious break from the
‘unitary actor’ paradigm: individuals no longer correctly
predict their own future preferences or behaviour
• In uncertain environments, this lead to a breakdown of
rational expectations
• Worse, agents can hold incorrect beliefs even in certain
environments
• This sort of mis-prediction is quite common – today: a
very general model of mis-predicting future preferences
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences
• When thinking about reference-dependent preferences
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

last term, we briefly mentioned that standard theory is


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

amenable to allowing instantaneous preferences for


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

goods to depend on some underlying state.


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

• Short-run fluctuations:
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

• Changes in external environment – weather, company, ...


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Changes in internal physiological state – fatigue, hunger, ...


• Changes in internal psychological state – depression,
anger, arousal ...
• Long-run systematic changes:
• Exogenous changes – aging... 1

• Endogenous changes – habit-formation / addiction,


adaptation to new reference point...
• If preferences are unpredictable, economics has a serious
problem
• If preferences appear to change in predictable ways, we
should understand how to model it Fig 1 Full LSE logo in colour
Fig 1
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

3
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences
• Stigler-Becker (1977) – “De Gustibus non est
Disputandum” argue that changing preferences is actually
an illusion:
• Reformulate consumption problem over very general
“commodities”:
Ut = U (Z1t , ...Zmt )
• Agents do not purchase commodities directly, but instead
only market goods
⃗ t = C1t , ...Ckt
C
• Agents then convert market goods into commodities using
their own time L and human capital S:
Zi = fi (C1it , ...Ckit , Lit , Sit )
• The trick then is specifying how human capital is derived:
⃗ t−1 , C
• Addiction: Sit = Si (C ⃗ t−2 , ...)
• Advertising: Sit = S(Ait )
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

4
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences
• But this “human capital” is just a specific way to interpret
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

the conditioning of preferences on an underlying state


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

variable:
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

Ut = U ( C
around the logo is shown above, and defines an area into which nothing should intrude.
⃗ t; S
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
⃗t )
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

⃗t = S(C
S ⃗ t−1 , C
⃗ t−2 , ...; S
⃗t−1 , S
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
⃗t−2 , ...)
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Stigler-Becker, and later Becker-Murphy (1988) “A Theory


of Rational Addiction” close the model by assuming that
agents:
• Understand the1 process governing changes in the state
variable
• Correctly use this process to predict the effect of current
consumption on future choices/utility, and choose current
consumption optimally on these rational expectations
• Evidence suggests that people systematically depart from
Fig 1
the latter assumption Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences
Evidence
• Consider a (too-)simple model of eating
• Let ct index how “filling” the food consumed at time t is; 0 =
no consumption, 1 = celery, 10 = chocolate cake
• Let st index how hungry the agent is at time t, and assume
st = 10 − ct−1

• Agent maximises Ut = ∞ i=t δ
(i−t) u(c , s ), and assume
i i
∂u/∂c|c=0 > 0, ∂u/∂c|c=10 ≤ 0
• Natural to think agent wishes to eat more filling foods
when he is hungry:
∂2u
>0
∂c∂s

• Prediction: if choosing at t for a future period τ > t, an


agent’s choice should depend only on expected cτ −1 (and
not on ct−1 )
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

6
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences
Evidence
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• Read and van Leeuwen conduct a field experiment in


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. several Amsterdam office buildings


Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

• Offer workers choice of a snack from along a spectrum of


This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

“healthy” (apples, bananas) to “unhealthy” (borrelnoten,


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Snickers bars); select now for a snack next week.


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Key feature: randomised into 4 groups based on current


satiation (before/after lunch) and expected future satiation
• Results: proportion of subjects choosing unhealthy snack
for next week: 1

Will be hungry Will be satiated


Currently hungry 78% 56%
Currently satiated 42% 26%
• c.f. shopping on an empty stomach
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences
Evidence
• Read and van Leeuwen returned the next week and
allowed their subjects to switch their snack choice.
• More complicated: this “empathy gap” interacted with our
now-familiar dynamically inconsistent taste for immediate
gratification.
198 DANIE L RE AD AND BARBARA VAN LE E UWE N

F IG. 1. P er cen t a ge of u n h ea lt h y sn a cks ch osen in a ll con dit ion s

h ypot h esis t est s below we r epor t sim pler t wo dim en sion a l ANOVAs or t t est s.
Fig 1 Full LSE logo in colour
Fig 1

All sign ifica n t r esu lt s r epor t ed below a r e a lso sign ifica n t in t h e fou r dim en -
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

sion a l ANOVA.
8
Fig 2
x x
H ypoth eses 1 th rou gh 3: Con cern in g In traperson al E m path y Gaps
Fig 2 LSE logo – clear space

The clear space around the logo must be


x equal to the space between the LSE

THELONDON AsSCHOOL
ca n be seen in F ig. 1, t h e pr opor t ion s of u n h ea lt h y sn a cks ch osen for
lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

a dva n ce ch oice wer e


POLITICAL SCIENCE
or der ed by con dit ion a ccor din g t o t h e pr edict ion s of H 1
The clear space is indicated by the blue line.
Nothing must enter this area.
The clear space must continue around any

x x
t h r ou gh Hx 3: PA(H S) wa s gr ea t er t h a n PA(SS), PA(H H ) wa s gr ea t er t h a n PA(H S),
element (eg text, sub logos) attached to
the LSE square

a n d PA(SH ) wa s gr ea t er t h a n PA(SS). Mor eover, a s post u la t ed by H 3, t h e cold-


t o-h ot a n d t h e h ot -t o-cold em pa t h y ga ps wer e a ppr oxim a t ely equ a l in size:

LSE logo
State-Dependent Preferences PA(SH ) 2 PA(SS) 5 30%; PA(H H ) 2 PA(H S) 5 36%. Th e com posit e h ypot h esis
wa s t est ed by m ea n s of a 2 3 2 a n a lysis of va r ia n ce on a dva n ce ch oices, wit h
h u n ger /a a n d h u n ger /i t r ea t ed a s a r epea t ed m ea su r e. Th e a n a lysis con fir m ed
The LSE logo Evidence
is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should abem usedaonin effect
all School publicationsofand bot h h u n ger /a [F (1,196) 5 8.5, p , .004] a n d h u n ger /i [F (1,196)

Giordano et al. (2007) examine effect of current craving


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It • must never 5be reset,
23.6,redrawn orp ,Do.001]
altered. not be on a dva n ce ch oice wit h n o in t er a ct ion (F , 1). Th e a bsen ce
tempted to draw a box around the full logo, but use the form shown here.
ofuseathenmasterinartwork
t er from
a ctdisk.ion su ppor t s t h e cla im t h a t h u n ger /i a n d h u n ger /a h a ve a n in de-
state on demand for future buprenorphine amongst
To ensure high quality reproduction, you should always
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print. pen den t a n d a ddit ive effect on ch oice. To su m m a r ize, we fou n d su ppor t for t h e
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

heroin addicts
around the logo is shown above, and defines an areacla imnothing
into which t hshould
a t intrude.
t h er e is a h ot -t o-cold a s well a s a cold-t o-h ot em pa t h y ga p, t h a t
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures aren theeit h er em pa t h y ga p is com plet e (i.e., pa r t icipa n t s did t a ke fu t u r e h u n ger or
only exception).

BUP (suboxone) is a partial opiod agonist used to treat


on black. These are available electronically •
You can use the square element of the logo either as white lettering on red, PMS 485, or white
sathet isfa
(EPS file) from LSE Design ctUnit.
ionAn EPSin
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
file istfor
o a ccou n t ), a n d t h a t t h e em pa t h y ga ps a r e of a bou t equ a l size.
Department. Use a TIFF file for non-PostScript printers andAn a GIF fileaforddit
the web. ion a l qu est ion is wh et h er t h e effect s of h u n ger /a differ ed in m a gn i-

heroin addiction; can be dosed to prevent cravings for


Also you can use either the abbreviated or full version of the logo.
t u de fr om t h ose of h u n ger /i. We in vest iga t ed t h is by exa m in in g t h e ANOVA
The abbreviated version is the square block with the letters LSE (fig 4).

several days r egr ession coefficien t s. As expect ed, given it s m u ch gr ea t er F va lu e, t h e coeffi-


cien t for h u n ger /i (.32) wa s gr ea t er t h a n t h a t for h u n ger /a (.19), bu t t h e t wo
Timing of study:
• coefficien t s did n ot differ sign ifica n t ly even wh en t h e p va lu e wa s set a t a
m odest • Day .2. Th0: er e quintuple
is n o sou n d st adoset ist ica l (mild
ba sis, t hwithdrawal appears
er efor e, for con clu din g t h a t after 5
h u n ger /i h a d a gr ea t er effect on a dva n ce ch oice t h a n h u n ger /a .
days)
• Day
H ypoth esis 4 5:
an d elicit valuations
5: T h e Im m ed1 iacy E ffectof additional single dose to be
Accordelivered
din g t o H ypot onh esisDay
4, we 10
expect ed m or e ch oices of u n h ea lt h y sn a cks
for im m edia•t e Satiated: receive
ch oice t h a n for a dva n cequintuple
ch oice. As is dose
clea r frbefore
BUPom in spectvaluing
in g F ig.
• Deprived: receive quintuple dose after valuing BUP
• Day 10: Elicit valuations for additional single dose at end of
current treatment session
• Satiated: receive single does before valuing BUP
• Deprived: receive single dose after valuing BUP
Fig 1 Fig 1 Full LSE logo in colour

• Day 11: Double dose The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

• Day 13: Double dose


9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences
Evidence

• Because subjects in all conditions are valuing the same


good (second dose on day 10), Stigler-Becker approach
requires same valuation
• Instead, similar picture to hunger (median valuations):
• When deprived, value immediate dose at $75; when
satiated, value immediate dose at $50 (p<0.001)
• Day-5 valuations lower in both states: deprived, value
delayed dose at $60; satiated, value delayed dose at $35

• Subjects were familiar with effects of BUP when both


deprived and satiated, and certainly people know the
effects of food on hunger; this is about more than
learning.

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences
Evidence
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

• Evidence suggests people are extremely adaptable to


tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

durable changes – but do they predict this adaptation?


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

• Gilbert et al. (1998) report a series of experiments:


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

• Experiment 3: happiness 1 month after 1994 Texas


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Gubernatorial (Ann Richards vs. George W. Bush)


• Compare predictions of happiness in event that W won:
Pre-Election Forecast Post-Election
Losers 5.00 4.07 5.33 1

Winners 4.10 4.90 4.40


• Possible that W was more progressive than expected by
both sides, or (authors’ interpretation) subjects failed to
predict adaptation to losing election

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences
Evidence
• Experiment 2: happiness 1 month after tenure decision
• Asked former assistant professors who had either
achieved or failed to achieve tenure to rate their
happiness. Split into “recent” (0-5 years) and “ancient”
(6-10 years)
• Asked current assistant professors to predict happiness
Recent Happiness Ancient Happiness
Positive Negative Positive Negative
Actual 5.24 4.71 5.82 5.23
Forecast 5.90 3.42 5.65 4.97
• Forecasters believed tenure would make them happier in
short run than it actually does (p=0.047), but do not
mis-predict the very long-run adaptation (p=0.61)
• Forecasters believed failing tenure would make them
unhappier in short run than it actually does (p=0.04), but
Fig 1
do not mis-predict the very long-run adaptation (p=0.66)
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• People are not making random responses in these


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. examples; instead, they always seem to predict that their
Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space

future preferences will too closely resemble their current


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

ones
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
• If hungry, think future selves will be relatively hungry
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• If craving, think future selves will be relatively craving


• If not accustomed to tenure, think future selves will be
relatively unaccustomed

• In all these cases there is a clear state variable that affects 1

preferences, which is expected to change in the future


• People underestimate the effect of this change in state on
their future preferences

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias
• Loewenstein, O’Donoghue, and Rabin (2003) formalise this
with a model of “simple projection bias”
• Consider an agent with state-dependent preferences
u(ct , st ) of the Stigler-Becker variety
• The agent has simple projection bias of degree α if they
mis-predict the future utility of consuming cτ in state sτ ,
when currently in state st , as:
ũ(cτ , sτ ; st ) = (1 − α)u(cτ , sτ ) + αu(cτ , st )
• First term: correct utility conditional on actual future state
• Second term: utility conditional on state remaining
unchanged
• [How is this different from a model where an agent just
mis-predicts their future state (e.g. as s̃ = γst + (1 − γ)sτ )]?
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias
• In period t, the agent thus believes her optimisation
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

problem is:
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print. ∞

δ τ ũ(cτ , sτ |st )
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
t
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
max Ũ (ct , c̃t+1 , ...|st ) =
ct ,c̃t+1 ,c̃t+2 ,...
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
τ =t
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• While u is time-consistent, her perceived intertemporal


The abbreviated version is the square block with the letters LSE (fig 4).

preferences Ũ t may be dynamically inconsistent


• i.e. future selves may wish to change consumption plans
after state has actually changed
• May solve for perception-perfect strategies (though harder
1
than βδ)
• If there is uncertainty about future state, maximise
expected utility in standard von Neumann-Morganstern
way:
[ ] ∑∞

Fig 1
max t
t Ũ (ct , c̃t+1 , ...|st ) =
ct ,c̃t+1 ,c̃t+2 ,...
E
δ τ [ũ(cτ , sτ |st )]
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


E
possible. The Pantone reference is PMS 485
τ =t
15
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias
• Re-consider our silly model of food consumption:
u(ct , st ); st = 10 − ct−1
• Under simple projection bias, a hungry (s = 8) agent
mis-predicts her post-lunch utility (s = 2) as:

ũ(cτ , 2; 8) = (1 − α)u(cτ , 2) + αu(cτ , 8)

• When predicting her future pre-lunch utility (s=8),


however:

ũ(cτ , 8; 8) = (1 − α)u(cτ , 8) + αu(cτ , 8) = u(cτ , 8)

• How does this compare to the Read-van Leeuwen results?


Will be hungry Will be satiated
Currently hungry 78% 56%
Currently satiated 42% 26%
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Durable Goods
• Think back to the very first model of reference-dependent
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

preferences with loss aversion we used to explain the


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

endowment effect.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• Suppose for simplicity the agent experiences gain-loss


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

utility from mugs (mt ) relative to a reference point


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

(rt = mt−1 ), but no gain-loss utility from money (yt ). That


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

is:
{
M mt + G(mt − rt ) + yt , if mt − rt ≥ 0
u(mt , yt , rt ) =
M mt + λG(mt − rt ) + yt , if mt − rt < 0
1

• Critically, the mug lasts for T + 1 > 1 periods – long


enough for the consumer to adapt to owning or selling
the mug
• What is the effect of projection bias on consumers’
willingness to pay/accept?
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Durable Goods
• Consider a mugless agent looking to buy:

T +1

Ũ (don t buy) = ũ(0, 0, 0; 0) + ũ(0, 0, 0; 0)
s=2
=0


T +1
Ũ (buy) = ũ(1, −yB , 0; 0) + ũ(1, 0, 1; 0)
s=2
= −yB + M + G + T (M + αG)

⇒yB = (T + 1)M + (1 + αT )G

• Note that ∂yB /∂α > 0 – why?


Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Durable Goods
• Consider a mug-endowed agent looking to sell:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here. T +1

To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
Ũ (don t sell) = ũ(1, 0, 1; 1) +
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
ũ(1, 0, 1; 1)
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
s=2
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
= (T + 1)M
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).


T +1
Ũ (sell) = ũ(0, yS , 1; 1) + ũ(0, 0, 0; 1)
s=2
= yS − λG + T (−αλG) = yS − (1 + αT )λG
1

⇒yS = (T + 1)M + (1 + αT )(1 + λ)G

• Note that ∂yS /∂α > 0 as well – why?


Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Durable Goods
• Thus both buying and selling prices increase due to
projection bias. What is the effect on the ratio?
• Let
yS (T + 1)M + (1 + αT )λG
L= =
yB (T + 1)M + (1 + αT )G
• Result 1: λ > 1 → > 0 (projection bias exacerbates ∂L
∂α
endowment effect for durables)
• Result 2: projection bias enables endowment effect for
permanent durables
(T +1)M +λG
• Suppose α = 0. Then limT →∞ L = limT →∞ (T +1)M +G =1
(T +1)M +(T +1)λG M +λG
• Suppose α = 1. Then L = (T +1)M +(T +1)G = M +G
independent of T

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

20
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Durable Goods
Evidence
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Loewenstein and Adler (1995) ask a slightly different


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

question: do subjects anticipate the endowment effect?


