Institutional and Behavioural

Economics
 Structure of the Course
Wed. (30.09.2020- 05.11.2020) 8:45-10:15; Thu. 12:15-15:30; 6 weeks

Day 1st 2nd

Introduction to Institutional Economics: What is Neoclasical Economics Model, Mind Mapping (Seminar:
Wed, 30.09.
Institutional Economics About? (Lecture, ) DL, AN)
Introduction to Institutional Economics: What is
Thu, 01.10.
Institutional Economics About? (Lecture, )
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Wed, 07.10.
Rights Theory, Transaction Cost Theory
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Thu, 08.10.
Rights Theory, Transaction Cost Theory
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Wed, 14.10. Rights Theory, Transaction Cost Theory

The Dynamics of Institutions: Drivers of institutional Scientific Papers (Seminar: DL, AN)
change, The evolutionary approach toward the
Thu, 15.10.
dynamics of institutions

Wed, 21.10. Introduction to Behavioural Economics Richard Thaler, Cass Sunstein (Nudges)
Kahneman and Tversky (Thinking, fast and slow; Risk Kahneman and Tversky (Thinking, fast and slow; Risk
Thu, 22.10.
aversion…) aversion…)..chapters from the book
Wed, 28.10. Richard Thaler, Cass Sunstein (Nudge) Richard Thaler, Cass Sunstein (Nudge) chapters from the
holidays book
Thu, 29.10. Theory of Planned Behavior (Fishbein, Aizen) Students presentations

Wed, 04.11. Theory by Hirschauer, Habil Presentation Students presentations

Thu, 05.11. Sven Gruener (Experiments…) Students presentations 2

Behavioural Economics
= Behavioral Economics = „psychological economics“

Psychology Economics

3
Neoclasical Economics Behavioural Economics
( Microeconomy/prise theory)

1. Homo Oeconomicus (rational) 1. Real-world acteur

2. normative theory of optimal 2. Descriptive theory of real behaviour
behaviour 3. Evidence-based
3. Theory-based

Normative theories define “good” decisions as

ones that are most likely to provide the
decision maker with desired outcomes
(Edwards, 1954; Yates, 1990).

4
Rational Choice/Neoclassical Economics
1. Optimizing (maximising utility)
- unlimited cognitive abilities (regardless of complexity / person)
- consumer sovereignty (infinite willpower / no self-control problems)
Choosing what works best for you (≠ temporarily tempting)
- unbiased beliefs & expectations

2. Self-interested
People are most interested in themselves

5
The idea of behavioural economics is not new..
(a) Loss aversion (Smith 1759, p. 176-177)
”Pain … is, in almost all cases, a more pungent sensation than the
opposite and correspondent pleasure.”

(b) Overconfidence (Smith 1776, p. 1)

”the over-weening conceit which the greater part of men have of
their own abilities”

(c) Self-control/present bias (Smith 1759, p. 273)

Adam Smith (1723-1790)
”The pleasure which we are to enjoy ten years hence, interests us Founder of the classical theory
so little in comparison with that which we may enjoy today.” of economics

6
The idea of behavioural economics is not new..
(a) Loss aversion (Bentham 1843, 307)
”Mankind in general appear to be more sensible of grief than
pleasure from an equal cause. For example a loss which would
diminish the fortune of an individual by one quarter, would take
more from his happiness than would probably be added by a gain
which should double it.”

(b) Self-control/present bias (Bentham 1843, 313)

”the wants of to-day eclipse those of to-morrow”

(c) Herding (Bentham 1825, 225; 1843, 259) Jeremy Bentham (1748-1832)
Founder the classical utiliarism
”A single individual is seldom able to withstand or change the laws („ The greatest fortune of
established by public opinion” the largest number“)

7
Behavioural economics: the label
Herbert Simon (1987: 612):
“The phrase ‘behavioral economics’ appears to be a
pleonasm. What ‘non-behavioral’ economics can we
contrast with it? The answer to this question is found in the
specific assumptions about human behavior that are made
in neoclassical economic theory.”
Economics are behavioral. However, „economics“ is usually
Herbert A. Simon (1916-2001)
associated with neoclassical economics (rational choice) … Nobel price „for his pioneering
research into the decision-making
process within economic
https://www.youtube.com/watch?v=eTXkZURBq7k organizations”

8
Effects of limited cognition and
implications of individual bounded
rationality of the design and
performance of organizations
learning
sciences and artificial
intelligence.
The idea of behavioural economics..game theory
Reinhard Selten
Investigated the impact of bounded rationality
on firm behaviour (Sauermann and Selten
1962) and provided early experimental
evidence on deviations from rational
economic behavior (Selten and Berg 1970) -
one of the founding fathers of experimental
economics
1930-2016
Nobel preis 2004; Game
theory
Film: A Beautiful Mind (John
Nash)
https://www.youtube.com/wat
ch?v=9wZM7CQY130
 Structure of the Course
Wed. (30.09.2020- 05.11.2020) 8:45-10:15; Thu. 12:15-15:30; 6 weeks

