Institutional and Behavioural

Economics
How people make decisions? Rational choice vs. real actors

 Rational Choice Theory: Expected utility maximisation

 Perfectly informed (e.g. perfect memory)
 Unlimited mathematical skills
Rules of logic
Laws of probability theory
 Real actors
Bounded rationality

2
Bounded rationality
Herbert Simon (1957)

1. Limited cognitive skills

People can not perform the complex calculations as rational choice approaches
assume. In addition, there is often a lack of time.

2. Imperfect information about relevant environment

Real world very complex: incomplete information (in contrast: assuming complete
information in rational choice approaches)

3
Bounded rationality
as environmental rationality

Simon (1990): „Human rational behavior […] is shaped by

a scissors whose two blades are the structure of task
environments and the computational capabilities of the actor.”
(=Information (=cognitive skills)
about environment)

 Core idea: Both elements interact (no independent consideration)

 E. Haeckel (1866): „ By ecology we understand the whole science of the relations

of the organism to the surrounding external world […] “

4
Dealing with limitations

 Limitations of human rationality

(information, cognitive abilities)

 Approaches to dealing with limitations

(1) Use of technologies
(2) Using heuristics

5
Technology
Example: Apps to coordinate

Situation
-- Problem: Natural disaster
-- Challenge: Coordination of volunteers

 Use of mobile apps for coordination of volunteers

 Individual strengths / weaknesses are considered
 Coordination as necessary

6
Technology
Example: Google Maps
Situation
-- Objective: To find the way to the destination

 Use of mobile apps (such as Google Maps)

Information problem can potentially be solved by using maps
However, apps are often perceived as time-saving and comfortable

7
Technology
Example: Dating portals
Situation
-- Search for partners
-- Complexity: many people, limited capacity (e.g. time)

 Use of dating portals to coordinate interests

In particular, commercial providers have large data set, which
characteristics could tend to match each other

8
Dealing with limitations

 Limitations of human rationality

 (information, cognitive abilities)

 Approaches to dealing with limitations

(1) Use of technologies
(2) Using heuristics

9
Heuristics
Problem: complexity

How do people deal with such complexities?

10
Heuristics
Definition:
• are commonly defined as cognitive shortcuts or rules of thumb
• are simple strategies to form judgments and make decisions by
focusing on the most relevant aspects of a complex problem.

Objective:
• to simplify decisions, especially under conditions of uncertainty. They
represent a process of substituting a difficult question with an easier
one (Kahneman, 2003).
Heuristics
• In their initial research, Tversky and Kahneman proposed three
heuristics—availability, representativeness, and anchoring and
adjustment. Subsequent work has identified many more.
Heuristics

https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/
https://en.wikipedia.org/wiki/List_of_cognitive_biases
Dhami (2016)

14
Heuristics
Tversky, A., and Kahneman, D. “Judgment under uncertainty: Heuristics
and biases.” Science, vol. 185, no. 4157, pp. 1124-1131.
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.
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).
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 =
Heuristics
• Herd behaviour
• Mental accounting
• Affect heuristic
• Recognition heuristic
Heuristics: Herd behaviour

Homo economicus
Would enter into interactions if it were to his
advantage (e.g., missing information, reputation)
Would not go into interactions, because it is just
fashionable

Real people
Relatively easily influenced by statements and
actions of other people

22
Heuristics:
Herd
behaviour

• https://www.youtube.com/watch?v=MEhSk71gUCQ
Heuristics:
Herd
behaviour

Standing ovation
• https://www.youtube.com/watch?v=ft7mwyiPyIo
Herd behaviour (Herding)
This effect is evident when people do what others are doing instead of using their own
information or making independent decisions.
The idea of herding has a long history in philosophy and crowd psychology.
relevant in the domain of finance, where it has been discussed in relation to the collective
irrationality of investors, including stock market bubbles (Banerjee, 1992). In other areas of
decision making, such as politics, science, and popular culture, herd behavior is sometimes
referred to as ‘information cascades’ (Bikhchandi et al., 1992). Herding behavior can be
increased by various factors, such as fear (e.g. Economou et al., 2018), uncertainty (e.g. Lin,
2018), or a shared identity of decision makers (e.g. Berger et al., 2018).
Banerjee, A. (1992). A simple model of herd behavior. Quarterly Journal of Economics, 107, 797-817.
Berger, S., Feldhaus, C., & Ockenfels, A. (2018). A shared identity promotes herding in an information cascade game. Journal of the
Economic Science Association, 4(1), 63-72.
Bikhchandi, S., Hirschleifer, D., & Welch, I. (1992). A theory of fads, fashion, custom and cultural change as informational
cascades. Journal of Political Economy, 100, 992-1026.
Economou, F., Hassapis, C., & Philippas, N. (2018). Investors’ fear and herding in the stock market. Applied Economics, 50(34-35),
3654-3663.
Lin, M. C. (2018). The impact of aggregate uncertainty on herding in analysts’ stock recommendations. International Review of
Financial Analysis, 57, 90-105.
https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be
Heuristics
Herd behaviour (conformity experiment by Asch, 1951)