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Perform usual mug endowment experiment


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

(Northwestern), but:
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

1 Control subjects: coin toss to determine mug allocation;


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
selling price elicited from winners and WTP (‘choice’) from
losers
2 Experimental
934 subjects:
THE ECONOMIC JOURNAL [JULY

•theyFirst
calledasked
the flip for selling
correctly price
and got for After
a mug.2 event they win
providing sellingcoin
prices,toss
subjects individually called a coin toss and were given a mug if they called it
•correctly.
ThoseFinally,
whothosewonwho then asked
received a mugifwere
want towhether
asked revisethey selling
would price
like to revise their selling price (although they were not actually allowed to do 1
• This is not
SO).3
asking whether sellers over-price, but rather
whether mugless realise their
Table valuations
2 will increase
Mean Valuationof Mugs

Number of Prediction
Group Form Description subjects of valuation

Control I Selling price 24 $5.96


(0.460)
2 Choice 29 $4.05
(0.329)
Experimental 3 Selling price contingent 53 $4. i6
Fig 1 Full LSE logo in colour
Fig 1
The full LSE logo should be used wherever
on getting a mug (0.293)
possible. The Pantone reference is PMS 4854 Desired revision of 34 $4.69
selling price (0.329)

Std. errors in parentheses. 21


Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x
THE LONDON SCHOOL II.2 Results equal to the space between the LSE
lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Durable Goods

• What is the effect of this on welfare?


• Suppose that both buyers and sellers in a market for a
durable good exhibit projection bias (e.g. residential
housing)
• Then both supply and demand shifted right relative to
unbiased (correct) schedules
• Price unambiguously higher: transfer from buyers to
sellers
• Quantity generically distorted: inefficiency
• What if only one side of the market is biased?
• Only buyers (e.g. consumer electronics)
• Only sellers (e.g. selling family heirlooms to antique store)

• How is this distinguished from asymmetric information?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

22
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Durable Goods
• Many of our largest expenditures (house, automobile) are
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

for durable goods for which we may expect people to


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. exhibit this bias


Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

• Consider a standard labour supply problem, in which an


This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

agent is also projection biased


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

max Ũ (⃗l, ⃗c; r0 ) s.t. w


⃗ ·L
⃗ ≤ p⃗ · ⃗c
The abbreviated version is the square block with the letters LSE (fig 4).

⃗l,⃗c

rt = γrt−1 + ct−1
and the agent has the opportunity to commit to a high 1

permanent level of consumption (e.g. house purchase)


• The agent does not realise they will quickly grow
accustomed to that high consumption, end up caught in
the rat race
• We will return to these issues when discussing ‘happiness’
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

23
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Durable Goods
• Loewenstein O’Donoghue and Rabin discuss durable
goods in a different context, more grounded in temporary
fluctuations in immediate valuations
• Suppose a durable good lasts T periods, and delivers a
flow of utility in each period f (st ) = st .
• Let st ∼ g(s) is an i.i.d. state variable, with E[s] = s̄
• An agent may purchase the durable good in any period,
and it is delivered in the next period
• Note that the good is worthwhile to purchase at price p if
p ≤ T s̄
• A projection-biased agent will be too likely to purchase the
good
• (Not in paper) as var(s) → ∞, a rational agent will still only
purchase based on s̄ whilst a projection-biased agent will
eventually purchase with probability 1
• c.f. non “economic” decisions such as suicide, waiting
periods for gun purchases
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

24
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Lecture 3: Applications of Projection Bias


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
• Important class of state-dependence is habit-formation
(macro adaptation, addiction, behaviour change, ... )
• Key economic assumption: 1. Turns out GYM is HABIT FORMING
2. Macro: Hedonistic treadmill: People get
∂2U used to luxuries
>0 3. Behaviour: Problem solving eg. change
∂ct ∂ct−1
people tax payment behaviour
• Recall Stigler-Becker approach, and re-write in terms of
state variable:
recall underlying state
st+1 = f (st , ct ) = γ · (st + ct ) (γ ∈ (0, 1))
• Then habit formation is really saying

∂2U
>0
∂st ∂ct "
u
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences and Habit Formation
From Habits to Addiction
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• DSM-IV has two primary criteria for diagnosing substance


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

dependence:
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

1 Tolerance, as defined by either of the following: (a) A need


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
for markedly increased amounts of the substance to
You can use the square element of the logo either as white lettering on red, PMS 485, or white

achieve intoxication or the desired effect or (b) Markedly


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4). diminished effect with continued use of the same amount
of the substance.
2 Withdrawal, as manifested by either of the following: (a)
The characteristic withdrawal syndrome for the substance
or (b) The same (or closely related) substance is taken to
relieve or avoid withdrawal symptoms. 1

• Reinforcement assumption does not guarantee these by


itself
• We add a second assumption, of tolerance:
∂U
<0
∂st
Fig 1 Fig 1 Full LSE logo in colour

• Note: clinical psychiatrists seldom differentiate between


The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

(cardinal) utility and marginal utility Marginal still >0 3


Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
• Following from Becker & Murphy (1988), consider the
following setup:
• An infinitely-lived agent receives ȳ income in every period,
and may divide it between a numeraire xt ∈ and an R
addictive good at ∈ {0, 1}.
• (Not innocuous, but good for simplicity) Suppose that
price of addictive good in any period pt = p̄ (and later,
consider infinitesimal deviations)
• The agent’s instantaneous utility is given by:
u(xt , at ; st ) = xt + ϕa at + ϕas at st − ϕs st
where ϕa , ϕas , ϕs > 0
• Note: Reinforcement given by ϕas > 0, tolerance by
ϕs ≥ ϕas 1. Want cons numeraire
• As before, let st+1 = γ(st + at ) 2. Want addictive good
Fig 1 Full LSE logo in colour
Fig 1
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485
SEE NOTES

4
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Note that this is in principle a very difficult problem: must


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

predict all future selves’ behaviour, and possibly different


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

behaviour in response to current decision


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

• By assuming stationarity, greatly reduce complexity to a


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

cutoff rule
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Intuition: suppose self-t plans to refrain, but knows


self-(t+1) onward plan to hit.
• Since self-t is refraining, know st > st+1
• But then it is optimal for a less-addicted self to hit and hit
forever 1

• Given reinforcement, self-t should then strictly prefer to hit


now So cant be case that someone less addictive would hit more and vv
• But then a cutoff rule implies just two possible strategies
1 If s0 ≥ s∗ (p̄), then hit in all periods
2 If s0 < s∗ (p̄), then refrain in all periods
• (Note: invert s∗ (p̄) to get initial demand function)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
• Consider an agent with s0 , choosing between these two
plans.
• How will the state variable evolve?
1 If she hits in all periods, then at = 1, so:
s1 = γ(s0 + 1) = γs0 + γ
s2 = γ(s1 + 1) = γ 2 s0 + γ 2 + γ

t
1 − γt
t t t
st = γ s0 + γ = γ s0 + γ
j=1
1−γ
γ
lim st =
t→∞ 1−γ
2 If she refrains in all periods, then at = 0, so:
st = γ t s0
lim st = 0
t→∞
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

RHS: 1. initial level matters but in limit less


2. Solve for Steady State in limit 6
Fig 2 LSE logo – clear space

Hence GAMMA controls max addiction and


Fig 2
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND

POLITICAL SCIENCE
speed of habit at any size

The clear space is indicated by the blue line.


Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• If she plans to refrain forever, then:


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

∞ withdrawal on all future states


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude. ∑
U (ref rain|s0 ) = ȳ − ϕs s0 + δ j (ȳ − ϕs sj )
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web. j=1
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
∑∞ futrre s = discounted from initial
= ȳ − ϕs s0 + δ (ȳ − ϕs γ j s0 )
j

j=1
1 1
= ȳ − ϕs s0
1 1−δ 1 − δγ GP: Infin sum - y today and
discounted in future.
• First term: gets to consume full amount of numeraire
Double discount on S0 =>
always hence RHS 1-DG on denom
• Second term: suffers due to initial addiction level, but
discounted by δ · γ in future periods
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
• If she plans to consume forever, then:
U (hit|s0 ) = (ȳ − p0 ) + (ϕa + (ϕas − ϕs )s0 )+
∑∞ ∞

+ δ (ȳ − p̄) +
j
δ j (ϕa + (ϕas − ϕs )sj )
j=1 j=1
1 δ
= ȳ − p0 − p̄+
1−δ 1−δ
∑∞addictive good
consume but spend on ϕa
+ (ϕas − ϕs )s0 + δ j (ϕas − ϕs )γ j s0 + +ζ
1−δ
terms dep. on S0 j=1
+ discounting effect over time
∑ ∞
1 (ϕas − ϕs )s0 ϕa
= ȳ − δ j pj + + +ζ
1−δ 1 − δγ 1−δ
j=0
numer consumption part of addicition discounted by DG
• Note: ζ < 0 is effect of tolerance (collect nuisance terms)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485
Zeta: tolerance

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences and Habit Formation
A simplified model of rational addiction
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• Thus the agent will consume if:


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
ϕas s0 ϕa ∑

p0 ≤ p = − δ j pj + ζ
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
+
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
1 − δγ 1−δ |{z}
Also you can use either the abbreviated or full version of the logo.
| {z } j=1
The abbreviated version is the square block with the letters LSE (fig 4).
| {z } tolerance
withdrawal enjoyment
avoidance

∂p∗
• Note 1: > 0. Cutoff 1

∂s0
∂ 2 p∗
• Note 2: < 0. Less sensitive to current state.
∂δ∂s0
• Note 3: ∂p∗ /∂pt = −δ t . Forward-lookingness.
Cutoff price dep non future price.
If I hit today im going to end up paying more in future - increasing
Fig 1 Fig 1 Full LSE logo in colour

pt.
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

Independent cons choice in


9
Fig 2
x x
HENCE if we look at price ELASTICITY we can actually READ
Fig 2 LSE logo – clear space

The clear space around the logo must be


x
THE LONDON SCHOOL OFF people's futur DELTA
equal to the space between the LSE
lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
A simplified model of rational addiction When ppl know future price d will they d behav
• Forward-lookingness assumption is a critical test of this
state-based approach to modelling addiction – is it true?
• Becker-Grossman-Murphy 1994 “An Empirical Analysis of
Cigarette Addiction” conduct first test.
• Find significant future-price elasticity, but problematic
empirical assumptions
• p. 407, “Still, the estimates are not fully consistent with
rational addiction, because the point estimates of the
annual Delta too low - but its been proven
discount factor are implausibly low”
correct!
• Gruber-Koszegi 2001 ‘Is Addiction “Rational”? Theory and
Evidence’ improve on the empirical approach:
• Use individual smoking rather than aggregate sales
(though restricted to sample of expectant mothers)
• Use high-frequency data on
enacted-but-not-yet-implemented tax changes
Fig 1 Fig 1 Full LSE logo in colour

If price of cigs +2$ in future how much will you consume today
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

QUARTERLY
LSE logo 1272
JOURNAL
State-Dependent Preferences and Habit Formation
OF ECONOMICS
QUARTERLY JOURNAL OF ECONOMICS
A simplified model of rational addiction
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a • Implied price
distinct visual identity for the School. The logo should be used on all School publications and

TABLE III TABLE III


information/publicity materials. It is widely used and recognised.

elasticities given
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

TAX ANNOUNCEMENT ONES OF—F


TAXIXED
ANNOUNCEMENT
EFFECTS MODELS
ON SMOKING—FIXED EFFECTS MODELS
tempted to draw a box around the full logo, but use the form shown here.
OF FFECT
MOKING
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
in square
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

Aggregate sales data


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
Natality
Aggregate
consumption
sales data
data Natality consumption data
brackets
(1982–1996) (1989–1996)
(1982–1996) (1989–1996)
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics • Overall current
e Effective
214.13 rate
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
27.998 20.660
27.998 214.13
20.215 20.660 20.215
Also you can use either the abbreviated or full version of the logo.

(0.306) (1.664)
The abbreviated version is the square block with the letters LSE (fig 4).
(0.050)
(0.306) (1.664)
(0.226)
price
(0.050)
elasticity
(0.226)
[20.803] [21.502] [20.347]
[20.803] [21.502]
[20.113] -0.35
[20.347] (interpret?)
[20.113]
Enacted
2.307rate 2.307
20.344 20.344
(1.066) (1.066)
(0.142)
• But most of this
(0.142)
[0.232] [20.181]
[0.232] is result of future
[20.181]
e Effective
4.001rate 1
4.001
20.118 prices 20.118
(22)(1.330) (1.330)
(0.180) (0.180)
[0.402] [20.062]
[0.402] • Including future
[20.062]
bs 8678 Number
8675 of obs 4342
8678 all similar4341 8675
4341 4342
prices,
re from regression of consumption
Coefficients
on listedare
variables,
from regression
as well asofaconsumption
full set of dummies coefficients
on listedforvariables, as well as a full set of dummies for
and calendar month of data.
state
Standard
of residence
errorsand
are calendar
in parentheses;
month implied
of data. price
Standard
elasticities
errors are in parentheses; implied price elasticities
ckets. Regressions for aggregate
are inpacks/capita
square brackets.
data are
Regressions
in the first
fortwo
aggregate
columns; regressionsdata are in(though
packs/capita only regressions
the first two columns; next
ette consumption data are forin the
natality
secondcigarette
two columns.
consumption
All regressions
data are in exclude
the second
monthtwoof columns. All regressions exclude month of
increase and month that itenactment
is effective.of tax increase and month that it is effective. month’s price
Fig 1
significant) Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

11
(monthly) relationship
frequency
Fig 2 between
(monthly)
x changes
relationship
in smoking
between changes in smoking
x
Fig 2 LSE logo – clear space

The clear space around the logo must be

ges in taxes. Weandstrongly


changes suspect
in taxes.
that We
anystrongly
omitted suspect that any omitted
x equal to the space between the LSE

L S THE ONDON CHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

E OF CONOMICS AND
at any size
State-Dependent Preferences and Habit Formation

• Consider now a (partially) biased agent (α ∈ (0, 1)).


OLD MODEL
• Her perceived utility from refraining is:
∞ future state
∑ current state
Ũ (ref rain|s0 ) = ȳ − ϕs s0 + δ j (ȳ − (1 − α)ϕs s̃j − αϕs s0 )
j=1
1 1 1
= ȳ − (1 − α) ϕs s0 − α ϕs s 0
1−δ 1 − δγ 1 − δ *single discounted:
≤ U (ref rain|s0 ) (strict if s0 > 0) dont realise i'll get less
addicted over time
Dont discount

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
State-Dependent Preferences and Habit Formation
• Her perceived utility from hitting is:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print. ∞
1
ȳ −
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

Ũ (hit|s0 ) = δ j pj +
around the logo is shown above, and defines an area into which nothing should intrude.

1−δ
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for j=0 only change is
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
wrong

∑ ∞

Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo. initial state
(1 − α) (ϕa + (ϕas − ϕs )sj ) + α δ (ϕa + (ϕas − ϕs )s0 )
j
The abbreviated version is the square block with the letters LSE (fig 4).

right j=0 j=0



∑ ] [
1 (ϕas − ϕs )s0
= ȳ − δ pj + (1 − α) j

1−δ 1 − δγ rite 1
j=0
[ ]
(ϕas − ϕs )s0 ϕa
+α +
− δmistakes: 11.−zeta
1 two δ disappears. Doesnt
≥ U (hit|s0 ) (strict if s0 < saccount
max ) for fact more addicted over time
2. Also single discounting - get wrong addiction
over time
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

Overstate benefit, understate cost


...They'll pay too much 13
Fig 2 Fig 2 LSE logo – clear space
x x

THE LONDON SCHOOL


x
see next pg
The clear space around the logo must be
equal to the space between the LSE
lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


State-Dependent Preferences and Habit Formation
What about projection bias?
• Note 1: Immediately apparent that p̃∗ > p∗ , i.e. projection
biased agents too-willing to consume addictive good
[ ] [ ] ∞

∗ ϕ as s0 ϕ as s 0 ϕa
p̃ = (1 − α) +ζ +α + − δ j pj
1 − δγ 1−δ 1−δ
j=1

• Relevant for initiation: fail to account for tolerance (only


(1 − α) · ζ)
∂ p̃∗ ϕas ϕas ϕas
• Note 2: = (1 − α) +α > . Too
∂s0 1 − δγ 1−δ 1 − δγ
sensitive to current state.
• Relevant for cessation: fail to account for (diminished)
reinforcement
• Note 3: Forward-lookingness preserved (plans still
Fig 1
always-or-never) Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Positive Habits
• We have argued that projection bias makes people too
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

prone to engage in bad habits (addictions), but what


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

about positive habits?