Day 1st 2nd

Introduction to Institutional Economics: What is Neoclasical Economics Model, Mind Mapping (Seminar:
Wed, 30.09.
Institutional Economics About? (Lecture, ) DL, AN)
Introduction to Institutional Economics: What is
Thu, 01.10.
Institutional Economics About? (Lecture, )
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Wed, 07.10.
Rights Theory, Transaction Cost Theory
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Thu, 08.10.
Rights Theory, Transaction Cost Theory
Approaches to Institutions: Contract Theory, Property Scientific Papers (Seminar: DL, AN)
Wed, 14.10. Rights Theory, Transaction Cost Theory

The Dynamics of Institutions: Drivers of institutional Scientific Papers (Seminar: DL, AN)
change, The evolutionary approach toward the
Thu, 15.10.
dynamics of institutions

Wed, 21.10. Introduction to Behavioural Economics Richard Thaler, Cass Sunstein (Nudges)
Kahneman and Tversky (Prospect theory…) Kahneman and Tversky (Thinking, fast and slow; Risk
Thu, 22.10.
aversion…)..chapters from the book
Wed, 28.10. Richard Thaler, Cass Sunstein (Nudge) Richard Thaler, Cass Sunstein (Nudge) chapters from the
holidays book
Thu, 29.10. Theory of Planned Behavior (Fishbein, Aizen) Students presentations

Wed, 04.11. Theory by Hirschauer, Habil Presentation Students presentations

Thu, 05.11. Sven Gruener (Experiments…) Students presentations 13

 Psychology

• Amos Tversky (1937-1996),

• Daniel Kahneman (1934*)
• Kahneman, Nobel prize economics 2002:
“for having integrated insights from
psychological research into economic
science, especially concerning human
judgment and decision-making under
uncertainty”

• https://www.youtube.com/watch?v=w2
0FiXzzyOM

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Economics + Psychology

Richard H. Thaler was the first economist to apply prospect theory to

economic issues and problems.
While Kahneman and Tversky (1979) had focused on risky decisions,
Thaler showed the importance of reference points and loss aversion in
deterministic settings.

Richard H. Thaler (born 1945)

Nobel prize for economic sciences in 2017
„for his contributions to behavioural
economics“
When economics started to be highly mathematical in 1950s,
rational models were the models which people could solve, it
was where the light was. Trying to put in all the complexities of
emotions, lack of willpower and salience makes these models a
lot messier. The economists like things to be neat and tidy. And,
of course, the world isn’t that neat and tidy. (R. Thaler)

https://www.youtube.com/watch?
v=t0uRjM6z90g
Prospect Theory
Kahneman and Tversky (1979)
„This paper presents a critique of expected
utility theory as a descriptive model of
decision making under risk, and develops
an alternative model, called prospect
theory. “

„EXPECTED UTILITY THEORY has

dominated the analysis of decision making
under risk. It has been generally accepted
as a normative model of rational choice
[24]”
Prospect Theory (1979): Methodology

(Example: Kahneman & Tversky 1979, p. 264)

Methodology
Experiments

Specifics
 Test persons: students
 Hypothetical decisions

21
Expected utility theory
Evaluation of action alternatives according to the expected utility theory
EU = ∑ pi*u(xi)  max

linear weighting of probabilities

Final situation
evaluated

22
Prospect Theory (1979)
Two phases decission process

Phase 1: Editing phase

The editing phase refers to how people involved in decision-making characterize
the options for choice or the framing effects. The effects explain how a person’s
choice is influenced by the wording, order, or method in which the choices are
presented.

An example to demonstrate the framing effect can be the choices that cancer
patients are given. Usually, cancer patients are presented with the choice of
undergoing surgery or chemotherapy to treat their illnesses, and they make a
decision based on whether the outcome statistics are presented in terms of
survival rates or mortality rates. Once the choices have been framed ready for
decision-making, the theory enters the second phase.
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Prospect Theory

2. Evaluation phase
In the evaluation phase, people tend to behave as if they would make a
decision based on the potential outcomes and choose the option with
a higher utility. The phase uses statistical analysis to measure and
compare the outcomes of each prospect. The evaluation phase
comprises two indices, i.e., the value function and the weighting
function, which are used to compare the prospects.
Prospect Theory (1979)
Phase 2: Evaluation ( Decission: Prospect with the highest V[alue])
Idea: Merging of two functions