 Basic structure of the experiment (Asch 1951)

The participants were consecutively shown several cards
with a fairly simple task: Which of the comparison lines is
as long as the reference line?
One of the pairs of cards
used in the experiment.
 Special feature: seating arrangement of the participants The card on the left has the
Several people are sitting at a conference table reference line and the one
on the right shows the
three comparison lines.

Subject sits in the back (it was said that only

Instructed persons by experimenter volunteers are available)
(previously no contact with the subject)
26
Heuristics
Herd behaviour (conformity experiment by Asch, 1951)

Participants will say, sequentially and aloud, which line of

comparison they agree with the reference line
(1) First, instructed persons say correct answer
One of the pairs of cards
(2) After that, instructed persons say the wrong answer used in the experiment.
The card on the left has the
 If the instructed persons give correct answers, the test reference line and the one
person almost always answers correctly. on the right shows the
three comparison lines.
 If the instructed persons give incorrect answers, the
wrong answers increase considerably.
 Results robust across many countries & replications:
about 20-40% of cases errors
27
https://www.youtube.com/watch?v=BOBhKR4MK3w
Heuristics: Herd behaviour
Why do people sometimes ignore their own perception?
Information: When many people believe or do something, that
information informs them that this may also be good or right for
themselves.
Peer pressure: If you consider it important what others think of you, you
may be following the group (Rejecting disapproval of the group)

Strive for conformity with other views and actions

29
Heuristics: Mental accounting
Situation [Based on Thaler 1980]
You have 2 tickets for a football match 50 KM away from your home town. On the
day of the game there is a massive blizzard and the roads are pretty bad. Is it more
likely that you will go to the game if you have paid 30 € per ticket or if you would
have got the tickets for free?
 Value equal in both situations. However, sunken costs often play a role in humans
(in contrast to Homo Oeconomicus). These are historical costs that should have
no bearing on decisions (rational choice), but people often perceive both
situations differently.
 Individuals commit the sunk cost fallacy when they continue a behavior or
endeavor as a result of previously invested resources (time, money or effort)
(Arkes & Blumer, 1985). This fallacy, which is related to loss aversion and status
quo bias, can also be viewed as bias resulting from an ongoing commitment.

30
Fallacy
Wiki: A fallacy (also called sophism) is the use of invalid or otherwise
faulty reasoning, or "wrong moves"[1] in the construction of an argument.[2][3] A
fallacious argument may be deceptive by appearing to be better than it really is.
Some fallacies are committed intentionally
to manipulate or persuade by deception, while others are committed
unintentionally due to carelessness or ignorance. The soundness of legal
arguments depends on the context in which the arguments are made.[4]

• van Eemeren, Frans; Garssen, Bart; Meuffels, Bert (2009). Fallacies and Judgments of
Reasonablene Empirical Research Concerning the Pragma-Dialectical Discussion Rules. Dordrecht:
Springer. doi:10.1007/978-90-481-2614-9. ISBN 978-90-481-2613-2.
• ^ Jump up to:a b c Gensler, Harry J. (2010). The A to Z of Logic. Rowman & Littlefield.
p. 74. ISBN 9780810875968.
• ^ Woods, John (2004). "Who Cares About the Fallacies?". The Death of Argument. Applied Logic
Series. 32. pp. 3–23. doi:10.1007/978-1-4020-2712-3_1. ISBN 9789048167005.
• ^ Bustamente, Thomas; Dahlman, Christian, eds. (2015). Argument types and fallacies in legal
argumentation. Heidelberg: Springer International Publishing. p. x. ISBN 978-3-319-16147-1.
Heuristics: Mental accounting applications
Willingness to pay with credit cards> Willingness to pay in cash
Receiving service / good immediately, but actual payment later (hence not
immediately coded as "loss")
Many smaller payments hurt more than once the sum of these smaller
payments.