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• This is often a meaningless distinction: can let a′ = (1 − a),


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

redefine abstaining from a bad addiction to be consuming


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

a good one
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Still useful if people tend to start life in an un-habituated


state s0 = 0 s=0 is not neutral hence distinguish btw gd and bad music
• Most people start unaddicted to cigarettes (and find them
initially unappealing) <=
• Most people start1 unhabituated to classical music (and
often find it boring initially)
• So we separate out ‘good’ habits for rhetoric’s sake:
∂2u
• Keep > 0 (reinforcement) > positive eff of STATE on marginal
∂s∂c consumption utlity today
∂u
• Change to ≥ 0 (benefit)
∂s
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

15
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
• Charness and Gneezy (2009) develop a simple experiment
to test the reinforcement effect of exercise
1 Randomly divide subjects from UChicago, UCSD into three
groups: Low, High, Control
2 Give all groups information about health benefits to
exercise, and about campus gym facilities.
3 Then introduce an experimental manipulation:
• Control: receive no additional offer
• Low: receive $25 offer to attend gym once in specified week
• High: receive $25 as above, and $100 bonus if attend 8
times in next month

• How can this design test: H0 : “exercise is not >> DO THEY KEEP GOING
habit-forming” against HA : “exercise is habit-forming”?

What we need is EXO VARIATION in Ct-1 as Ct-1 tends to be ENDO. Eg. milk
Fig 1
yesterday milk today cos this pers likes milk (OLS invalid)
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

INCENTIVES TO EXERCISE 921

LSE logo
Projection Bias and Exercise Habits
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
Funny: BD discounters play catchup at end of
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
month to get the $100 LOL
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

(a) Study 1

• What does this tell us about present bias, or projection


bias?
• Were subjects making any “mistakes”?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
• Goal: strip everything down to an experiment & a model
we can estimate
• Recall our gym model (‘investment good’) from
DellaVigna-Malmendier:
• Agent has linear utility from money, delayed gym benefit b,
immediate gym disutility −c + ε, ε ∼ F [Note slight change
in how cost is modeled] avergae disutility, E is stochastic disutil on day
• New: assume agents have β β̂δ preferences and simple
projection bias of degree α
• Assume CG09 High treatment is a “black box”
habit-creator
• Assume habit ∈ {0, 1}; CG09 moves agent from 0 to 1
• Ignore exact dynamics for now; assume multiple weeks
necessary to move back from 1 to 0 one week wont dishabituate me
• If habituated, agent receives additional utility immediate
flow η when exercising eta is effect of habit
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Exercise Habits
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Acland-Levy (2012) run a field experiment on UC Berkeley


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

undergraduates
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Key innovation: “p-coupon”


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

• Pays the subject $p every day they go to the gym in a


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

designated week
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
• Like a negative per-use fee in DellaVigna-Malmendier,
problem set Plays same role as P in prev model
RECALL - LT1 finding SUPPLY SIDE cost of going to gym

• Acland-Levy elicit subjects’ valuations for the same coupon


twice: Whats the1 WTP, (L) - RECALL
• Pre-treatment: all subjects unhabituated
• Post-treatment:
• Treated subjects have completed a CG09 ‘high’ intervention
• Control subjects unhabituated (CG09 ‘low’ intervention)

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
• Her expected utility if she has a p-coupon is then:
p + β̂b − c − ε ≥ 0
paid, delay benefit (D=1 as 1wk), cost

• A control subject’s valuation of a p-coupon is:


∫ ∞
T parameter 7 days 7× (p + b − c + ε)dF (ε)
c−β̂b−p
If have coupon, p. No coupon, normalise p=0
• And her valuation of that p-coupon is:
   
 ∫ ∞   ∫ c−β̂b 
   
7 × pdF (ε) + 7 × (b − c + ε)dF (ε)
 c−β̂b−p   c−β̂b−p 
| {z } | {z }
Face Value Commitment Value
As long as e this range, PAID, x7
• Note: commitment value helps identify naivete – how?
Fig 1 Fig 1 Full LSE logo in colour
Lower limit: go if have coupon to go if didnt have
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485
coupon. DISTORTION on behaviour. Bhat can be low
eg. Sophist/ Naive then Bhat 1, Commitment 20 can be
Fig 2
x x
x
Fig 2 LSE logo – clear space

The clear space around the logo must be


equal to the space between the LSE
negative
THELONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OFE CONOMICS AND at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias and Exercise Habits
• A habituated subject thinks she will go if:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

p + η + β̂b − c − ε ≥ 0
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• So she values the p-coupon at:


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
>> VALUE for POST HABIT
[ ]
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

[ ∫ ] ∫
graphic elements used with it (full bleed pictures are the only exception).


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
c−η−β̂b

Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo. pdF (ε) + 7 × (b − c + ε)dF (ε)
The abbreviated version is the square block with the letters LSE (fig 4).
c−η−β̂b−p c−η−β̂b−p

• But before the treatment, she was in state s = 0 and so


thought: right think no change
PROJ BIAS
p + (1 − α)η + α(0) + β̂b − c − ε ≥ 0
1

• and valued the p−coupon at: VALUE for PRE habit


[ ∫ ] [ ∫ ]
∞ c−(1−α)η−β̂b
7× pdF (ε) + 7 × (b − c + ε)dF (ε)
c−(1−α)η−β̂b−p c−(1−α)η−β̂b−p

• Test for projection bias: change in valuations amongst


treated
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

21
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
Table 1: Habit Formation — Regression of average weekly attendance.
Figure 4: Figure
Actual4:vs.Actual
Predictedvs. Predicted
Post-Treatment (Charness
(1) (2) Post-Treatment
Attendance Attendance
Figure 4:
Figure 4:
Figure
Actual
Actual4: vs.
vs.
Actual
Predicted
vs. Predicted
Predicted Post-Treatment
Post-TreatmentPost-Treatment Attendance
& Gneezy)
Attendance Attendance
Treated 0.045 -0.100

44 4

4
(0.057) (0.196)

4
[0.477]a
Treatment Period X Treated 1.209⇤⇤⇤ 1.275⇤⇤⇤

33 3

3
(0.150) (0.181)

3
Actual Attendance

1 Actual Attendance
Attendance [0.780]a

Actual Attendance
ActualAttendance
Imm. Post-Treatment X Treatedb 0.256⇤⇤ 0.585⇤⇤⇤
22 2

2
(0.122) (0.217) replicate research

2
[0.186]a
Actual

Later Post-Treatment x Treatedb 0.045 –


11 1

1
(0.098)
Complied w/ treatment 0.057
• Treatment effect 0.338 after accounting (0.071) for
1.582⇤⇤⇤
00 0

Treatment Period X Complied


non-compliance
0

5 5 0 Predicted Attendance
0 Predicted Attendance 1 1
55 5 00 Predicted
(0.180)
0Attendance 11 1
Predicted
b
Predicted Attendance
Attendance ⇤⇤
Imm. Post-Treatment X Compliance
Control Subjects: 0.338
Control Subjects:
• No evidence of persistence after
ControlSubjects:
Control Subjects: winter
Control Difference
Subjects:
(0.154) < 1 holiday
Difference < 1 (is this
Treated
b Subjects
Difference
Subjects <<1
TreatedDifference Difference
1 <1
good or bad?) x Compliance
Later Post-Treatment TreatedSubjects
Treated Subjects 0.061 < 1 Difference < 1
TreatedDifference
Subjects
(0.126) <<1Difference
Difference
Difference 1 <1
Notes: Average
Notes: weekly
Averagegymweekly
attendance
gym attendance
in the 8 weeks in the
following
8 weeksthe following
treatment themonth
treatment plotted
month against
plotted against
Notes: Average
Notes:
predicted Average
Notes:Weekweekly
Average
E↵fects
weekly
attendance
predicted gym
gymweekly
attendance attendance
gym
attendance
conditional attendance
in the
in
conditional
on receiving the
on88noweeks
intreatment.
weeks thefollowing
Yes
receiving following
8 weeks
noYes following
the treatment
the treatment
treatment.
Weeks inYes the
whichtreatment
Weeks month
month
a in
subjectplotted
month
plotted
which against
plotted
against
received
a subject againsta
a received
Fig 1
predicted
predicted Controlsattendance
predicted
attendance
attendance conditional
conditional conditional
on
on receiving
receivingon no Yes
receiving
no treatment.
no
treatment. Yes
treatment.
Weeks
Weeks in
in –Weeks
which
which in
aa subject
which
subject a
Fig 1 Full LSE logo in colour

received
subject
received received
a
a a
p-coupon for p-coupon
attendancefor attendance
are omittedare fromomitted
this calculation.
from this calculation.
Predicted attendance
Predicted attendance
is based on is anbased
OLS on an OLS
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

p-coupon
p-coupon for IV
p-coupon
for attendance
for
attendance attendance
are
are omitted
omittedare from
omitted
from this
this from –this calculation.
calculation.
calculation. Yes
Predicted
Predicted –
Predicted
attendance
attendance attendance
is
is based
based on
is
on based
an
an OLS
OLS on an OLS
regression ofregression
attendance of attendance
Observations on week dummies
on weekand dummies
covariates
7433 andusing
covariates
7433 control using
group
1520 control
data group
for all data
weeksforandall weeks and
regression
regression
treated regression
of attendance
of
group attendance
treated
data of the
group
for attendance
on
on week
week
data dummies
on week
dummies
pre-treatment
for the dummies
and covariates
and
pre-treatment
period. covariates
and covariates
period. using
using control
using
control group
control
group data
datagroupfor all
for all
dataweeks
weeksfor all
and
and
22weeks and
treated group Num
treated dataClusters
group
for the
datapre-treatment
for the pre-treatment
period. 111
period. 111 80
Fig 2
x treated groupR-squared
data for the pre-treatment period. 0.21
x
0.22 0.13
Fig 2 LSE logo – clear space

The clear space around the logo must be


x equal to the space between the LSE

THELONDON Notes:
SCHOOL lettering and the edge of the red square.
Observations of weekly attendance at the subject-week level. Robust standard er-
This applies to the reproduction of the logo

OFE CONOMICS AND at any size

POLITICAL SCIENCE in
rors parentheses, clustered by individual. ⇤ significant at 10%; ⇤⇤ significant at 5%; ⇤⇤⇤
The clear space is indicated by the blue line.
Nothing must enter this area.
The clear space must continue around any
x
significant at 1%. a Terms in square brackets are p-values from a Chow test of equal coef-
element (eg text, sub logos) attached to
x x the LSE square

Figure 5: Figure
Predicted
5: Predicted
versus Actual
versus
Attendance
Actual Attendance
ficients between our sample (column 1) and Charness and Gneezy (2009)’s sample. b Imm.
Figure 5:
Figure 5:
Figure
Predicted
5: Predicted
Predicted versus Actual
versus Actual
versus Attendance
Attendance
Actual Attendance
Post-Treatment refers to the 8 weeks following the intervention (excluding the bu↵er week

LSE logo
Projection Bias and Exercise Habits for columns
following semester
Predicted
(1) and (2). Predicted
Predicted
Predicted
andPost-Treatment
Later
Predicted
and
and
(excluding
Actual
Actual
andTarget-
Actual
andbreak).
the Actual
semester Target-
Week
Target-
refers to the
Actual Target-
Target-
Attendance
19 weeks ofWeek
Week Attendance
Week Attendance
Attendance
observations
Week Attendance
in the
Control Control Treated Treated
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a Control
Control Control Treated
Treated Treated
distinct visual identity for the School. The logo should be used on all School publications and
44 4

information/publicity materials. It is widely used and recognised.


4

The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
33 3

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
week

Visits per week

around the logo is shown above, and defines an area into which nothing should intrude. 37
3
week

Visits per week

This helps the LSE logo to stand out and prevents any detraction from its presence, by other
per week

graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
Visits per

on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Visits per
22 2

Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
2

Also you can use either the abbreviated or full version of the logo.
Visits

The abbreviated version is the square block with the letters LSE (fig 4).

* increase their prediction so ETA effect!!


LOWER prediction
11 1

1
1
00 0

p=0 p=0 p>0 p>0 p=0 p=0 p>0 p>0


0

p=0
p=0 p=0
1 p>0
p>0 p>0 p=0
p=0 p=0 p>0
p>0 p>0
Un-incentivized
Un-incentivized
Predictions: Predictions:
Un-incentivized
Un-incentivized
Un-incentivized Predictions:
Predictions:Post-treatment
Predictions:
Pre-treatment Post-treatment
Pre-treatment Actual attendance
Actual attendance
Pre-treatment
Pre-treatment Post-treatment
Pre-treatment Post-treatment
Post-treatment Actual attendance
Actual attendance
Actual attendance

• Both dramatically over-estimate probability of gym going naive present


• Control predictions fall, treated rise (or incentivised fall by bias
36 36
less) 36
36 36
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

23
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
• Acland-Levy estimate a GMM structural model to fit the
data
• (You can skip the econometrics here)
• Note: can only identify (1 − β̂) = ω · (1 − β)
Table 5: GMM Parameters
Name Parameter Model 1 Model 2
Panel A: Directly Estimated Parameters
Net daily cost C b 4.713⇤⇤⇤ 4.582⇤⇤⇤
(0.417 ) (0.421)
Cost of naivete (b )b 3.099⇤⇤⇤ 2.993⇤⇤⇤
(0.289) (0.290)
Habit value ⌘ 2.602⇤⇤⇤ 2.618⇤⇤⇤ Dollar terms
(0.733) (0.738)
Predicted habit value (1 ↵)⌘ 0.160 0.226
(0.747) (0.757) Dont predict any of it
Probability of habituation ⇡ 0.320⇤⇤ 0.306⇤⇤
(0.133) (0.136)
Demand for commitment (1 b)b – 1.500⇤⇤⇤
(0.250)
Scale parameter, daily shock " 1.528⇤⇤⇤ 1.490⇤⇤⇤
(0.148) (0.150)

Fig 1
Panel B: Extended Parameters
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


Degree of projection bias
possible. The Pantone reference is PMS 485 ↵ 0.939⇤⇤⇤ 0.914⇤⇤⇤
(0.285) (0.286) Estimate. VERY PB.
Degree of beta-naivete ! – 0.666⇤⇤⇤ Predict No change
24 at all
Fig 2
x x
Fig 2 LSE logo – clear space (0.037)
x Notes: The daily shock, ✏, is drawn from a mean-zero type-1 extreme value distri-
The clear space around the logo must be

bution. Standard errors in parentheses. ⇤ significant at 10%; ⇤⇤ significant at2/3


equal to the space between the LSE

LONDON SCHOOL 5%; naive - they think they


lettering and the edge of the red square.
THE This applies to the reproduction of the logo

OFE CONOMICS AND ⇤⇤⇤


at any size

significant at 1%. Parameters in Panel B are calculated by transformations of


The clear space is indicated by the blue line.
POLITICAL SCIENCE
x
Nothing must enter this area.
The clear space must continue around any
parameters in Panel A, with standard errors implied by the delta rule. Model 2
element (eg text, sub logos) attached to
have 2/3 towards 1
x x the LSE square

includes an additional moment restriction on the di↵erence between unincentivized


predictions and p-coupon valuations.

LSE logo
Projection Bias and Positive Habits
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• What do these experiments predict about long-run habit


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

state?
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
42
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

• Significant problem for ‘planner’:


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• If agents are projection-biased over η, inefficient demand


for CG09 treatment.
• If agents have β̂ ∼ 1, inefficient demand for long-run
subsidies.
1

• How should a firm respond – inform or exploit? (We’ll


come back to this in week 7)

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

25
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Lecture 4: Heuristics and Biases I

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias Outside the Lab: Catalog Sales
• Conlin, O’Donoghue, and Vogelsang (2007): does
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

projection bias affect real-world behaviour?


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• Consider simplified model of purchase and return


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

decision:
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web. • t = 0, 1, 2
Also you can use either the abbreviated or full version of the logo.