 „Value function “ (ᴠ)  „Probability weighting function“

Modification of utility (ᴨ)
function Weighting of probabilities

V(x, p; y, q) = ᴨ(p)ᴠ(x) + ᴨ(q)ᴠ(y), falls p+q<1 oder x≥0≥y oder x≤0≤y

V(x, p; y, q) = ᴠ(y) + ᴨ(p)[ᴠ(x) - ᴠ(y)], falls p+q=1 & (i) x>y>0 oder (ii) x<y<0
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Elements of Prospect Theory I (Kahneman and Tversky (1979))
1. Individuals derive utility not from wealth (or consumption) levels,
but rather from gains and losses relative to some reference point
2. Individuals are more sensitive to losses than to gains (loss aversion).
The utility function captures the loss aversion of individuals in a link
at the reference point, with the function being steeper in the losses
region compared to the gains region.
Prospect Theory (1979)
Properties of the value function
2. Perception of changes relative to neutral
reference point (reference point)

Example: Evaluation of the temperature

depend on what is "usual" for the season
13 degrees are warm in winter, cold in
summer (reference point: season)
Reference point
What can be a reference point? Status quo
/ expectation / goal

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Prospect Theory (1979)
1. Change
Example: (2 Persons, ∆ wealth)
Person 1: 500 €  1000 € (gain)
Person 2: 1500 €  1000 € (loss)

Who is happier?

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Prospect Theory (1979)
1. Change
Example: (2 Persons, ∆ wealth)
Person 1: 500 €  1000 € (gain)
Person 2: 1500 €  1000 € (loss)

Who is happier?
Rational Choice: no difference
Prospect Theory: Person 1

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Value function (Loss Aversion)

https://www.youtube.com/watch?v=mO
FtpotONzk
Elements of Prospect Theory II. (Kahneman and Tversky (1979))
3. Individuals exhibit diminishing sensitivity to gains and losses, i.e.,
moving from a 100 to 200 € gain (or loss) has larger utility impact
than moving from a 10,000 to a 10,200 gain (or loss)
4. Probability weighting: individuals weigh outcomes by subjective,
transformed probabilities or decision weights, overweighting low
probabilities and underweighting high probabilities
Probability Weighting Function
Owerweighting the probability of
flight accident
Prospect theory: Framing
A Tversky, D Kahneman (1981): The framing of decisions and the psychology of
choice. Science, Vol. 211, Issue 4481, pp. 453-458

33
Framing
In the social sciences, framing = set of concepts and theoretical
perspectives on how individuals, groups, and societies, organize,
perceive, and communicate about reality.
Framing may affect peoples perception and choice.
Framing bias is an individual decision-making misconception caused by
the fact that a person interprets the surrounding world according to a
decision frame chosen by her or his subjective opinion.
Framing: Asian Disease
Framing: Asian Disease
Framing: Asian Disease Results

Tversky and Kahneman found that whereas

72% of people given the gain frame chose Program A's 200 of 600
certain lives saved, only 22% of people given the loss frame chose
Program C's 400 of 600 certain deaths.

This result supports prospect theory: people will take risks to avoid
losses but will avoid risks to protect gains.
Examples of use of Framing
Energy saving campaign: which frame more effective?
a) If you use the energy saving method, you safe €350 per year
b) If you don‘t use the energy saving method, you loose €350 per year.

Food marketing: fat content: which framing more effective?

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Examples of use of Framing
Food marketing: fat content: which framing more effective?

40
https://criticalmediareview.wordpress.com/2015/10/19/what-
is-media-framing/
Literature

• Thaler, R. (2016): Behavioral Economics: Past, Present, and Future. American Economic
Review 106(7): 1577-1600.
• Tversky, A., Kahneman, D. (1981): The framing of decisions and the psychology of choice.
Science 211(4481): 453-458.
• Friedman, M. (1953): The Methodology of Positive Economics. In: Essays in Positive
Economics, Chicago: 3-34.

Recent scholars working on development of behavioural economics

https://scholar.google.com/citations?hl=en&view_op=search_authors&mauthors=label:behavioral_economics

42
Heuristics
Tversky, A., and Kahneman, D. “Judgment under uncertainty: Heuristics
and biases.” Science, vol. 185, no. 4157, pp. 1124-1131.
Heuristics
• are commonly defined as cognitive shortcuts or rules of thumb that
simplify decisions, especially under conditions of uncertainty. They
represent a process of substituting a difficult question with an easier
one (Kahneman, 2003).