32
Heuristics: Mental accounting applications
Casino
Suppose a person is lucky and successful in the casino. Experimental evidence has
shown that gamblers deal differently with the gained money. They are more willing
to use it again in gambling.

Environment economics: Dog tax

For some dog owners this account is already "full" by paying the dog tax and
little willingness to take away leftovers.

33
Heuristics: Affect heuristic

 reliance on good or bad feelings experienced in relation to a stimulus.

Affect-based evaluations are quick, automatic, and rooted in
experiential thought that is activated prior to reflective judgments
(Slovic et al., 2002).
 Kahneman (2011): Affect heuristic is substitution behaviour
 Instead of answering a difficult question : „What do I think about it?“
 Answering simple question: „How do I feel about it?“

34
Heuristics: affect heuristic
Consumer theory
Homo Oeconomicus: "I chose X after weighing all the pros and cons of
the relevant alternatives."

Reality: "I chose X" ≈ "I like X"

Example: car purchase or job selection

Often primarily a choice of attractiveness and then justify decision by
multiple reasons
35
Heuristics: affect heuristic

Application example: Climate change

 Many Americans say that climate change is taking place.
 However not regarded as a serious problem.
 Consequences rather long term and therefore little priority today
 Cause: Missing emotions (explanatory approach on affect heuristics)

36
Heuristics: recognition heuristic

 Decision-making strategy for comparative judgments

 Often used when evaluating two objects for a particular criterion

 Idea:
If we recognize one of two objects and one does not recognize the other,
then we decide according to recognition heuristics for the recognized object.
„If one of two objects is recognized and the other is not, then infer that the
recognized object has the higher value with respect to the criterion.” (Goldberg und
Gigerenzer (2002).

37
Heuristics: recognition heuristic

Object A Object B
(unknown) (known)

If humans have only heard something about an object, they assign a higher value to
this object with regard to a criterion

(here: object B > object A).

38
Heuristics: recognition heuristic
Application example: Marketing
People have preference for products known to them
Advertising industry can specifically try to anchor the name of the product deep
in the memory of the population

39
Heuristics

https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/
https://en.wikipedia.org/wiki/List_of_cognitive_biases
Dhami (2016)

40
http://www.law.harvard.edu/programs/olin_center/papers/pdf/Sunstein_963.pdf
Fairness
https://www.youtube.com/watch?v=meiU6TxysCg
Thinking slow and fast
• The book summarizes research that
Kahneman conducted over decades, often
in collaboration with Amos Tversky.
• It covers all three phases of his career:
• his early days working on cognitive biases
(Heuristics),
• his work on prospect theory,
• and his later work on happiness.
1. section: Two modes of thought
The central thesis is a dichotomy between two modes of thought:

"System 1" is fast, instinctive and emotional;

"System 2" is slower, more deliberative, and more logical.

The book delineates cognitive biases associated with each type of

thinking, starting with Kahneman's own research on loss aversion.
2. section: Heuristics
• Kahneman uses heuristics to assert that System 1 thinking involves
associating new information with existing patterns, or thoughts,
rather than creating new patterns for each new experience.
3. Section: Prospect Theory
4. Section: Wellbeing and happiness
Agenda

1. How do people think: System 1 vs System 2

2. Overconfidence
3. Knowledge Illusion

48
 How do people think?
 Explanatory approach: hypothetically dividing the human brain into two
systems (Stanovich and West 2000/2, Kahneman 2011)
 System 1: emotional system
 System 2: cognitive system

Dhami (2016: 1398): It is important to note that the two systems are purely fictitious
characters that provide a way of organizing our understanding of the brain. Indeed “there is
no part of the brain that either of the systems would call home” (Kahneman, 2011, p. 29).