• Weather ωt ∼ H, iid
The abbreviated version is the square block with the letters LSE (fig 4).

t=0 Don’t
0 • Value of item
ω0 realised
v(X, ε, ω2 ) =
Purchase (X ′ β + ε)u(ω2 )
1
depends on individual
t=1 Return
characteristic X,
−c individual shock ε,
ε, ω1 realised
future weather ω2
Keep
• Decide whether to
t=2 purchase at price p in
Fig 1
v(X, ε, ω2 ) − p Fig 1 Full LSE logo in colour

ω2 realised The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

period 0, to return at
cost c in period 1 2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias Outside the Lab: Catalog Sales
• First margin: Return behaviour
• Rational agent:
UR = EH [v(Xi , εi , ω2 )|Xi , ε2 ] = [Xi′ β + εi ] · EH (ω2 )
Return iff UR − p < −c
p−c
⇐⇒ εi < − Xi′ β
EH (u(ω2 ))

• Biased agent:
ŨR = EH [v(Xi , εi , ω2 |ω1 )|Xi , ε2 ]
= [Xi′ β + εi ] · [(1 − α)EH (ω2 ) + αu(ω1 )]
Return iff ŨR − p < −c
p−c
⇐⇒ εi < − Xi′ β ≡ Λ̃(ω1 )
[(1 − α)EH (u(ω2 )) + αu(ω1 )]

• Intuitively, ω1 will only affect return decision for biased


agents
• But Xi may differ between biased, unbiased – must be
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

careful
3
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias Outside the Lab: Catalog Sales
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a

• Second margin: Purchase behaviour


distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
p−c
− Xi′ β ≡ Λ̃(ω0 )
suitable for print.

Expect to return if εi <


It is important to keep the LSE logo clear from any other graphics. The minimum clear space

[(1 − α)EH (u(ω2 )) + αu(ω0 )]


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

Order if: 0 ≤ P r(εi < Λ̃(ω0 ))(−c)


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

+ P r(εi ≥ Λ̃(ω0 ))
The abbreviated version is the square block with the letters LSE (fig 4).

[ ]

× (Xi β + E[ε|ε > Λ̃(ω0 )] [(1−α)E[u(ω2 )] + αu(ω0 )]
⇐⇒ Xi β > g(ω0 , α)
1

• Purchase threshold decreasing in αu(ω0 ) – cold days set


threshold too low if α > 0

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

4
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias Outside the Lab: Catalog Sales

• Lemma 1: Pr(return | order) is increasing in the return


cutoff Λ̃(ω1 , α) and decreasing in the order cutoff g(ω, α)

• Direct effect: if α > 0, then Pr(return | order) is decreasing


in u(ω1 )
i.e. people will return coats if they are delivered on warm
days, because they underestimate the benefit

• Indirect effect: if α > 0, then Pr(return | order) is increasing


in u(ω0 )
i.e. people who ordered on cold days over-estimated the
value, will be more likely to return for any ω1

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Projection Bias Outside the Lab: Catalog Sales
Results
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• 2.2 million clothing orders for large catalog distributor; ZIP


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

code and basic demographics


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• Run probit regression of return rate on: order-date temp,


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

receiving-date temp, average temp, controls


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• 30◦ F colder order date increases probability of return by


0.57pp (4%)
• Receiving-date temp not significant predictor (but 1

measured with noise...)

• Structural model: α = 0.3–0.4 depending on category

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

6
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Projection Bias and Exercise Habits
• Acland-Levy estimate a GMM structural model to fit the
data
• (You can skip the econometrics here)
• Note: can only identify (1 − β̂) = ω · (1 − β)
Table 5: GMM Parameters
Name Parameter Model 1 Model 2
Panel A: Directly Estimated Parameters
Net daily cost C b 4.713⇤⇤⇤ 4.582⇤⇤⇤
(0.417 ) (0.421)
Cost of naivete (b )b 3.099⇤⇤⇤ 2.993⇤⇤⇤
(0.289) (0.290)
Habit value ⌘ 2.602⇤⇤⇤ 2.618⇤⇤⇤
(0.733) (0.738)
Predicted habit value (1 ↵)⌘ 0.160 0.226
(0.747) (0.757)
Probability of habituation ⇡ 0.320⇤⇤ 0.306⇤⇤
(0.133) (0.136)
Demand for commitment (1 b)b – 1.500⇤⇤⇤
(0.250)
Scale parameter, daily shock " 1.528⇤⇤⇤ 1.490⇤⇤⇤
(0.148) (0.150)

Fig 1
Panel B: Extended Parameters
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


Degree of projection bias
possible. The Pantone reference is PMS 485 ↵ 0.939⇤⇤⇤ 0.914⇤⇤⇤
(0.285) (0.286)
Degree of beta-naivete ! – 0.666⇤⇤⇤ 6
Fig 2
x x
Fig 2 LSE logo – clear space (0.037)
x Notes: The daily shock, ✏, is drawn from a mean-zero type-1 extreme value distri-
The clear space around the logo must be
equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


bution. Standard errors in parentheses. ⇤ significant at 10%; ⇤⇤ significant at 5%;
This applies to the reproduction of the logo

OF E CONOMICS AND
at any size
⇤⇤⇤
POLITICAL SCIENCE significant at 1%. Parameters in Panel B are calculated by transformations of
The clear space is indicated by the blue line.
Nothing must enter this area.
The clear space must continue around any

x x
x
parameters in Panel A, with standard errors implied by the delta rule. Model 2
element (eg text, sub logos) attached to
the LSE square

includes an additional moment restriction on the di↵erence between unincentivized


predictions and p-coupon valuations.

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
42
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

Heuristics and Biases


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Heuristics and Biases
• Judgment under uncertainty is hard, and humans do
surprisingly well. But our brains are not computers.
• Kahneman (2011) (following Stanovich & West) argues
decision-making is governed by two systems:
1 System 1: “operates automatically and quickly, with little or
no effort and no sense of voluntary control”
2 System 2: “allocates attention to effortful mental activities...
including complex calculations”

• When facing a hard problem, System 1 instead answers a


heuristic: a simplified, but related, question which often
provides a good approximation
• Kahneman and Tversky (1974) argue that people tend to
appeal to very similar types of heuristics
• Behavioural economists are interested in how these
heuristics may systematically affect people’s choices
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Heuristics
Some Examples Mercilessly Stolen from Kahneman (2011)
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• Hard: How much would you contribute to save an


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

endangered species?
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

• Easy: How strongly do I feel when I think of dying dolphins?


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Hard: How happy are you with your life as a whole?


• Easy: What is my mood right now?

• Hard: How will this candidate fare in the primary?


1
• Easy: Does she look like a political winner?

• Hard: How should predatory financial advisers be punished?


• Easy: How angry do they make me feel?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Heuristics

• While these examples are intuitively appealing,


behavioural economists need a systematic model to
abstract how people will make choices

• Beginning with Tversky-Kahneman (1974) (with much


coming from Slovic, Bar-Hillel, and some others),
psychologists have identified a plethora of candidate
heuristics
• We will focus on the “big three” – which I claim encompass
some minor heuristics, but not all would agree
1 Availability – infer from ease of recall
2 Anchoring and Adjustment – stick to initial parameters
3 Representativeness – infer from similarity to hypothesis

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Availability Heuristic
• Which kills more people in the US annually (Combs &
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

Slovic, 1979):
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
% Choosing Actual Media Reports
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

1a. Lung Cancer


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

1b Vehicle Accidents
The abbreviated version is the square block with the letters LSE (fig 4).

2a. Emphysema
2b. Homicide
• Under the availability heuristic, people assess the 1

probability of an event by the ease with which instances


can be brought to mind
• Good: larger classes do have more examples
• Bad: affected by familiarity, cognitive ease of category,
salience

Fig 1
• Homicides are more salient (and media-hyped). How does Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever

this affect allocation of public resources? possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Availability Heuristic
• Ease of search:
• Are there more English words
(a) beginning with r
(b) with r as their third letter?
• Most people find it easier to think of the former than the
latter (right? sure!)
• Tversky & Kahneman (1971) find that most subjects say (a).
Except (b) is correct.
• Ease of imaginabiity:
• Can one form more 2-person committees or 8-person
committees from a pool ( of )
10 people?
( )
10 10
• Correct answer is just =
k 10 − k
• But harder to remember who is in an 8 person committee
than 2 (though both characterise same partition)
• Median estimate for k = 2: 70; median for k = 8: 20.
• Correct for k ∈ {2, 8}: 45.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Availability Heuristic
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Ease of recall:
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• TK71 read a list of “well-known personalities” to subjects;


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

ask whether list had more male or female names


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

• When male celebrities were relatively more famous,


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

subjects overestimated male names (and vice versa).


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Egocentrism:
• Ross and Sicoly (1979) asked married couples to separately
estimate their own contribution to 20 household activities
• If subjects agree (or are at least unbiased), estimated 1

shares should sum to 100


• Grand mean significantly >100; 16 of 20 tasks significantly
> 100 (including negative ones, e.g. ‘causing arguments’)
• Implications for bargaining, contracts, etc?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Availability Heuristic

• Salience:
• Steinbrugge et al. (1969) show that demand for
earthquake insurance increases after an earthquake, then
subsides over time.
• Eisner and Strotz (1961) find the following WTP for flight
insurance:
1 Coverage against any act of terrorism: $14.12
2 Coverage against mechanical failure: $10.31
3 Coverage against any cause: $12.03

• How does this interact with prospect theory’s probability


weighting?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Anchoring-Adjustment Heuristic
• People often make estimates starting from some initial
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

value (anchor), which is partially adjusted to reach the final


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

value.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• The anchor is sometimes informative (guess, partial


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
calculation), and sometimes arbitrary
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
• Incomplete adjustment means initial anchor affects
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4). judgment
• Informative anchors:
• KT gave students 5 seconds to answer
8×7×6×5×4×3×2×1
• A second group was given 1 × 2 × 3 × 4 × 5 × 6 × 7 × 8 1

• People seemed to calculate first few terms, then


extrapolate.
• Median: . Of second group: . Correct: .
(c.f. “Exponential-Growth Bias”, Levy and Tasoff, 2015)
• Uninformative anchors:
• “What percentage of African nations are members of the
Fig 1
UN?” Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

• KT spin a wheel of fortune marked 0 to 100, ask subjects if


answer is higher or lower than spin outcome. 15
Fig 2
x x
x
• For subjects who spun 10, median estimate is 25%
Fig 2 LSE logo – clear space

The clear space around the logo must be


equal to the space between the LSE

THE

OF
LONDON SCHOOL
E CONOMICS AND
• For subjects who spun 65, median estimate is 45%
lettering and the edge of the red square.
This applies to the reproduction of the logo
at any size
Anchoring-Adjustment Heuristic
• Bruner & Potter asked subjects to identify pictures being
gradually brought into focus
• Group 1: Begin moderately blurred, end slightly blurred.
• Group 2: Begin severely blurred, end slightly blurred.
• 50.7% of Group 1 correctly identify, but only 25.0% of
Group 2
• People anchor on some initial guess, and partially adjust.
More blurred initially means worse initial guess.

• Related to Belief Perseverence (incomplete debiasing)


• e.g. 1998 BMJ study finds link between childhood
immunisation and autism (anchor)
• Article is retracted (first author even loses medical license),
but 25% of public still believe result, further 39-53% believe
in equal evidence on both sides (incomplete adjustment).
• Tied up with psychology of memory. c.f. ‘push polls’

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Other Heuristics
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

• Hindsight Bias
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
• Events which have occurred are subsequently judged to
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

have been inevitable


This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

• Curse of Knowledge
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• People judge things they know to be relatively easy to learn


The abbreviated version is the square block with the letters LSE (fig 4).

• Note: this is why your Professors seem evil


• Confirmation Bias
• People judge evidence which confirms their beliefs as
more reliable than evidence against 1

• Note: Hindsight, Curse of Knowledge related to


“Information Projection”

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness Heuristic
• Representativeness is the tendency for people to use
similarity as a proxy for probability
• KT offer the following example.
• “Steve is very shy and withdrawn, invariably helpful but with
little interest in people, or in the world of reality. A meek
and tidy soul, he has a need for order and structure, and a
passion for detail.”
• 1. Rank the relative likelihood that Steve is each of in the
following professions:
{ Farmer, Salesman, Airline Pilot, Librarian, Physician }
• 2. How similar does Steve sound to each of these
professions?
• KT find subjects answer both questions identically
• Note: there are 212,742 librarians in the U.S., and
2,206,000 farmers.
• “Insensitivity to prior probabilities”
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness Heuristic
• This insensitivity has its own name: base-rate neglect
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

• KT give subjects another description d, and tell subjects in


tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

Group 1 that Steve is drawn randomly from a pool of 30


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

lawyers and 70 engineers


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for P1 (E|d) P (d|E)P1 (E) 3 P (d|E)
• Bayes’ rule:
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web. = =
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
P1 (L|d) P (d|L)P1 (L) 7 P (d|L)
• Subjects in Group 2 were given the same, but told 70
lawyers and 30 engineers
P2 (E|d) P (d|E)P2 (E) 7 P (d|E)
• Bayes’ rule: = =
P2 (L|d) P (d|L)P2 (L) 3 P (d|L)
1

• Regardless of the description, the likelihoods should differ


by (3/7)2
• Instead, the groups produced identical assessments
• Interpretation: using representativeness – P (d|E) – and
discarding other information.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness Heuristic
• In the first lecture, I gave you the following problem:
“Suppose one in a hundred people have Ebola. We have a test for Ebola
that is 99% accurate. This means that if a person has Ebola, the test
returns a positive result with 99% probability, and if a person does not have
Ebola, it returns a negative result with 99% probability. If a person’s Ebola
test returned positive, what is the probability that she has Ebola?”
• Only one correct way to calculate this:
P r(+|E)P r(E)
P r(E|+) =
P r(+|E)P r(E) + P r(+|¬E)P r(¬E)
0.99 × 0.01
= = 0.5
0.99 × 0.01 + 0.01 × 0.99

• Instead, people use only the representativeness:


P r(+|E)
P˜r(E|+) = = .99
P r(+|E) + P r(−|E)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

20
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness Heuristic
• Consider the following example:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

An urn is filled with either 2/3 red and 1/3 green balls, or 1/3
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

red and 2/3 green balls.


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

• Subject 1 has drawn 5 balls, of which 4 are red and 1 is green.


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

• Subject 2 has drawn 20 balls, and found 12 were red and 8


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4). were green.
Who should be more confident that there are in fact 2/3 red
balls in the urn?
• Most people report that Subject 1 has far stronger
evidence. 1

• The correct posterior odds for Subject 1 are , while


for Subject 2 they are .
• Subject 1’s draw is more representative of the red urn, but
the greater sample size of Subject 2 is far more important.
• Insensitivity to sample size leads to a conservatism bias

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

21
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness Heuristic
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 also participated in anti-nuclear demonstrations.

Please rank the following statements by their probability, using


1 for the most probable and 8 for the least probable:
• [5.2] Linda is a teacher in elementary school.
• [3.3] Linda works in a bookstore and takes Yoga classes.
• [2.1] Linda is active in the feminist movement.
• [3.1] Linda is a psychiatric social worker.
• [5.4] Linda is a member of the League of Women Voters.
• [6.2] Linda is a bank teller.
• [6.4] Linda is an insurance salesperson.
• [4.1] Linda is a bank teller and is active in the feminist
movement.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

22
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness Heuristic
Bill is 34 years old. He is intelligent, but unimaginative,
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

compulsive, and generally lifeless. In school, he was


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

strong in mathematics but weak in social studies and


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

humanities.
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

Please rank the following statements by their probability, using


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

1 for the most probable and 8 for the least probable:


The abbreviated version is the square block with the letters LSE (fig 4).

• [4.1] Bill is a physician who plays poker for a hobby.