• are simple strategies to form judgments and make decisions by

focusing on the most relevant aspects of a complex problem.
Heuristics

Objective
Dealing with complexity (e.g., ignoring information)
Dealing with limitations (e.g., time, knowledge)

Useful in everyday life & often good decisions

!! Sometimes systematic errors

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Heuristics
• In their initial research, Tversky and Kahneman proposed three
heuristics—availability, representativeness, and anchoring and
adjustment. Subsequent work has identified many more.
The availability heuristic
involves making decisions based upon how easy it is to bring something
to mind.
When you are trying to make a decision, you might quickly remember a
number of relevant examples. Since these are more readily available in
your memory, you will likely judge these outcomes as being more
common or frequently-occurring.
For example, if you are thinking of flying and suddenly think of a
number of recent airline accidents, you might feel like air travel is too
dangerous and decide to travel by car instead. Because those examples
of air disasters came to mind so easily, the availability heuristic leads
you to think that plane crashes are more common than they really are.
Heuristics
Availability heuristic

 Are there any experiences of your own? Did you come into direct contact?
If yes, then greater belief that an event is likely to occur
If only read about it, less conviction

 Are there any experiences in the recent past?

Events that are not so long ago have a greater impact on fears

48
 Heuristiks
Aavailability heuristic

What relevance does availability heuristics have in practice?

Perception based on availability
Objective frequency (Kahneman 2011: „The world in our heads is not
.
a precise replica of reality.”)

 Individual level: Insurance

 Political Process: Allocation resources according to fears, not dangers

49
The representativeness heuristic
involves making a decision by comparing the present situation to the most
representative mental prototype
When you are trying to decide if someone is trustworthy, you might compare
aspects of the individual to other mental examples you hold. A sweet older
woman might remind you of your grandmother, so you might immediately
assume that she is kind, gentle and trustworthy.
If you meet someone who is into yoga, spiritual healing and aromatherapy
you might immediately assume that she works as a holistic healer rather
than something like a school teacher or nurse. Because her traits match up
to your mental prototype of a holistic healer, the representativeness
heuristic causes you to classify her as more likely to work in that profession.
The representativeness heuristic
Representativeness is one of the major general purpose heuristics, along
with availability and affect. It is used when we judge the probability that an
object or event A belongs to class B by looking at the degree to which A
resembles B. When we do this, we neglect information about the general
probability of B occurring (its base rate) (Kahneman & Tversky, 1972).
Representativeness heuristic
• Judgment Under Uncertainty: Heuristics and Biases, Tversky and
Kahneman
They describe an individual who is seen as shy, withdrawn, helpful, but
not necessarily concerned with the world of reality. This person is also
described as tidy, meek, and detailed with a passion for order and
structure.
If you had to make a judgment about which profession this individual
likely holds, which one would you select: farmer, salesman, airline pilot,
librarian, or physician?
Representativeness heuristic
A large proportion of people will choose LIBERIAN in the above problem, because the
description matches the stereotype we may hold about a LIBERIAN rather than farmers. In
reality, the likelihood of being farmer is far greater, because farmers make up a much larger
proportion of the population.
Heuristic: The anchoring heuristic

Anchoring is a particular form of priming effect whereby initial

exposure to a number serves as a reference point and influences
subsequent judgments. The process usually occurs without our
awareness (Tversky & Kahneman, 1974) and has been researched in
many contexts.
Anchoring occures when the subject bases his extimate on the result of
some incomplete computation
I five sec pls extimate the result of the
multiplication:

8 x 7 x 6 x 5 x 4 x 3 x 2 x 1=
I five sec pls extimate the result of the
multiplication:

1x2x3x4x5x6x7x8 =
Heuristic: The anchoring heuristic
When these first multiplications gave a small answer – because the
sequence started with small numbers – the median estimate was 512;
when the sequence started with the larger numbers, the median
estimate was 2,250 (The correct answer is 40,320.)
In another study by Tversky and Kahneman, participants observed a
roulette wheel that was predetermined to stop on either 10 or 65.
Participants were then asked to guess the percentage of the United
Nations that were African nations. Participants whose wheel stopped on
10 guessed lower values (25% on average) than participants whose wheel
stopped at 65 (45% on average). The pattern has held in other
experiments for a wide variety of different subjects of estimation.
Prospect Theory (1979)
Further development

http://cemi.ehess.fr/docannexe/file/2780/tversjy_kahneman_advances.pdf 59
Textbook
Prospect Theory: For Risk and Ambiguity provides the first
comprehensive and accessible textbook treatment of the way
decisions are made both when we have the statistical probabilities
associated with uncertain future events (risk) and when we lack
them (ambiguity).
The book presents models, primarily prospect theory, that are both
tractable and psychologically realistic. A method of presentation is
chosen that makes the empirical meaning of each theoretical model
completely transparent. Prospect theory has many applications in a
wide variety of disciplines.
With numerous exercises and worked examples, the book is ideally
suited to the needs of students taking courses in decision theory in
economics, mathematics, finance, psychology, management science,
health, computer science, Bayesian statistics, and engineering.

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