49
How do people think?

System 1: emotional / heuristic / intuitive / automatic system

• fast, automatic, unconscious, requires little mental effort
• processing familiar situations
• swift response to challenges
• can not be switched off

System 2: cognitive / analytic / reflective system

• slow, deliberative, conscious, requires cognitive effort
• Processing less familiar situations
• Taking into account rather long-term consequences of our actions

50
How do people think?
System 1: emotional system
 Complete the phrase "War and ..."
 Driving on empty road
 Crouch when a ball hits you
 Locate the origin of a particular sound
 Experienced chess players decide on
complex situations intuitively
System 2: cognitive system
 How much is 411: 37?
 Weighing value for money from 2
washing machines
 Parking in tight parking space
 Count the number of letters A in a text
 Decision for study subject
51
Agenda

1. How do people think: System 1 vs System 2

2. Overconfidence
3. Knowledge Illusion

53
Overconfidence
Moore und Healy (2008) three categories of overconfidence:
overestimation, overplacement, overprecision

 Overestimation
Individuals overestimate their own abilities / performance / chances of success.
Example: Individual participates in a quiz that includes 10 questions. She / he
believes to answer 5 questions correctly. In fact, only 3 questions are answered
correctly.
e.g. Students in exam

54
3. Overconfidence

 Overplacement [=better-than-average]
This effect occurs when people think they are better (for example their
performance) than other people.
Example: "93% of car drivers believe that they are better drivers than the average."

 Overprecision
Individuals value their own information as more accurate than they actually are. In
other words, people are too sure that they know the right answer.
Example: "How long is the Nile?" Individuals tend to be too sure to know the
correct answer
55
Overconfidence

 Kahnemann
https://www.youtube.com/watch?v=tyD
QFmA1SpU 57
Agenda

1. How do people think: System 1 vs System 2

2. Overconfidence
3. Knowledge Illusion

58
Knowledge Illusion

Rebecca Lawson (2006) conducted experimental studies:

a schematic drawing of a wheel were shown to subjects
Special feature: wheel incomplete, parts missing (for example bicycle
frame, chain, pedals)
Task: Complete the bike!

Lawson (2006: 1669)

https://www.liverpool.ac.uk/~rlawson/PDF_Files/L-M&C-2006.pdf

59
Lawson (2006: 1669)
https://www.liverpool.ac.uk/~rlawson/PDF_Files/L-M&C-2006.pdf
62
A B C D
New rating after the task
Knowledge Illusion
e.g. zippers, climate
change, etc.
Rozenblit and Keil (2002) have proposed
the following 3-step procedure (three questions) :

1. On a scale of 1 to 7, how well do you understand how ... work?

2. How do ...? Describe the steps as much as you can.
3. Rate again on a scale of 1 to 7 how well you understand how ... work?

67
Knowledge illusion

Results (Rozenblit und Keil,2002):

 Most subjects have little to say in Question 2 (for example, no activity in a

zipper manufacturing factory to know the procedures)
 When repeating the first question: Many subjects reduced their assessment of
their knowledge.

 Message: People live in an illusion. Many people believe that they have a
better understanding of how things work than they actually have.

68
Knowledge Illusion (WC)
We perceive the world as being greatly simplified and at the same time
believe to understand it quite well.

Picture left:
Illustration, what
we think we
know

https://www.buildinggreen.com/sites/default/files/live/images/StealthDiagram_from_scan.jpg
70
Knowledge Illusion (WC)

Picture right: Illustration, what we actually

know

We press a button and something happens

https://www.simplybathrooms.co.uk/wp-content/uploads/2018/08/Grohe-Rimless-Toilet.jpg

71
Knowledge Illusion
How can Knowledge Illusion be explained?

Knowledge conflation
= People have difficulty distinguishing between: i) what they know and ii) what
others know
In other words, by understanding others, we believe we understand it.

Why you feel you do not have much to say in your own lectures?
Have you ever had a feeling of discomfort in a presentation because the content
seems trivial to you and it seems valuable to even say it?
This is an example of mixing up your own knowledge and the knowledge of other
people.