• [4.8] Bill is an architect.
• [1.1] Bill is an accountant.
1
• [6.2] Bill plays jazz for a hobby.
• [5.7] Bill surfs for a hobby.
• [5.3] Bill is a reporter.
• [3.6] Bill is an accountant who plays jazz for a hobby.
• [5.4] Bill climbs mountains for a hobby.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

23
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness Heuristic
Conjunction Fallacy
• Both tableaus are examples of the conjunction fallacy.
• The probability of a compound event (A ∧ B) cannot be
greater than the probability of either individual event.
• Since not probability exceeds 1, trivial to show:
P r(A ∧ B) = P r(A|B)P r(B) ≤ P r(B)
• An agent commits the conjunction fallacy when they judge
that P r(A ∧ B) > min{P r(A), P r(B)} – i.e. that the
compound event is strictly more likely than one of its
components
• (Sometimes, use weak conjunction fallacy:
P r(A ∧ B) ≥ min{P r(A), P r(B)})
• What explains these examples?
• Linda doesn’t “seem” like a bank teller, so bank teller is
ranked poorly.
• But the “feminist” part of “feminist bank teller” does sound
Fig 1 a bit like Linda, so the compound event is ranked towards Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever

the middle.
possible. The Pantone reference is PMS 485

24
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Lecture 5: The Representativeness Heuristic


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness
• Suppose the world is described by k-dimensional states
ω∈Ω
• For example (setting k = 2):
• ω1 = ⟨feminist, bank teller⟩
• ω2 = ⟨non-feminist, bank teller⟩
• ω3 = ⟨feminist, non-bank-teller⟩
• ω4 = ⟨non-feminist, non-bank-teller⟩
• In reality, only one ω is true.
• The set of possible realities Ω is the state-space.
• A hypothesis is just a subset of states: h ⊂ Ω
• e.g. “Linda is a bank teller” = {ω1 , ω2 }
• “if Linda is a Feminist, then she is not a bank teller”
= {ω2 , ω3 , ω4 }

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

3
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness
• How should someone evaluate the likelihood of a
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

hypothesis?
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• A hypothesis is just a collection of states


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• Suppose a person has prior beliefs π – that is,


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

P r(ω = ωi ) = π(ωi )
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

• Then the probability of a hypothesis being true is:


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.


The abbreviated version is the square block with the letters LSE (fig 4).

P r(hr ) = π(ωi )
ωi ∈hr

• Now compound hypotheses are strictly smaller sets:


• h1 = “Linda is a bank teller” = {⟨F,B⟩, ⟨NF, B⟩}
• h2 = “Linda is a feminist bank teller” = {⟨F,B⟩} ⊂ h1
• So if people properly evaluate hypotheses, cannot commit
conjunction fallacy
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

4
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness
Gennaioli-Shleifer Model
• Gennaioli-Shleifer (2010) suggest that people use a
representative stereotype to evaluate a hypothesis
• We restrict attention to hypotheses that pin down some
dimensions, and leave others free
• e.g. h1 “Linda is a bank teller” pins down dimension 2 (job),
and leaves dimension 1 (feminism) free
• Let Fr be the free dimensions of hypothesis r (e.g. F1 =
{1})

• The model makes two assumptions:


1 Limited memory: rather than remember all the states
associated with a hypothesis, the agent chooses just one
(in paper, finite number b)
2 Recall by representativeness: the agent uses
representativeness to select the states for their represented
state space
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness
Gennaioli-Shleifer Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• A scenario is a particular way of filling in the free


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

dimensions of a hypothesis:
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Formally, consider a particular ωj′ for every free dimension


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

j. Then the scenario is the set of events that agrees on


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

these free dimensions:


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

s = {ω ∈ Ω|ωj = ωj′ ∀ j ∈ Fr }

• For example, there


1 are two possible scenarios to fill in the
free dimension for h1 :
1 s1 = {ω ∈ Ω|ω1 =F} = {⟨F, B⟩, ⟨F, NB⟩}
2 s2 = {ω ∈ Ω|ω1 =NF} = {⟨NF, B⟩, ⟨NF, NB⟩}

• Simply have to fill in her political stance. One scenario is


she’s a feminist, the other is she isn’t.

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

6
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness
Gennaioli-Shleifer Model
• The central contribution is that the representativeness of
a scenario is how likely it makes the hypothesis to be true:
P r(hr ∩ s)
P r(hr |s) =
P r(hr ∩ s) + P r(¬hr ∩ s)
• Note that hr ∩ s identifies a single state

• For example, given h1 “Linda is a bank teller”:


• s1 “Linda is a feminist” has:
π(⟨F,B⟩)
P r(B|F ) =
π(⟨F,B⟩) + π(⟨F, NB⟩)
• s2 “Linda is not a feminist” has:
π(⟨NF,B⟩)
P r(B|N F ) =
π(⟨NF,B⟩) + π(⟨NF, NB⟩)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness
Gennaioli-Shleifer Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• Let the most representative scenario for hr be the


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

stereotype for that hypothesis, sr .


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• The representativeness heuristic then says that, given


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

hypotheses h1 , ..., hN , people evaluate a hr using just the


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

stereotypes:

P r(h ∩ sr )
P˜r(hr ) = (∪ r )
N
1 Pr j=1 (hj ∩ sj )

• Denominator just a normalisation to account for missing


ωs

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness
Gennaioli-Shleifer Model

• For example, suppose the distribution of types is:


F NF
B 2/9 1/6
NB 4/9 1/6
• Given our h1 :
2/9
• P r(B|F) = 2/9+4/9 = 1/3
1/6
• P r(B|NF) = 1/6+1/6 = 1/2
• So people think of a non-feminist for h1 ; i.e. s1 =“Linda is a
non-feminist”.

• Given our h2 (“Linda is a feminist bank teller”), there are no


free dimensions.
For formalism’s sake, we can write s2 = Ω

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness
Gennaioli-Shleifer Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• How does this generate the conjunction fallacy?


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

P˜r(h1 ) P r(h1 ∩ s1 ) P r (⟨B, N F ⟩)


You can use the square element of the logo either as white lettering on red, PMS 485, or white
1/6
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for 3
• = =
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
= =
P r(h2 ∩ s2 ) P r(⟨B, F ⟩)
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

P˜r(h2 )
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
2/9 4

• Representative scenarios are often not likely


• When people hear “bank teller”, they think how much more
likely it is for a non-feminist to be a bank teller than for a 1
feminist to be one
• But this ignores how much more likely it is that Linda is a
feminist than a non-feminist to begin with (2:1 odds)

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness
Gennaioli-Shleifer Model
• Proposition: When testing h1 and (h1 ∩ h2 ) ⊂ h1 ,
P˜r(h1 ∩ h2 ) ≥ P˜r(h1 ) only if scenario s1 is not the most
likely for h1 .
• Only when the agent chooses an unlikely but highly
representative scenario s1 , which is ruled out by the
addition of h2 , will they commit the conjunction fallacy.
• A “boundedly-rational” agent (i.e. one who could only
remember one state) would always use the likeliest
scenario, and would never commit the conjunction fallacy
• If only one state represents F, choose (F,NB) since 4/9 >
2/9
• Only one state represents (F,B), namely (F,B)
cr(h1 )
P (4/9)
• But then cr(h2 ) = (2/9) =2
P

Fig 1
• What about h′1 “Linda is a Feminist” vs. h′2 “Linda is a Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever

Feminist Bank Teller”?


possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness
Gennaioli-Shleifer Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Gennaioli and Shleifer develop a fuller model in the


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

optional reading, which can allow people to observe “data”


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

before evaluating a hypothesis.


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
• Data are just another partition of Ω
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• For a stereotypical thinker, data will only matter when it


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

changes the scenario they use to represent a hypothesis


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• For example, if “Linda was not a college activist” changes


the conditional probabilities of being a bank teller, people
may no longer use the unlikely “non-feminist” scenario to
represent h1
• People will therefore under-react to most data, and 1

over-react to stereotype-changing data


• This is unfortunately beyond the scope of this course
• Caution: “stereotypes” in this context are not quite the
same as the usual meaning of the word. But how does this
model of representative thinking relate to discrimination?
Fig 1
• What about non-categorical inferences? Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Representativeness in Sequences

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness in Sequences
• Judgment by Representativeness: “the probability that
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

event A originates from process B is evaluated by the


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. degree to which A resembles B.”


Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• Last time: representativeness and the conjunction fallacy


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• This time: representativeness and ‘the law of small


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

numbers’
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• Consider a sequence of 6 tosses of a fair coin. Which is


most likely:
1 H-T-H-T-T-H
2 H-H-H-T-T-T 1

3 H-H-H-H-T-H
• KT 1972 show that most subjects rank 1 as most likely, 3
as least likely.
• Intuitively, a fair coin “should” have about half heads, half
tails. Streaks don’t feel right.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


The Gambler’s Fallacy
• When judging by representativeness, people will predict
that the future realisations will help make the sequence
look more ‘representative’
• e.g. when a roulette wheel has come up red 5 times in a
row, it is ‘due’ to come up black
• This is the gambler’s fallacy: the false belief that a
sequence of independent draws from a distribution will
exhibit negative autocorrelation
• Aubry (2012 LSE MSc Thesis) flipped a fair coin, and after
history H-H-H asked subjects to choose between £100 if
H, or £X if tails
• Of course, all of you would be indifferent at X = 100
• Only 60% of subjects prefer “£100 if H” over “£95 if T”
• Average premium amongst remaining is 36.2%

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

15
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Evidence for the Gambler’s Fallacy
• A quick browse on the internet reveals the following
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

advice from “lottery experts”:


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• ‘Daily Numbers usually run in short term TRENDS. If a


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

number has not been drawn for ten lottery drawings, it is a


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

Due number. ’
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
• ‘Consecutive sets of numbers at the beginning and ending
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

of your lotto game should not be played.’


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• ‘Another thing to keep in mind is not to play numbers that


are all Odd or Even.’
• Amazingly, people believe this nonsense. Terrell (1994)
examined the average payouts of the NJ state lottery – 1

equal division of 52 percent


BELIEV ERS IN THE LAof intake
W OF amongst783those with
SMA LL NUMBERS

the lucky numbers: TABLE I

Number Mean

Winners repeating within 1 week 8 $349


Winners repeating between 1 and 2 weeks 8 $349
Winners repeating between 2 and 3 weeks 14 $308
Winners repeating between 3 and 8 weeks 59 $301
Winners not repeating within 8 weeks 1622 $260
Downloaded from http://qje.ox

All winners 1714 $262


Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used whereverAverage payouts to winning numbers
possible. The Pantone reference is PMS 485

Why is this evidence of GF? 16


Fig 2
x x day is an indicator of both the number of bettors on that number
Fig 2 LSE logo – clear space

The clear space around the logo must be


x
THE LONDON SCHOOL and the costliness of errors bettors are making. Tickets cost 50
equal to the space between the LSE
lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Evidence for the Gambler’s Fallacy
• Gold and Hester (1987) ran a similar experiment to Aubry:
1 Randomly assign subjects a colour: red or black
2 Subjects told a ‘fair coin’ would be flipped 22 times
3 Being psychologists, GH cheat and report a sequence: 17
mixed, 1 black, 4 red
4 Before 23rd flip, subjects given a choice between:
• 70 extra credit points for sure
• 100 extra credit points if next colour matches own

• Results:
• 5/29 (17%) of ‘red’ subjects chose risky option
• 22/30 (73%) of ‘black’ subjects chose risky option

• Clever bit: add treatment where 23rd flip is delayed by ≈


20 minutes
• Subjects reminded of realised sequence
• But now, 44% of ‘red’ subjects chose risky, 55% of ‘black’

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The Hot-Hand Fallacy
• People also believe in what appears superficially to be the
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

opposite of the gambler’s fallacy


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• The Hot-Hand fallacy is the false belief that a sequence of


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

independent draws from a distribution will exhibit positive


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

autocorrelation
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• Named after the belief in basketball that players can


The abbreviated version is the square block with the letters LSE (fig 4).

develop a ‘hot hand’ – conditional on making a basket/free


throw, the probability that a subsequent shot will be made
increases
• Except there is no evidence that this occurs 1

• Gilovich, Vallone, Tversky (1985) test using actual


free-throw data from the NBA
• Because ‘hot’ players may receive the ball more often,
analyse individual within-game autocorrelation in making a
free throw
• No systematic positive autocorrelation; Larry Bird’s is
Fig 1 Full LSE logo in colour

negative
Fig 1
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


The Hot-Hand Fallacy
• But just try convincing someone there is no ‘hot hand’
• GVT survey coaches and players, and almost all thought it
was a real phenomenon
• The NBA is a high-stakes environment; if coaches are
making wrong decisions based on this belief, they could be
losing millions
• Note: Miller-Sanjurjo point out that p(H|H) < 0.5 for a fair
coin in finite samples
• Camerer (1989) shows that the HH fallacy affects betting
markets
• If some people are biased but the marginal dollar is not,
would be much less economically important
• Camerer examines point spreads in NBA betting as
function of recent success of teams
• Spread should be set to equalise money on either side of
bet
• What holds for individual holds for team:
Fig 1
• After winning streaks, teams on average fail to meet spread
Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever

• After losing streaks, teams on average surpass spread


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Representativeness and The Law of Small Numbers
• Representativeness can explain these two seemingly
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

different biases
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• Gambler’s Fallacy: known data-generating process (coin).


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

Adjust prediction to help sample resemble process.


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

• Hot-Hand Fallacy: unknown data-generating process


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

(current skill). Adjust inference to help process resemble


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4). sample.
• Both results derive from belief in the
“law of small numbers”: exaggeration of how likely it is that
a small sample will resemble the population from which it
is drawn. 1

• Representativeness is the most general concept. We want


in particular to explain:
• “Misconceptions of chance”: Gambler’s and Hot-Hand
fallacies
• “Insensitivity to sample size” : if small samples already
Fig 1
resemble population, will under-react to increasing sample
Fig 1 Full LSE logo in colour

size (i.e. the true “law of large numbers”)


The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

20
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Lecture 6: Belief in the Law of Small Numbers

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

• When people use the representativeness heuristic, they


Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

use similarity as a proxy for probability.


This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

• Two seemingly-opposite effects in sequences:


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• With known process, belief in negative autocorrelation


The abbreviated version is the square block with the letters LSE (fig 4).

(Gambler’s Fallacy)
• With unknown process, belief in positive autocorrelation
(Hot-Hand Fallacy)
1

• We will argue that both fallacies result from trying to make


short sequences seem “similar” to the generating process

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

2
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in The Law of Small Numbers
Rabin 2002 Model
• Setup:
• The state of the world is characterised by a rate θ ∈ [0, 1]
(e.g. coin type)
• An infinite sequence of signals st ∈ {a, b}, t ∈ N is
generated
• Agents will observe some finite sequence ⃗st
• Conditional on θ, st are i.i.d. Bernoulli with P r(st = a) = θ.
• Agents’ beliefs about the rates in the population are given
by π(θj ) = P r(θ = θj )
• Let Θ ≡ {θ ∈ [0, 1]|π(θ) > 0} be finite
• i.e. the agent believes there are a finite number of types
possible
• We will consider three forms of beliefs for the agent:
1 Prediction (GF): P r(st = a|⃗
st−1 , θ)
2 Type Inference (HH): P r(θ = θt |⃗ st−1 , π)
3 Population Inference: P r(π = πj |⃗ s1,t , ⃗s2t , ...)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

3
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in The Law of Small Numbers
Rabin 2002 Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• Most of the model in one line:


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

∃ N ≥ 4 such that the agent (Freddy) incorrectly


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

believes that signals in state θ are drawn without


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

replacement from an urn with θN a signals, and (1 − θ) b


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

signals
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• Freddy correctly uses Bayes’ law to update his beliefs


The abbreviated version is the square block with the letters LSE (fig 4).

• But because he has the wrong model of the world, he will


use the wrong conditional probabilities

• Denote histories by ht , posterior beliefs about states


1
πtN (θ), and (abusively) posterior beliefs about events
πtN (st = s′ )
• Note: this restricts the priors allowed to Freddy.
• In particular, assume that given N , if θ ∈ Θ then θN ∈ N
(urns are well defined)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

4
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
• The Gambler’s fallacy is an immediate consequence.
• Suppose Freddy has observed one realisation, and
consider N and θ such that θN ∈ N and π(θ) = 1 (i.e.
Freddy knows the rate for sure)
• Freddy will predict that the next draw be negatively
correlated with the first realisation:
θN − 1
π2N (s2 = a|s1 = a) = <θ
N −1
(1 − θ)N
π2N (s2 = b|s1 = a) = > (1 − θ)
N −1

• Note, Freddy will correctly predict the


[ average
] (given θ):
• Freddy believes the pr of two a’s is θ · θN −1
N −1 (too low)
[ ]
(1−θ)N
• Freddy believes the pr of one a is 2 · θ · N −1 (too high)
Fig 1
• The expected number of a’s is still 2θ Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Completing the Model
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

• What happens if a 4-Freddy observes ⃗


tempted to draw a box around the full logo, but use the form shown here.
s5 ?
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Rather than letting him run out of balls, Rabin extends the
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

model:
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

∃ N ≥ 4 such that Freddy incorrectly believes that sig-


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

nals in state θ are drawn without replacement from an


The abbreviated version is the square block with the letters LSE (fig 4).

urn with θN a signals, and (1 − θ) b signals, and that this


urn is replaced after every second draw.

• Note that this does not affect the preceding examples 1

• Will not substantively change intuition of remaining


results, either
• We will explicitly state when “urn-replacement” is called
for.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

6
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Gambler’s Fallacy With Replacement

• Lemma 1 Consider N and θ such that θN is an integer and


π(θ) =1.
1 For all odd t, and histories ht−2 ,
πtN (st = a|st−1 = b, ht−2 ) = πtN (st = a|st−1 = a, ht−2 ) = θ
2 For all even t, and histories ht−2 , πtN (st = a|st−1 =
θN −1
b, ht−2 ) = NθN N
−1 > θ > N −1 = πt (st = a|st−1 = a, ht−2 )

• Note 1: because of replacement, only immediate past


realisation matters
• Note 2: even periods are exactly as before
• Note 3: odd periods have a new urn, and hence no GF

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Overinference
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• The interesting results will come when Freddy tries to do


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. inference with his wrong model:


Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

πtN (⃗st |θ∗ )π(θ∗ )


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

πtN (θ∗ |⃗st ) =∑


on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
N s |θ)π(θ)
θ∈Θ πt (⃗
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
t

• Overinference from small samples – hot-hand fallacy


• Will lead to belief
1
in “fictitious variation” about the
distribution of types in a population
• But will also lead to conservatism about any particular rate
when observing long sequences
• This may be surprising, but note that Freddy will struggle to
understand the inevitable streaks

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Inference: Rational Baseline

• Ex: Consider a Bayesian with diffuse priors over


θ ∈ {1/4, 1/2, 3/4}
• The agent observes ⃗
s2 = aa, and wants to calculate her
posterior beliefs
• First, calculate (correct) conditionals:
• π(aa|θ = 1/4) = (1/4)2 = 1/16
• π(aa|θ = 1/2) = (2/4)2 = 4/16
• π(aa|θ = 3/4) = (3/4)2 = 9/16

• And so she updates using Bayes’ rule:


1/16
• π(θ = 1/4|aa) = 1/16+4/16+9/16 = 1/14
4/16
• π(θ = 1/2|aa) = 1/16+4/16+9/16 = 4/14
9/16
• π(θ = 3/4|aa) = 1/16+4/16+9/16 = 9/14

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Overinference
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Suppose a 4-Freddy also begins with diffuse priors and


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

observes aa
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• The mistake occurs in the first step, when he computes


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

the incorrect conditionals:


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

• π 4 (aa|θ = 1/4) = (1/4)(0/3) = 0


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• π 4 (aa|θ = 1/2) = (2/4)(1/3) = 1/6


• π 4 (aa|θ = 3/4) = (3/4)(2/3) = 1/2

• When he updates his beliefs with these wrong conditional


probabilities:
1
• π 4 (θ = 1/4|aa) = 0
0+2/12+6/12 =0
2/12
• π 4 (θ = 1/2|aa) = 0+2/12+6/12 = 1/4
6/12
• π 4 (θ = 3/4|aa) = 0+2/12+6/12 = 3/4
• The chance that θ = 3/4 is 64%, but Freddy believes it is
75%
Fig 1
• The chance that θ = 1/4 is 7%, but Freddy believes it is 0% Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Overinference
• Suppose that Freddy is reading the second quarterly
report from his mutual fund manager Helga, and the
reports of all the other managers in the market
• Freddy initially believes fund managers are types drawn
from possible types Θ = {Bad, Mediocre, Good}
• Good managers beat market w/probability 3/4; mediocre,
1/2; bad, 1/4
• Suppose Helga is actually mediocre, as are all managers
• Pr( gg | M ) = 1/4 = Pr(bb | M)
• Pr(gb ∪ bg | M ) = Pr(gb|M)+Pr(bg|M) = 1/2
• Helga will have some good histories and some bad ones

• We have already shown that Freddy will too-often think


that Helga is an extreme type
• What will Freddy infer about the distribution of managers?
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Overinference
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Freddy thinks that the conditional probabilities are:


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

P˜r(gg|G) = ( 34 )( 21 ) = 12 , P˜r(gb ∪ bg|G) = 2( 34 )( 31 ) = 12 , P˜r(bb|G) = 0


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

P˜r(gg|M ) = ( 24 )( 13 ) = 16 , P˜r(gb∪bg|M ) = 2( 24 )( 32 ) = 23 , P˜r(bb|M ) = 16


around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

P˜r(gg|B) = 0, P˜r(gb ∪ bg|B) = 2( 1 )( 3 ) = 1 , P˜r(bb|B) = 1


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for 4 3 2 2
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics

• Suppose Freddy believes the distribution of managers is


Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

symmetric, with π(G) = π(B) = q, and π(M ) = 1 − 2q.


The abbreviated version is the square block with the letters LSE (fig 4).

• In a large sample there will be 1/4 (gg) realisations, 1/2


mixed, and 1/4 (bb) by the law of large numbers
• To match the gg’s:
1 1 1
P˜r(gg|π) = q̃ + (1 − 2q̃) + 0q̃ =
1

2 6 4
1
⇒ q̃ =
2
• Confirm that q̃ also matches mixed and bb frequencies
• Even if all Helgas are mediocre, Freddy infers that half are
good and half are bad (and none are mediocre!) Fig 1 Full LSE logo in colour
Fig 1
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
General overinference
• The method of the previous slide works well for most
symmetric beliefs (and when the true rate is 1/2)
• What can we say about more general beliefs:
π(G) = α, π(B) = β, π(M ) = 1 − α − β?
• What does Freddy believe is the probability of observing
K1 gg realisations, K2 gb or bg realisations, and K3 bb
realisations?
L(α, β) = P˜r(gg|α, β)K1 · P˜r(gb ∪ bg|α, β)K2 · P˜r(bb|α, β)K3

β
• P˜r(gg|α, β) = 12 α + 16 (1 − α − β) + 0β = 1
6 − 6 + α
3
β
• Similarly, P˜r(bb|α, β) = 1
6 − α
6 + 3
β
• And P˜r(gb ∪ bg|α, β) = 2
3 − α
6 − 6
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
General overinference
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• Being a good econometrician, Freddy recognises a


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.

suitable for print. maximum-likelihood estimator!


Never download the logo from the internet. Web versions are screen resolution and not

It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

max L = K1 ln P˜r(gg|α, β)+K2 ln P˜r(gb∪bg|α, β)+K3 ln P˜r(bb|α, β)


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
α,β
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

• If all Helgas are mediocre, then K1 = K3 = K2 /2


• FOC:
∂ −1 2 2
= − + =0
∂α 1 − α + 2β 4 − α − β 1 − β + 2α 1

∂ 2 2 1
= − − =0
∂β 1 − α + 2β 4 − α − β 1 − β + 2α
• Is there a solution with symmetric beliefs α = β?
• Take either FOC, find α = β = 1/2, as before.
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Overinference
• Can we generalise this result about fictitious variation?
• Freddy must infer how much heterogeneity there is in the
rate population
• Let a source be a particular draw of a rate (e.g. a particular
Helga)
• Freddy observes 2 realisations apiece, from an infinite
number of sources
• Let πi ∈ ∆(Ω) denote a possible distribution of sources
• e.g. 1/3 good managers, 1/3 mediocre, 1/3 bad
• restrict attention to symmetric distributions

• Then p(πi ) is Freddy’s prior belief that the distribution of


sources is πi
• e.g. 50% chance of a world with 10% good/bad managers
• Note that after observing a large number of Helgas, this
will converge to p(π ∗ ) = 1 for some π ∗ – but is it the correct
Fig 1
one? Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

15
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Overinference
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

• Proposition
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white

If π is symmetric and π(θ = 1) < 1/2, then for any N < ∞, there is
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

a mean-preserving spread π̂ such that, if p(π̂) > 0 and


The abbreviated version is the square block with the letters LSE (fig 4).

p(π) = 1 − p(π̂), Freddy’s beliefs will converge to π̂ if the true


distribution of types is π.
• That is, only two possible distributions – same average
1
rate, but different variance
• Freddy will exaggerate the probability of extreme types in
the population.

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Overinference
• Sketch of proof:
1 Let d(π, N ) be the proportion of aa realisations an
N-Freddy expects from π
2 Since dN (π, N ) > 0, d(π, N ) < d(π, ∞) for all N < ∞ – i.e.
N-Freddy expects too few extreme realisations from the
true π
3 Note that if π̂ = (1 − k)π + kπ ′ , then
d(π̂, N ) = (1 − k)d(π, N ) + kd(π ′ , N )
4 Let π ′ s.t. π ′ (θ = 1) = π ′ (θ = 0) = 1/2 (most extreme), and
note d(π ′ , N ) = d(π ′ , ∞) = 1/2 > d(π, ∞)
5 From above, ∃k s.t. d(π, ∞) = d(π̂, N ) for
π̂ = kπ ′ + (1 − k)π (intermediate value theorem)
6 Thus after observing an infinite sequence h of 2 signals per
source, if the true distribution is π Freddy’s beliefs will
converge to a mean-preserving spread of π, namely π̂

• For very general distributions, Freddy may come to believe


Fig 1

in too much variation in Helgas’ abilities Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Hot-Hand
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Fictitious variation enables the hot-hand fallacy:


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• There are 82 games in the NBA regular season


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• LeBron James may have good, bad, and mediocre days:


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

θ ∈ {B, M, G}, and as with Helga, Freddy will infer strictly


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

more variation in the types of days than there actually is.


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• Even if all days are mediocre, there will be some games


The abbreviated version is the square block with the letters LSE (fig 4).

with many misses, and some with many successes


• Without fictitious variation, Freddy will eventually realise
that π(θ = M ) = 1 (i.e. P r(s|M ) = 1/2)
• Then P˜r(a|aa) =1 1
2, and P˜r(a|aaa) < 1
2
• With fictitious variation, Freddy may come to believe that
π(θ = B) = π(θ = G) = 1/2.
P˜r(ss|θ=B)π(θ=B)
• Then π(θ = B|ss) = = 0,
P r(ss|θ=B)π(θ=B)+P˜r(ss|θ=G)π(θ=G)
˜
π(θ = G|ss) = 1.
• So P˜r(s|ss) = P˜r(s|ss, θ = G) = 3/4, and P˜r(s|sss) = 2/3
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Belief in the Law of Small Numbers
Conservatism
• A somewhat surprising result concerns Freddy’s
conservatism when inferring from a long sequence of
draws from a single source
• Proposition 6 Suppose that N is even. If the true rate is
θ∗ > 1/2, limt→∞ πtN (θ̂) = 1 for some θ̂ ∈ [1/2, θ∗ ].
• Proof: beliefs converge to some θ̂, then algebra to
maximise Freddy’s likelihood function (algebra).
• Intuition is flip of previous result: for any θ > 1/2, (infinitely)
too many bb realisations than he would have expected
• e.g. suppose Θ = {1/4, 1/2, 3/4} and a 4-Freddy observes
aaaaaaaaaaaaaaaaaabb
• Since θ = 1/4 cannot generate the bb at the tail, Freddy
believes π(1/2) ≈ 1.
• What if Freddy were instead told that an unordered
Fig 1
sequence contained 18 a draws and 2 b’s? Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Belief in the Law of Small Numbers
Hot-Hand
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

• Conservatism results from Freddy choosing the


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

least-unlikely outcome, given the streaks which he dislikes


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• If instead Freddy believes that the state of the world


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

sometimes shifts, he let this explain such streaks


graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for

• This is the approach taken in Rabin and Vayanos:


PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
st = θt + εt
θt = µ + ρ(θt−1 − µ) + ηt
• This also generates the hot-hand fallacy: after observing
aaaaaaaaaaaaaaaaabb, Freddy believes that b is too likely to
be the next draw – similar to our earlier LeBron result. 1

• Note that allowing an agent to believe in state-changes of


the world is in itself an important model
• Barberis et al. show that an agent who believes in such a
regime-change model when the world is truly a random
walk will generate under-reaction to information (and
over-reaction to a string of good/bad realisations)
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

20
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


A Game for Next Lecture

• Everyone must guess a number in [0,100]


• Whoever guesses closest to 2/3 the average of everyone
else’s guess wins £10
• I get to submit a guess, too
• Ties to be decided by coin flip

• On spare paper, write your guess and either your name or


a pseudonym if shy

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

21
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

Lecture 7: Behavioural Game Theory


Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

1
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Play in Dominance-Solvable Games
Beauty Contests
• We formalise a p-beauty contest as the following:
• Players: i ∈ {1, ..., N }
• Actions: ai ∈ [0, 100]
• Payoffs: πi (ai , a−i ) = 1{ai = minj |aj − p · ā−j |}

• Unique Nash equilibrium: all 0 if p < 1, and all 100 if p > 1


• Suppose p = 2/3
E AMERICANECONOMIC • REVIEW
Since a−i cannot exceed 100, DECEMBER 1995
should never guess ai ≥ 66.6
• But then a−i cannot exceed 66.66, so never guess
written on 0.15 ai ≥ 44.4
A.
he players • But then a−i cannot exceed 44.4, 17 guess ai ≥n 29.6
so never
median
• If doing n rounds of iteration, then guess
mean ai = 100 · 23 → 0
27.05
sest to the
yoffs were ao
• Thus both Nash and IDSDS predict the winning answer is
* 0.10-
er of each c
0. Is it?
here was a
Fig 1 Fig 1 Full LSE logo in colour

e who tied.
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

After four 2

um of his
Fig 2
x x

THELONDON SCHOOL
x
Fig 2 LSE logo – clear space

The clear space around the logo must be


equal to the space between the LSE
lettering and the edge of the red square.

ional fixed
This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x

y $3) for x x
element (eg text, sub logos) attached to
the LSE square

about 45 0 10 20 30 40 50 60 70 80 90 100
Evidence on Dominance-Solvable
eriod. LSE logo ChosenNumbers Games
Nagel
IL (AER 1995) first-round choices, p=2/3:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

lts The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
01-B.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
median33
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

gel (1993)
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
mean 36.73
uthor upon
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

parametric
Also you can use either the abbreviated or full version of the logo.
, 0.10-
0.00
The abbreviated version is the square block with the letters LSE (fig 4).

ahl (1994)
o
a and con-
X 0.05-
1

quencies of
alue of p, 0 10 20 30 40 50 60 70 80 90 100
Chosen Numbers
ns are also
hoices are
Fig 1 Fig 1 Full LSE logo in colour

2A,and "/2
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485

0.15
e numbers C.
median 66 3
10 percent
Fig 2
x x
x
Fig 2 LSE logo – clear space

The clear space around the logo must be


equal to the space between the LSE
mean 60.12
THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


BOSCH-DOM:NECHET AL.: BEAUTY-CONTEST
VOL.92 NO. 5 Evidence on Dominance-Solvable Games
EXPERIMENTS 1691
BOSCH-DOM:NECHET AL.: BEAUTY-CONTEST
EXPERIMENTS 1691
nts) was 14.4, while the (a)
utcommentswas 26.8. External
In percentValidity all entrants)
of Financial was (1,468subjects)
Times experiment14.4,
while the (a)
supposed to submit com- average 0.14
of those without commentswas 26.8. In FinancialTimes experiment (1,468subjects)
.
gewas 18.9. However, the FT C all 0.12 entrants were supposed to submit com-
ose in E with comments ments Bosch-Domenech et al. (AER 2002) use a series of 2/3 beauty
X 0.10
0) 0.08
and their averagewas 18.9.
- 0.06 choice of those inwinning
18.91
averageHowever,
number: 13
the
. 0.14
C 0.12
X 0.10
E with comments average 18.91
rants)was 25.2, whereas average
was 25.5. contests announced
(4.5 I) 0.04
*' 0.02 in major newspapers. Prizes included (a)
percent of all entrants)was 25.2, whereasa
0) 0.08
- 0.06 winning number: 13

g examples in the instruc- without 0comments


? 0.00 I '
15 22 it 33 was 25.5. - h
) 0.04
*' 0.02

pair of BA club-class tickets to NYC, (b) 100,000 pesetas ≈ 50 100 a


? 0.00 ' - h
sions. In FT, Thaler used Similarly, providing examples choices in the instruc- 0 15 22 33 50 100
mber 20 as a winner) tions may affect
inBEAUTY-CONTEST decisions. In FT, Thaler used
e600, (c) 100 DM ≈ e520
BOSCH-DOM:NECH ET AL.: EXPERIMENTS 1691 choices
ces above 50. Indeed, in an example (with number 20 as a winner) in
(b)
0 were
nts) wasless whilethan
frequent
14.4, the order to prevent Spektrum choices experimentabove (2,72950. Indeed, in
subjects) (b)
4 percent 9 FT, numbers above 50 were (a) less than
utcomments
cations: was in FT,In
26.8. FinancialTimes experiment (1,468subjects) frequent Spektrumexperiment(2,729 subjects)
in toS. submit com- in the0.12 a) 0.14other two publications:4 percentin FT, 9
percent
supposed 0.14
0.10 in E, and 10 percent inaverage S. 22.08 a) 0.14
was 18.9.
geopening article
However, include the a percent
.
C 0.12
0.12
X 0.08
for
ose performing
in E with commentsthe exper- aE 0.10 |winning
requested
0.06
that the opening article
average number:
18.91include
14.7 a 0.10 average 22.08
50) 0.08 13 0.08
reasoned for winning number: the
er did
rants) also several
was 25.2, whereas pre-
Q)
- 0.060.04 justification performing exper- a
5 0.06
|winning number: 14.7

was 25.5. days before the iment.