72
https://www.youtube.com/watch?v=02h7f2T_6mA

Steven Sloman is a Professor of Cognitive,

Linguistic, and Psychological Sciences at Brown
University.
Behavioural based theories (concepts)
• Freakonomics (Lewith and Dubner)
• Theory of planned behaviour (Izac Ajzen)
• Motivation crowding theory (Bruno Frey)
Freakonomics
• https://www.youtube.com/watch?v=h1YjkXGxbT0
• http://freakonomics.com/
The quarterly journal of economics, 2000
Freakonomics (from wiki)
Stephen Dubner, a journalist, met Steven Levitt, a professor of economics at the University of
Chicago, when his editor asked him to write a profile on Levitt for The New York Times Magazine. At
the time, Dubner was writing a book on the psychology of money and didn't have much interest in
meeting the young economist from Chicago who had just won the Clark Medal, a prize given
annually by the American Economics Association to the most promising economist under 40.
Likewise, Levitt had little interest in the profile, but agreed to a two-hour interview because his
Mom liked The New York Times Magazine.[6]
Upon meeting Levitt, Dubner extended the two-hour interview to three days.
After publication of Dubner’s 2003 Times Magazine article, Dubner and Levitt were asked to write a
book, which cemented their partnership. In 2005, William Morrow published Freakonomics: A
Rogue Economist Explores the Hidden Side of Everything, a book about cheating teachers, bizarre
baby names, self-dealing Realtors, and crack-selling mama's boys.[1] Freakonomics would go on to
be translated into 40 languages and sell 5 million copies worldwide.[1]
Dubner and Levitt co-authored three other books: SuperFreakonomics (2009), Think Like a
Freak (2014), and When to Rob a Bank (2015). In all their books, Dubner and Levitt use economic
ideas to explore real-world phenomena, answer perplexing questions, and offer unconventional
analysis.
Theory of planned behaviour
Fishbein, M., & Ajzen, I. (2010). Predicting and changing behavior: The
reasoned action approach. New York: Psychology Press (Taylor &
Francis).
Ajzen, I. (2012). The theory of planned behavior. In P. A. M. Lange, A. W.
Kruglanski & E. T. Higgins (Eds.), Handbook of theories of social
psychology (Vol. 1, pp. 438-459). London, UK:
Sage. https://doi.org/10.4135/9781446249215.n22

https://people.umass.edu/aizen/index.html
Theory of planned behaviour

Several models for behavior change have converged to the hypothesis

that attitudes, norms, and self-efficacy are important determinants of
intentions and behavior.
To improve the accuracy of behavior-change models, some researchers
have tried to combine behavioral economics models with existing
models for behavior change.
However, these attempts have failed because the existing models [e.g.,
Theory of Planned Behavior (TPB)] are not consistent with Expected
Utility Theory (EUT), which underlies various behavioral economics
models.
Theory of planned behaviour
• https://www.youtube.com/watch?v=DFn-IOcpd8A
Bruno Frey: Not just for the money (1997)

Book available
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1
.1.464.255&rep=rep1&type=pdf

Bruno Frey:
https://www.youtube.com/watch?v=wteG9pjyLUQ
81
Journal of economic surveys
Do people act just because they expect a monetary gain? Do they work solely
because they are paid?
I claim that this is not so: people undertake many activities simply because they like them.
I claim even more: a higher monetary compensation crowds-out this inner motivation in
important circumstances. To offer higher pay then makes people less committed to their work,
and may reduce their performance.
Not Just for the Money develops an economic theory of human motivation which is at the
same time broader and, in relevant cases, contradictory to economics teaching.
Human motivation is not restricted to monetary incentives. In addition to the extrinsic
motivation induced from outside, intrinsic motivation is also crucially important.
Five basic propositions characterizing the relationship
between intrinsic and extrinsic motivation are advanced in
the book:
(1) Intrinsic motivation is of great importance for all economic activities. It is
inconceivable that people are motivated solely or even mainly by external
incentives.
(2) The use of monetary incentives crowds out intrinsic motivation under
identifiable and relevant conditions (Crowding-Out Effect).
(3) Other external interventions such as commands or regulations can drive out
intrinsic motivation.
(4) External interventions may enhance intrinsic motivation under some
conditions (Crowding-ln Effect).
(5) Changes in intrinsic motivations may spill over to areas not directly affected by
monetary incentives or regulations (SpillOver Effect).
Field Experiment: „Kindergarden“Gneezy/Rustichini 2000,
Journal of Legal Studies

Parents motivation to collect their childern in time

Problem: Parents used to arrive late to collect their children, forcing a teacher to stay
after closing time.
Experiment: monetary fine introduced for late-coming parents.
Result: the number of late-coming parents increased significantly.
After the fine was removed no reduction occurred.

The authors argue that penalties are usually introduced into an incomplete contract, social or private.
They may change the information that agents have, and therefore the effect on behavior may be
opposite of that expected.

85
(Gneezy/Rustichini 2000, Journal of Legal Studies)
Lesson learned:
Depending on the situation, external interventions (monetary
incentives & regulation) can lead to a reduction in intrinsic
motivation.