e game,
) 0.04
*' 0.02
0.02
0.00 I
This newspaper did also several pre-a
' 15 of 22 the before the100
Q)
0.04
0.02
gred. This probably
examples in the instruc- caused announcements ? 0.00 0
0 15 22
33
33 game,
50 -
50 days
h
100 0.00
rticipants
sions. than in
In FT, Thaler used the other opening
cr
article appeared. This
choices
choices probably caused 0 15 22 33 50 100
choices
mber
nts. Furthermore,
20 as a winner) without in a higher numberof participantsthanin the other cr
a)
ge, E
ces above 50. Indeed,
published a short- in Newspaper (a experiments. (c)Furthermore,without
article S
the authors' Expansi6n
knowledge,
(b)
experiment E published
(3,696 subjects) a short-
a)
(c)
0pening
were less containing
frequent than Spektrumexperiment (2,729 subjects)
(a
on the 4three
cations: percent in FT, 9 ened
consecutive a) version of the opening article containing
0.14
S
Expansi6n experiment(3,696 subjects)
0.12 of the game on the three consecutive
blication.
percent S. shortening thea) rules
in The a)
0.14
0.12
0.10 average 25.47
a)
0.14
ion that comments
article include were a days following its publication. The shortening 0.12
opening C
a)
0.10
0.08 winning number:
average 16.99
22.08 a)
0.10 average 25.47
uently, we received
for performing the exper- fewer resulted a
0.08 in the omission that comments
0.06 |winning number: 14.7were C winning number: 16.99
0.06
0.04 a) 0.08
an from
did the
also other
several news- welcome
5
Q) and, consequently, we received fewer 0.06
er pre- 0.04
0.02 0.04
dementioning
game, days thatbefore only one the comments 0.00 0.02 from E than from the other news- 0.02
0.00 0 15 22 33 50 100
ould be In fact, papers. It also omitted mentioning that only one
probablycaused
red.Thisaccepted. 0 15 22 33 50 100 0.00
choices 0 15 22 33 50 100
ubmittedthan
rticipants in the num-
multiple other number cr
per person would be accepted. In fact, choices
choices
amountedto without
nlyFurthermore, about 1 severalFIGURE participants 1. RELATIVE submitted
FREQUENCIES OF CHOICES
multiple num-
nts. IN THREENEWSPAPER EXPERIMENTS
.ge, E published a short- bers. (c)amountedto about 1 FIGURE1. RELATIVEFREQUENCIES OF CHOICES
a)
(a However, they only
IN THREENEWSPAPER EXPERIMENTS
entries. Fig 1 Full LSE logo in colour

pening article containing percent of the


Fig 1
S
Expansi6n experiment(3,696 subjects)
The full LSE logo should be used wherever
possible. The Pantone reference is PMS 485
Results
on the three consecutive a)
0.14
blication. The shortening iterated 0.12 best reply B. Results
(IBRd, see Section I). We
that and
analyze
ion compare
comments were the a)
C report 0.10 these
findings as: winning number: 16.99
average 25.47 iterated best reply (IBRd, see Section I). We 4
0.08
rom the three
uently, we received Newspaper fewer Choices.-Here
a)
0.06 we analyze and comparethe reportthese findings as:
Fig 2 LSE logo – clear space
the data sets 1:ofThe choices threefrom the three Newspaper
Fig 2

ently
an fromwe make
the other use of x
news- Fact x0.04
0.02 xNewspaper experiments
The clear space around the logo must be
equal to the space between the LSE
re-
dments received
mentioning thatfor onlythese one experiments. sultTHE
0.00 inLsimilar
ONDONSubsquently frequencydistributions.
SCHOOL we make useInofpartic- the
lettering and the edge of the red square.
This applies to the reproduction of the logo
Fact 1: The three Newspaper experiments re-
ould be accepted. In fact, large ular, number
OF E0CONOMICS 15 22 AND 33
all ofshow comments spikes
50
received
at number these100 sult in similarfrequencydistributions.In partic-
for choices
at any size

they The clear space is indicated by the blue line.


POLITICAL SCIENCE choices
ow the relative
ubmitted multiple num- experiments.
frequen- 33.33, 22.22, and 0.14 x
Nothing must enter this area.
The clear space must continue around any
element (eg text, sub logos) attached to
ular, they all show spikes at number choices
mbers [in intervals
nly amounted to [0, about x
0.5); 1 x
Figures FIGURE l(a)-(c)
1. RELATIVE show the relative
FREQUENCIES frequen-
the LSE square
OF CHOICES 33.33, 22.22, and 0.14
.etc.], the average choice, cies of In the linechosenINwithTHREE numbers
NEWSPAPER
previous [in intervals
we take
EXPERIMENTS
work, [0, 0.5);
spikes
and the numberof partic- [0.5, 33.33 1.5); and 22.22
[1.5, 2.5);as an etc.], the average
indication that achoice,
number In line with previous work, we take spikes
Results experiments.The the ofwinning number, follow and Levelthe number 1 and Level 2 based 33.33 and 22.22 as an indicationthat a number
of partic-
wspaper
milarityof choices despite ipants
LSE
Evidence on Dominance-Solvable Games
logo
iterated
participants
in the
indicate
best three Newspaper
reply (IBRd, see
the similarity
experiments.
Section I).
of choices despite
The We of participantsfollow Level 1 and Level 2 based
bject
analyze andand
pools compare notwith- the figures report these findings as:
ollability
rom of such
the three experi- the differences
14
The spike at in in Figurepools
33.5subject 1 resultsand fromnotwith-
the choice in
Newspaper
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
E The logo should constrained to the interval so that 2/3 of the 14
and [1,of
the
ently results
we make confirm
use of the
the
distinct visual identity for the School. being
standing
Fact
information/publicity materials. It is widely used and
1:isthe The uncontrollability
three publications
be used on all School
recognised.The rounding
33.66. Newspaper
such
100],
of thisexperiments
experi-re-
and othernumbers
The spike at 33.5 in Figure 1 resultsfrom the choice in
E being constrainedto the interval[1, 100], so that 2/3 of the
mon of decision- ments.average In addition, the up
results confirm the
ments pattern
receivedThe for LSE logothese sultIt must
from
is a unique graphic device. in33.5 similar
never toreset,
be frequency
in the
34redrawn distributions.
or altered. Do not
figure be
yields 33.5. The In partic-
interval averageis 33.66. The roundingup of this and othernumbers
entified in the lab experi- existence
tempted to draw a box around the full logo, but use of
constraint
ular, they in Eashown
the form
all and common
showhere.
the restriction
spikes pattern at of decision-
to number
integers inchoices
FT also from 33.5 to 34 in the figure yields 33.5. The interval
To ensure high quality reproduction, you should
identified
always use the master artwork from disk.
in the lab experi-
contest
ow thegame relativeas
Neverlevels
frequen-
of making,
download the logo from
suitable for print.
• Nash equilibrium prediction is all kinds of wrong here
internet. Webpreviously
causes
the33.33,
the
22.22,spike
versions at
and
are screen
ments of the Beauty-contest game as levels of
1. 0.14
resolution and not constraint in E and the restriction to integers in FT also
causes the spike at 1.
mbers[in intervals [0, 0.5);
It is important to keep the LSE logo clear from any other graphics. The minimum clear space

etc.], the average choice,


around the logo is shown above, and defines In line
an area intowith
which nothing should intrude.
previous
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
work, we take spikes
and the number of elements used with it (full33.33
bleed picturesand 22.22 as an indicationthat a number
wspaperexperiments.
graphic partic-
The • And a naive Nash equilibrium player does exceptionally
of participants
on black. These are available electronically
are the only exception).

follow Level 1 and Level 2 based


You can use the square element of the logo either as white lettering on red, PMS 485, or white
(EPS file) from the LSE Design Unit. An EPS file is for

milarityof choices
bject pools and
This contentAlso
despite
notwith-the Thu,
downloaded
you can use eitheron 7 Feb
abbreviated
poorly
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

2013
or full version06:40:54
of the logo. AM
14
ollabilityofAllsuch use
The subjectexperi-
abbreviated toversion
JSTOR Terms
is the square blockandThe
withConditions
thespike
letters LSEat(fig33.5
4). in Figure 1 resultsfrom the choice in
This content downloaded on Thu, 7 Feb 2013 06:40:54 AM
the results confirm the E being constrained to the interval[1, 100], sosubject
All use that 2/3toof the Terms and Conditions
JSTOR
mon pattern of decision- • But Nash equilibrium seems useful in some contexts.
average is 33.66. The roundingup of this and othernumbers
from 33.5 to 34 in the figure yields 33.5. The interval
entified in the lab experi- constraint in E and the restriction to integers in FT also
contest game levels as of causes the spike at 1.
• Perhaps initial play differs from equilibrium play
• We first want to confirm that as players learn, Nash
1
predictions work
All use subject to JSTOR Terms and Conditions• Then develop model for systematic deviations in initial play
This content downloaded on Thu, 7 Feb 2013 06:40:54 AM

• (And when might we expect Nash even in first-time players)

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

5
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


90-
~~
. 80- +
~~~~~~~~~~~~~~~~~~~0
+
i
-~80
70- o ~~
. 80- +
~~~~~~~~~~~~~~~~~~~0
+
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0 c 60-
a) o 0
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50-
o 0
a) 50-
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++

Evidence on~~~~~~~~~~~~~~~~~~~~~~~~~~~+
Dominance-Solvable Games~~~~~~~~~~~~~~~~~~~~~~~~~~~+
Si +

~~
~~~~~~~~~~~~~~+ 30 ++
Si
40- + + -40
Si
++
+

~~~~~~~
~~~~~~~~~~~~~~~~~~~+ 530 30 ++
+

+ +~~~~~~~~~~~~~~
Learning over time
+~~~~~~~~~~~~~~~~
+ + ++
+ + +~~~~~~~~~~~~~~
300++ + +~~~~~~~~~~~~~~~~
Nagel (1995), cont’d: all guesses ~0 reported on blackboard, mean
+ + ++
do d io ~0 40 100 0 10 20 3 40 5 60 70 80 90 100
s in First Period Choices in First0Period
10 20 3 40 do d io 40 100 0 10 20 3 40 5 60 70 80 90 100
Choices in First Period Choices in First Period
VOL. 85 NO. 5
and winner announced. Then repeat
NAGEL: UNRAVELINGIN GUESSINGGAMES
100-
1319
for several more such
100- B. 100- 100- 100-
A. 90- B. A. B.
90- 90- 90- 90-
80-
80- 80- 80-
-~80
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. +
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c 60- o c60- 60- *2 60-
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oa) 0
50- 50
H a) H
U)
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50-
++
50-

Si
40- + 0+ 40-
-40 ++ 40-
530 ~~~~~~~
~~~~~~~~~~~~~~~~~~~+
0+
0 30- o
O
+ 30-
Si

30 ++
+
~~~~~~~~~~~~~~~~~~~~~~~~~~~+
30-
+ 0+
0
20 + *. ++ o) 0+ +
20- 20 + *.
+ 10: +4 +
+~~~~~~~~~~~~~~ ++
+
10 .- +
++
10: +4 +

50 60 70
300++
80 90 100 0
+
10o 20 30 40 0 60 70
i 80
+~~~~~~~~~~~~~~~~
90 100
+ + ++

0
in Second Period 10 20 3 40 do d io ~0 40 100
Choices in Second 10 1020 2030 3 40 4050 5 60 6070 7080 8090 90100 100
0 0Period 0 10o 20 30 40 0 60 70
i 80 90 100
Choices in First Period Choices in Second Period
rounds. Choices in First Period Choices in Second Period

100-
100-
90-
C. 100-i100- 100-
B. 90-
C. B.
+ C.
90- 90- 90-
80-
80- 0 80- 80- 80-
c
70Q o0
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. 60-
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0 50 +
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50- 50- 0 50 +
40- 0 0L
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40- 40- 40- 40-
o s~~~~~~~~~~~~~~~~~~~
30-
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o)
30-
~~~
5 30 30-
~~~~~~~~~~~~~20- +++
0+
0
0+ +
s~~~~~~~~~~~~~~~~~~~
30-
20-
10- + ++
20-20 + *. ++ ~~~
~~~~~~~~~~~~~20- +++

10 .- +
++
10- 10: +4 +
10- + ++
50 60 70 80 90 100 0 10o 20 30 40 50 d0 70 80 90 10
0
in Third Period10 20 30 40 50 60 70 80 90 100 0 Period
Choices in Third 0 10 10o
20 2030 3040 4050 0 6060 70 70 i 80 8090 90100 100 0 10o 20 30 40 50 d0 70 80 90 10
Fig 1 Choices in Second Period Choices
Fig Choices
1 Full inin Third
LSE logo PeriodPeriod
in Second
colour Choices in Third Period
VER TIME FOR SESSIONS 1-3 FIGURE 4. The full LSE logo should be used wherever
OBSERVATIONS OVER TIME FORpossible.
SESSIONs 4-7is PMS 485
The Pantone reference
FIGURE 3. OBSERVATIONS OVER TIME FOR SESSIONS 1-3
7 FIGURE 4. OBSERVATIONS OVER TIME FOR SESSIONs 4-7
N FRom FIRST TO SECOND (p 4): A) TRANSITION FROm FIRST TO SECOND
= A/): A) TRANSITION FRom FIRST TO SECOND 7
100-i To THIRD PERIOD;
M SECOND (p 100-
PERIOD; B) TRANSITION FROM SECOND To THIRD PERIOD; (p 4): A) TRANSITION FROm FIRST TO SECOND
C. + B) C.
TRANSITION FROM SECOND To THIRD PERIOD; PERIOD; B) TRANSITION FROM SECOND To THIRD PERIOD;
HIRD To
90- FoURTH PERIOD C) TRANSITION FROm PERIOD;
THIRD To90- FoURTH PERIOD
C) TRANSITION FROm THIRD To FoURTH PERIOD C) TRANSITION FROm THIRD To FoURTH PERIOD 6
80- 80-
Fig 2 Fig 2 LSE logo – clear space
o0 x x 0
070 c The clear space around the logo must be
x 70Q equal to the space between the LSE

that.c60 the split prize was bestTHE LONDON


in Sthe
CHOOL lettering and the edge of the red square.
reply 1/2 and . 2A60-
sessions, given the This applies to the reproduction of the logo

bvious
OF E CONOMICS AND down again] or wrote that the split prize was at any size
best reply in the 1/2 and 2Asessions, given the
50- right answer.) actual strategies.
POLITICAL SCIENCE Instead
LO 0 the
50 best reply is a The clear space is indicated by the blue line.

0
ess toward the equilibri- too small
0L
C to state+ the obvious right answer.) Nothing must enter this area.
actual strategies. Instead the best reply is a
40- moving target that xapproaches 0. The adjust- The clear space must continue around any

The40-
element (eg text, sub logos) attached to

ssions
x x adjustment process towardthe equilibri- the LSE square
moving target that approaches 0. The adjust-
5 30is quite different ment process is thus more complicated. Com-
sions. 20- Zero is never the ums~~~~~~~~~~~~~~~~~~~
in 30-
the 1/2 and 2A3sessions is quite different ment process is thus more complicated. Com-
paring Figures 3 and 4, one can +++see that the
from ~~~~~~~~~~~~~~~~20-
that in the 4/3 sessions. Zero is never the paring Figures 3 and 4, one can see that the
10- 10- + ++

0 10 20 Evidence on Dominance-Solvable Games


LSE logo
30 40 50 60
Choices in Third Period
70 80 90 100 0 10o 20 30 40 50 d0
Choices in Third Period
70 80 90 10

FIGURE 3. The LSE logo is the School’s


OBSERVATIONS OVERmainTIME
marketing
FOR Grosskopf-Nagel4. (GEB 2008) have people
and publicity
SESSIONS 1-3
symbol, and 4-7 play 2-player, and
is designed to create a
FIGURE OBSERVATIONS OVER TIME FOR SESSIONs
A/): A)information/publicity
(p =TRANSITION FRom FIRST used TO SECOND (p 74): A) TRANSITION FROm FIRST TO SECOND
distinct visual identity for the School. The logo should be used on all School publications and

PERIOD; B) TRANSITION
This content The
C) TRANSITION
LSE logo is FROM
downloaded
temptedFROm
materials. It is widely

to draw a THIRD
SECOND
a unique graphic
on Thu,
box around To
device. It To
7 Feb
the fullFoURTH
2013 either give feedback on (a) choices of other members of this
and recognised.
THIRD
must never
06:32:06
logo, but use the
PERIOD;
be reset, redrawn or altered. Do PERIOD;
AM
form shown here.
PERIOD
not be B) TRANSITION FROM SECOND To THIRD PERIOD;
C) TRANSITION FROm THIRDThis
To content
FoURTH PERIOD on Thu, 7 Feb 2013 06:32:06 AM
All use subject to JSTOR Terms and Conditions downloaded
treatment, (b) just whether won or not, (c) no feedback.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
All use subject to JSTOR Terms and Conditions

It is important to keep the LSE logo clear from any other graphics. The minimum clear space

down again] around


or wrote
the logo is shown above, and defines an area into which nothing should intrude.
that the split detraction fromwas
This helps the LSE logo to stand out and prevents any prize its presence, by best
other reply in the 1/2 and 2Asessions, given the
too small to state the obvious right answer.)
graphic elements used with it (full bleed pictures are the only exception).
actual strategies. Instead the best reply is a
You can use the square element of the logo either as white lettering on red, PMS 485, or white
The adjustment process
on black. These toward
are available electronically (EPSthe equilibri-
file) from the LSE Design Unit. An EPS filemoving
is for target that approaches 0. The adjust-
um in the 1/2 PostScript
and 2A3
Department.
printing, this is commonly used by commercial printers and the LSE Reprographics
Usesessions is quite
a TIFF file for non-PostScript printers anddifferent
a GIF file for the web. ment process is thus more complicated. Com-
from that in the
Also you4/3 sessions.
can use Zero
either the abbreviated is ofnever
or full version the logo. the paring Figures 3 and 4, one can see that the
The abbreviated version is the square block with the letters LSE (fig 4).

This content downloaded on Thu, 7 Feb 2013 06:32:06 AM


All use subject to JSTOR Terms and Conditions
1

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

7
Fig 2
x x
Fig 2 LSE logo – clear space

The clear space around the logo must be


18
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Equilibrium Models
• Nash Equilbrium is built up in three stages:

1 Players are rational:


• are best-responding to some belief
• therefore never play dominated strategies
2 Rationality is common knowledge:
• cannot expect others to play dominated strategies
• players only employ strategies that survive iterated deletion
3 Strategies are common knowledge:
• all players hold correct beliefs about the strategies of others

• (1) provides minimum level of rationality, but often has no bite


• (1)+(2) yield IDSDS, but most games are not dominance solvable
• (1)+(2)+(3) yield Nash – existence, precision, but often wrong

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

8
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Level-k model
• Our goal is to relax (2) and (3), but keep (1)
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

• We are interested in limited strategic inference


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
• Players are “rational” from a decision-theoretic perspective
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• But they fail to account for how other players are


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).

responding to their own incentives and beliefs


You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• What sorts of beliefs should players hold?


The abbreviated version is the square block with the letters LSE (fig 4).

• Nash equilibrium looks for fixed points as sole criterion


• I think you are as smart as I am
• If I think you’re doing a, and so I should play BR(a), then I
think you’re 1smart enough to move on to BR(BR(a))
• If a ∈/ BR(BR(a)) then it is implausible for me to believe a
• We will construct theory of beliefs directly
• I fail to consider that you may be as smart as me
• If I think you’re doing a, I should play BR(a)
• Goal of model is to specify plausible beliefs

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

9
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Level-k model
• Stahl and Wilson (GEB 1995) introduce the main features
of level-k thinking:
• Players in a particular game are independently drawn from
some known population of “level” types
• A player’s level determines his strategic reasoning capacity:

• Level-0 players randomise (we assume uniform)


• Level-1 players think all others are Level-0, and
best-respond
• Level-2 players think all others are Level-1, and
best-respond
• Level-k players think all others are Level-(k − 1), and
best-respond

• Stahl and Wilson only consider levels 0 – 2. Typically a small


number of levels will suffice, but no theoretical limit
• We will (next) relax beliefs, and allow players to (correctly)
perceive all lower types in “cognitive hierarchy”
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

10
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Level-k model
• When is level-k different from Nash?
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• If level-k players ever choose a PSNE, then level-j players


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

will also play that same equilibrium for all (j > k)


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception). • We are not looking for fixed points, but we might find them
You can use the square element of the logo either as white lettering on red, PMS 485, or white

anyway
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• If there is a unique rationalizable strategy, players will


The abbreviated version is the square block with the letters LSE (fig 4).

converge as k grows
• In 2-player games, rationalizability and dominance coincide
(more generally, rationalizable ⊂ IDSDS)
• If only one strategy survives IDSDS, it will also be Nash
• If IDSDS takes1
k rounds to find unique strategy, level-k and
up will play it
• Thus level-k will yield novel predictions when:
• The game is IDSDS-solvable, but only after many rounds
(beauty contest)
• The game has multiple Nash equilibria
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

11
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Level-k model and p-beauty contests
• How will level-k players behave in the p-beauty contest?
• Level-0: randomise
• Level-1:
• Believe others are level-0, so ā−i =
• level-1 chooses ai =
• Level-2:
• Believe others are level-1, so ā−i =
• level-2 chooses ai =
• Level-k:
• Choose ai =

• Prediction: excess mass around (level-1) and


(level-2).
• Confirmed by Nagel 1995
• But is level-k the only way to get this result?

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

12
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Incomplete Iterated Dominance
• A different plausible model of thinking in these beauty
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and

contests would be Incomplete Iterated Dominance (Dk):


information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.

• D0: Eliminate no strategies, assume others play randomly


To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

and best-respond.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.

2
· 50 = 33.3)
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
(In beauty contest, play
You can use the square element of the logo either as white lettering on red, PMS 485, or white 3
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
• D1: Eliminate any strictly dominated strategies and
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.
The abbreviated version is the square block with the letters LSE (fig 4).
assume others play conditionally randomly.
(a > 100p clearly dominated, so others randomising on [0,
66]. Play 32 66
2 = 22)
• D2: Iterate deletion, and assume others play conditionally
randomly. 1

(a > p(100p) now dominated, so others randomising on [0,


44]. Play 14)
• Note: this differs from IDSDS by adding conditionally random
play
• Thus in the standard p-beauty contest, Dk yields the same
Fig 1 predictions as level-k. How can we distinguish? Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

13
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Level-k and Costa-Gomes Crawford
• Costa-Gomes and Crawford (AER 2006) have subjects play
an asymmetric 2-player beauty contest:
• Player 1 guesses a1 from interval [A, B]; Player 2 guesses
a2 from interval [C, D]
• Player 1’s target is p · a2 ; Player 2’s target is q · a1
• Ex: suppose parameters are ([100,900], 0.5) and
([100,500], 1.5):
Type Player 1 Player 2
L1 =D0 Best-response .5 · 300 = 150 1.5 · 500 = 750 ⇒ 500
L2 Best-reponse 250 225
L3 Best-response 112.5 375
D1 Undominated [100, 250] [150, 500]
Best-response 0.5 · 325 = 162.5 1.5 · 175 = 262.5
D2 Undominated [100, 250] [150, 375]
Best-response 0.5 · 262.5 = 131.25 1.5 · 175 = 262.5
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

14
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Level-k and Costa-Gomes Crawford
• CGC estimate frequencies of types based on play in
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

several
VOL. 96 NO. 5 games:
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
COSTA-GOMES AND CRAWFORD: COGNITION AND BEHAVIOR
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
1741

Never download the logo from the internet. Web versions are screen resolution and not
suitable for print. T
ABLE 1—SUMMARY OF BASELINE AND OB SUBJECTS’ ESTIMATED TYPE DISTRIBUTIONS
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
Econometric from
graphic elements used with it (full bleed pictures are the only exception). Apparent Econometric Econometric from Econometric from guesses and
You can use the square element of the logo either as white lettering on red, PMS 485, or white from from guesses, guesses, with search, with
Type
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS fileguesses
is for guesses excluding random specification test specification test
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
L1 20 43 37 27 29
Also you can use either the abbreviated or full version of the logo.
L2 12 20 20 17 14
The abbreviated version is the square block with the letters LSE (fig 4).
L3 3 3 3 1 1
D1 0 5 3 1 0
D2 0 0 0 0 0
Eq. 8 14 13 11 10
Soph. 0 3 2 1 1
Unclassified 45 0 10 30 33

Note: The far-right-hand column includes 17 OB subjects classified by their econometric-from-guesses type estimates.

• Level-k
Sophisticated explains most
subjects (Table 1). behaviour
It also sup- –using
subjects’ types almost nobody
search as well as guesses. is doing
1

ports our a priori specification of possible types Taking both into account, 55 of 88 subjects are
D-k
by giving no indication of significant numbers reliably identified as one of our types, 45 of
of SW’s Worldly type or any other type omitted them non-Equilibrium (Table 1). This analysis
• Eq. are
from our players who jump to
specification. Nash
reaffirms equilibrium
the absence of ofgame
of significant numbers
Information search adds another dimension types other than L1, L2, Equilibrium, or hybrids
These players do not doofparticularly
• econometric analysis.5 Following CGCB,
to our well,
L3 and/or Equilibrium. given
These results Lk and Dk
are con-
we link search to guesses by taking a procedural sistent with previous analyses, but significantly
Soph. are best-responding
view• of decision-making, in which a subject’s refine to actual
and sharpen distribution, and are
them.
type determines his search and guess, possibly Thus, to the extent that our subjects’ devia-
rare
with error. Each of our types is naturally asso- tions from equilibrium can be predicted, they
ciated with algorithms that process information appear to be based almost entirely on level-k
Fig 1
about targets and limits into decisions. We use Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


thinking. Given the definitions of level-k types,
those algorithms as models of subjects’ cogni- possible. The Pantone reference is PMS 485
our results strongly affirm subjects’ rationality
tion, making conservative assumptions about and ability to comprehend games and reason
how it is related to search that allow a tractable about others’ responses to them. Although they
characterization of types’ search implications. challenge the use of equilibrium as a universal 15
Fig 2
x x The types then provide a kind of basis for the Fig 2 LSE logo – clear space

The clear space around the logo must be


model of initial responses to games, the sim-
enormous x space of possible guesses and
THE LONDON SCHOOL
equal to the space between the LSE
lettering and the edge of the red square.
plicity of the alternative nonequilibrium model
searches, imposing enough structure to make it
OF E CONOMICS AND
This applies to the reproduction of the logo
at any size they suggest should help to allay the common
Level-k and Costa-Gomes Crawford
• More interestingly, CGC observe what information
subjects are using to make their choices
• Consider a Level-2 player 2
• Must first predict what Level-1 player 1 will do. So look up
own limits.
• Next, look up player 1’s target to get his preferred
response.
• Next, player 1’s limits to find actual response.
• Next, own target to get best response.
• Perhaps then own limits again if forgotten.

• Perform a ML estimation using this new search


information, report in column 6 of earlier table
• Searches suggest 33% are L1; 16% L2; and 11% Nash
• Nobody is Dk, but 38% are unclassified

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

16
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Level-k and stag hunt
• Consider the following n-player stag hunt:
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.

i’s Payoff All Others Stag Else


The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be
tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.
It is important to keep the LSE logo clear from any other graphics. The minimum clear space
Stag X 0
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
Rabbit 1 1
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.
Also you can use either the abbreviated or full version of the logo.

• What are the pure-strategy Nash equlibria?


The abbreviated version is the square block with the letters LSE (fig 4).

• How would you play if n = 2?


• How would you play if n = 20?

• What does level-k predict?


1

• Level-0 randomise
• Level-1: Stag iff X · (0.5)n > 1 ⇐⇒ X > 2n
• Level-2: Stag iff L1 plays stag ⇐⇒ X > 2n
• Intuitive result: given x, as group size increases less likely
to coordinate on Stag equilibrium
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

17
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THE LONDON SCHOOL lettering and the edge of the red square.
This applies to the reproduction of the logo

OF E CONOMICS AND at any size


Cognitive Hierarchy
• Camerer, Ho, Chong (QJE 2004) argue that people ought
to be aware of lower level-k types
• Assume that players are correct about relative frequency
of lower types
• Impose exponential distribution to create a “τ -CH” model
• Note: τ desirable for limiting degrees-of-freedom, but we
will typically state a distribution explicitly
• Suppose the distribution is a τ -CH with τ = 2. Then the
frequency of type i is f (i):
• f (0) = e−τ 11 = f0
• f (1) = e−τ 1!
τ
= τ f0
2
• f (2) = e−τ τ2! = τ2
n
2 f0
• f (n) = τn! f0
• And so type i thinks the frequency of j < i is gi (j):
• g1 (0) = 1
1
• g2 (0) = 1+τ = 1/3
τ
• g2 (1) = 1+τ = 2/3
Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

18
Fig 2 Fig 2 LSE logo – clear space
x x
The clear space around the logo must be
x equal to the space between the LSE

THELONDON SCHOOL lettering and the edge of the red square.


This applies to the reproduction of the logo

OF E CONOMICS AND
at any size

The clear space is indicated by the blue line.


POLITICAL SCIENCE Nothing must enter this area.
The clear space must continue around any
x
element (eg text, sub logos) attached to
x x the LSE square

LSE logo
Cognitive Hierarchy
An Extensive-Form Game
The LSE logo is the School’s main marketing and publicity symbol, and is designed to create a
distinct visual identity for the School. The logo should be used on all School publications and
information/publicity materials. It is widely used and recognised.
The LSE logo is a unique graphic device. It must never be reset, redrawn or altered. Do not be

• Cognitive hierarchy may involve learning in dynamic games


tempted to draw a box around the full logo, but use the form shown here.
To ensure high quality reproduction, you should always use the master artwork from disk.
Never download the logo from the internet. Web versions are screen resolution and not
suitable for print.

• Consider the following Centipede Game


It is important to keep the LSE logo clear from any other graphics. The minimum clear space
around the logo is shown above, and defines an area into which nothing should intrude.
This helps the LSE logo to stand out and prevents any detraction from its presence, by other

• 4 rounds; either take 80% of pie or pass and let pie double
graphic elements used with it (full bleed pictures are the only exception).
You can use the square element of the logo either as white lettering on red, PMS 485, or white
on black. These are available electronically (EPS file) from the LSE Design Unit. An EPS file is for
PostScript printing, this is commonly used by commercial printers and the LSE Reprographics
Department. Use a TIFF file for non-PostScript printers and a GIF file for the web.

P 1a
Also you can use either the abbreviated or full version of the logo.
P 2a P 1b P 2b
The abbreviated version is the square block with the letters LSE (fig 4). (6.4x, 1.6x)
pass pass pass pass

take take take take

1
(0.4x, 0.1x) (0.2x, 0.8x) (1.6x, 0.4x) (0.8x, 3.2x)

• Unique SPNE: “take always”


• We may suspect that game doesn’t always end in round
1a when actually played

Fig 1 Fig 1 Full LSE logo in colour

The full LSE logo should be used wherever


possible. The Pantone reference is PMS 485

19
Fig 2 Fig 2 LSE logo – clear space
x x