87
Eating out
Money does not always work

Situation a
„You go to a restaurant and pay for the services you receive at the end
of the dinner.“

Situation b
“A friend invited you to a dinner. The food was really good. To express
your appreciation, you give the friend a reasonable amount of money
before you go. "

88
Regulation does not always work
Situation (University lectures: voluntary work)
„ Some particularly committed university lecturers teach more than the
prescribed workload. In contrast, some university lecturers teach less
than their actual compulsory workload. Legislators are tightening the
controls on all university lecturers. ”

 What influence may the control have on the behavior of the particularly
committed university lecturers?

89
Theoretical Background
--Extrinsic/Intrinsic motivation
--Crowding Effects (short definition)
--Crowding Effects: Determinants
--Spill-Over Effects

90
Behavioural Motivations
Extrinsic and Intrinsic Motivation

 Neoclassical economics: Extrinisic Motivation (particularly money, force)

relevant for behaviour
 Intrinsic motivation neglected
 Intrinsic motivation:
• Deci (1971): “one is said to be intrinsically motivated to perform an activity
when one receives no apparent reward except the activity itself”
• Internalized norms and values (typical ques ons: Are you convinced that you
are doing the right thing? Can you identify yourself with the behaviour: Does
behavior happen because you like something?)

How are extrinsic and intrinsic motivations related?

 Crowding Effects
91
Theoretical Background
--Extrinsic/Intrinsic motivation
--Crowding Effects (short definition)
--Crowding Effects: Determinants
--Spill-Over Effects

92
Crowding Effects
Possible effects of
Support intrinsic motivation
external intervention (e.g. (Crowding-In Effect)
Monetary incentives)  When the individual perceives
intervention as supportive
Not relevant for intrinsic
motivation
(Crowding-Neutral Effect)
Suppress intrinsic motivation
(Crowding-Out Effect)
 e.g. If a person perceives the
intervention as control
93
Crowding Effects
Crowding-In Effect

 Monetary incentives increase intrinsic motivation

(16.-19. century common view)
 Passions are relatively uncontrolled
 Striving for material interests raises moral standards
 Material interests help to work hard for your own interests
Recent psychological theories (e.g. equity theory) expect Crowding-In
effects
 Example: If you feel overpaid at work, an attempt is made to
eliminate this inequality through improved performance (i.e.
higher salary leads to more productivity)
94
Crowding Effects
Crowding-Neutral Effect

 Monetary incentives have no effect on intrinsic motivation

(Representative of this view: Adam Smith)
 Consistent with standard economics (neoclassical view)

95
Crowding Effects
Crowding-Out Effect

 Monetary incentives reduce intrinsic motivation

 Similar views are referred to in the literature for example with the
term "commercialization effect": market destroys its own ethical basis

96
Psychological background
Perception of an intervention as controlling / supportive

Two psychological processes: Impaired Self Determinantion and Self-Esteem

1. Impaired Self-Determination
 External intervention influences perceived self-determination
 Is the responsibility seen in itself or in the person carrying out the intervention?

Increase of self-determination Reduction of self-determination

Perception: supportive Perception: control
(↑intrinsic motivation) (↓intrinsic motivation)

97
Psychological background
Perception of an intervention as controlling / supportive
Two psychological processes: Impaired Self Determinantion and Self-Esteem
2. Impaired Self-Esteem
 External intervention influences the feeling of whether one's own participation is
valued or one's own competence is valued.
Y N
e o
s
Increase Self-Esteem Reduce Self-Esteem
Perception: supportive Perception: control
(↑intrinsic motivation) (↓intrinsic motivation)

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Theoretical Background
--Extrinsic/Intrinsic motivation
--Crowding Effects (short definition)
--Crowding Effects: Determinants
--Spill-Over Effects

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Determinants of the Crowding Effects-Theory [1]
Personal relationships

 The more personal the bond, the greater the importance of intrinsic
motivation.
 Pure (impersonal) market transactions (e.g. supermarket, eBay): prices
relevant, intrinsic motivation irrelevant
 Personal relationships become relevant outside of the pure (impersonal) price
system. (Here it can happen, for example, that external interventions undermine
the intrinsic motivation).

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Determinants of the Crowding Effects-Theory[2]
Type of activity / task

 Depending on the activity (e.g. job), individuals are motivated to different

extents, i.e. different responses to external interventions
 The more interesting the activity for a person, the higher the intrinsic
motivation to do the job well & more external intervention reduces self-
determination and thus intrinsic motivation
 Evidence from psychological experiments: task-specific incentives damage
performance in interesting tasks; task-specific incentives helpful for boring or
repetitive tasks
 The more involved one is in decision-making processes, the more intrinsic
motivation can be suppressed by external interventions.

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Determinants of the Crowding Effects-Theory[3]
Equal treatment

 The more equally individuals are treated, the more negatively are influenced
those individuals who are overly intrinsically motivated.
 A feeling of lack of recognition of competence and commitment
 Reduction of intrinsic motivation

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Theoretical Background
--Extrinsic/Intrinsic motivation
--Crowding Effects (short definition)
--Crowding Effects: Determinants
--Spill-Over Effects

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Spill-Over Effects

 Change in intrinsic motivation is relevant for other areas of life

Housekeeping: Child always receives payment for mowing the lawn and now expects
payment for other household tasks (e.g. Refusal of all unpaid work)

 Changing intrinsic motivation is relevant to other people

Friends: Reduction of intrinsic motivation in person A can be transferred to person B

 Change in intrinsic motivation is relevant for other time periods

Work motivation: controlling intervention - motivation crowding out - reduction of intrinsic
motivation, even if controlling intervention no longer exists

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Application of the theoretical concepts

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Application of Crowding Effects-Theory
1. blood donation

 What influence do cash payments have on the willingness to donate?

 Neoclassical economics: monetary incentives  willingness to donate ↑

 How do people feel about paying money for donating blood?

 Partially aversion to the commercialization of blood donations
("Selling Blood")
 Partially moral concerns

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Application of Crowding Effects-Theory
1. blood donation

 If altruistic considerations are the reason for donating blood, the following
effects can be expected in response to cash payments:
(1) motivation crowding out  Suppression of intrinsic motivation
(2) Less motivation to donate blood if there is no pricing mechanism
 What are the consequences?
(i) If prices are high enough, presumably enough blood will be donated even
without intrinsic motivation (price effect overcompensates crowding out
effect).
Problem: cost increase

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Application of Crowding Effects-Theory
1. blood donation

What should be considered in reality?

 Culture dependency: what is common?
 In some countries, market mechanisms are perceived as “normal” more than
in other countries.
 In regions where people are more likely to accept price mechanisms,
suppressions of intrinsic motivation tend to be weaker.

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Application of Crowding Effects-Theory
2. work motivation

To what extent is the crowding effects theory relevant to work motivation?

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Application of Crowding Effects-Theory
2. work motivation

 Many economic theories focus on extrinsic incentives:

 Pessimistic world view: rational maximizers - workers do as little as necessary
 Consequence of principal-agent models (empoyer-employee): Distrust is very
important
 Employer (principal) monitors / controls the employee (agent)
 Neglect of voluntary work (e.g. animal protection)
 Symbolic awards work very well in increasing intrinsic motivation (but not too
much awards not to inflate them)

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Application of Crowding Effects-Theory
2. work motivation

 High work ethic ( high intrinsic motivation)

 Interesting task
- Income to survive vs. income beyond
(low intrinsic motivation vs. search for meaningful activities)
 Personal relationship between employer and employee
 Employees are integrated into the decision-making process of the
employer

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Application of Crowding Effects-Theory
2. work motivation

 Negative effect on work motivation ( Crowding-Out Effects)

Crowding-Out of intrinsic motivation, provided that external intervention is
perceived as being controlling.

Example: Personal relationship between employer and employee

Case A: Monetary reward for employees, provided they have worked exactly as
instructed by the employer.
Case B: Motivated employees and unmotivated employees are treated with the
same external interventions (adjustment of intrinsic motivation for motivated
employees).

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Application of Crowding Effects-Theory
2. work motivation

Why is intrinsic motivation relevant? Argument "Increasing prices could

overcompensate possible motivation crowding out effects"
 Problem 1: Quality of innovative / creative or artistic activities may be higher if
individuals are intrinsically motivated and not only through money.
 Problem 2: Cost increase due to compensation of crowding out effects
 Problem 3: Spill-Over effects

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Closing remarks
Relevance for regulator
Question: How should (monetary) incentives be designed to achieve a
goal?
Considering the intrinsic motivation effects (possibly unintended
effects)

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