Ec 201: Principles of Microeconomics

Behavioural Economics

Tim Besley

March 2022

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Introduction

Week 6: Markets and government when people do not know their

own best interests?
How does the case for the market system change when individuals lack
the capacity to understand what is good for them?
We will study a world where decision utility and experience utility
diverge
This will build on the behavioural economics part of what you covered
with Dimitra last term
new issues are studying market equilibrium and government intervention
This will raise some interesting issues about the scope of paternalism

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Outline

Brief recap of some core ideas

Then study market equilibrium with (some) “behavioural” consumers
(Lecture 11)
reconsider equity and e¢ ciency of market equilibrium
Develop a simple model for considering government intervention
(Lecture 12)
consider market-based solutions
also implications for taxation and regulation

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Behavioral Economics (Recap)

“A method of economic analysis that applies psychological insights

into human behaviour to explain economic decision-making.”
or economics with “real humans”
provides a way of bringing economics and psychology closer together
Key insight
need to consider possibility that behaviour does not deliver what is
good for people
we take the “rational” or “informed” outcome as the benchmark
Many examples
smoking
going to the gym
eating healthily

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Behavioural Biases

Heterogeneity
biases can di¤er across individuals
and across di¤erent kinds of activities
and consequences di¤er too
e.g. investing in a pension versus eating at a bad restaurant
Remedies are ideally targeted
Leads to questions about market allocations
as these are where “consumer sovereignty” is greatest

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Core Two Good Example

Two individuals A and B

Two goods x1J and x2J where J 2 fA, B g
Endowments s1J = σJ S1 and s2J = σJ S2
Decision utility:
u J x1J , x2J .

So this determines demands from:

n o n o
x1J , x2J = arg max u J x1J , x2J
subject to
p1 x1J + p2 x2J p1 s1J + p2 s2J .

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Behavioural consumers

Let
U J x1J , x2J

be experience utility.
We will say that a consumer type A is “behavioural” if

U J x1J , x2J 6= u J x1J , x2J .

But a priori we cannot say what the implied distortion might be

consuming things that are not “good” for you
or failing to consume enough of what is good for you.
Are preferences …xed?

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Test yourself example

Take preferences from week one class:

Preferences for A are
q
A
u x1A , x2A = x1A + θ2 x2A
q
A
U x1A , x2A = x1A + 2 x2A
So θ 6= 1 is a way of thinking about being “behavioural”.
Preferences for B are
q
u B x1B , x2B = U B x1B , x2B = 2 x1B + x2B .

Derive equilibrium prices in this case

Contrast the outcome with the case where A has no behavioural
consumers.
try it for yourself but will put up a note on the solution.
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General Equilibrium with Behavioural Consumers

Will focus on the case where one type of consumer is behavioural

Allow us to think about how markets are “distorted” by this.
Will explore this by thinking through an Edgeworth box diagram
Core logic holds much more generally.
Recall that this allows us to think about how two consumers will
trade from an endowment point towards a Pareto e¢ cient point.
We can illustrate a competitive equilibrium as a point where marginal
rates of substitution are equal and all endowments are consumed.
Assume that individual A is behavioral, i.e. there is divergence
between experience and decision utility.

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Basic Edgeworth Box

Look …rst at decision utility for both consumers

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Gains from Trade Based in Decision Utility

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Competitive Equilibrium Based on Decision Utility

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Experience Utility versus Decision Utility for A

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Experience Utility versus Decision Utility for A

Scope for a Pareto improvement

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Lessons

A competitive equilibrium based on decision utility need not be Pareto

e¢ cient according to experience utility
Using experience utility, there are also implications for inequality
individual A is not as well o¤ as she “expects” to be given her decision
utility.
So is there a case for intervention on both e¢ ciency and equity
grounds?
But what form should that intervention take?
Now begin to explore things in a simple speci…c model

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Government Intervention with Behavioural Consumers

Now explore arguments for government intervention.

We will develop a very simple structure for thinking about taxes and
regulation
using a model of competitive market provision
There will be two goods
for one of these consumers may have “defective” preferences
we will call this “gym membership”
but there is a wide range of examples
and the behavioural "bias" to go in any direction

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Basic Framework

There are two goods:

food
gym membership
Normalize the price of food at one and gym membership costs p
Gym membership is a discrete good
you either by one or zero units denoted by δ 2 f0, 1g
We will study who buys it with and without behavioural biases

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Basic Framework

Preferences of all consumers

uδ + x

where u 2 [0, U ] is the utility from gym membership

this says that di¤erent consumers value gym membership di¤erently
δ = 1 if they join a gym
x is food.
All consumers have an endowment m of food which they can
consume or trade for a gym membership
Their budget constraint is

x + pδ m

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Standard Model of Demand for Gym Membership

Compare u p + m with m
then buy gym membership if and only

u p.

Now let G (u ) be the cumulative distribution function of u.

recall from your basic statistics that this tells how many people have a
valuation less than or equal to u
go back to a basic stats book if you have forgotten

The fraction of gym members will be all those with u p or

1 G (p )

which de…nes a downward sloping demand curve in p.

fewer people will join a gym if the price is higher.

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Demand for Gym Membership

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Supply Side

There are more than two gyms

gym places can be created at cost c per place
gyms are assumed to be homogenous goods
Suppose that there is Bertrand competition between gyms
Each gym posts a price per membership
customers then choose a gym
pricing decisions must form a Nash equilibrium
Then the equilibrium price is p = c.
otherwise any gym can lower its price and attract the whole market
no market imperfection on the supply side
demand is 1 G (c )

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Market equilibrium

Gym membership only for those who value the good more than the
marginal cost
Hence markets achieve an e¢ cient allocation of people to gym places
This is using the standard assumption that everyone knows the value
of gym membership
markets facilitate trade and supply is generated though markets
the outcome is Pareto e¢ cient
not possible to reallocate food and gym members decisions to make
everyone better o¤

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Market equilibrium

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Behavioural consumers

Suppose that a fraction µ of consumers are “behavioural”

a fraction 1 µ are rational
For both types u is “true” experience utility
But behavioural consumers value it at βu
if β > 1, they are over-optimistic about their valuation of using a gym
if β < 1, they undervalue taking exercise at the time of taking out
membership
What will the demand function look like now?
it will di¤er between rational and behavioural consumers

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Two types of consumers

Rational consumers
buy the good if and only if
u p
Behavioural consumers
buy the good if and only if βu p or

u p/β

The demand function is now

1 µG (p/β) (1 µ ) G (p )

Demand function di¤ers from rational demand if µ > 0 and β 6= 1

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Market equilibrium

Same Bertrand competition logic says that

p=c

marginal cost pricing

But now if β 6= 1, there will be over or under consumption compared
to rational outcome
β > 1 overconsumption
β < 1 underconsumption
Equilibrium demand is

1 µG (c/β) (1 µ ) G (c )

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Market equilibrium

Optimism bias (β > 1)

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Market equilibrium

Pessimism bias (β < 1)

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E¢ ciency

The market can now have feasible Pareto improvements

β > 1:
for u 2 [p/β, p ] behavioural consumers buy the good
but they would not buy the good if they knew that were over optimistic
they would regret their purchase decision ex post
β < 1:
for u 2 [p, p/β] behavioural consumers buy the good
but they would buy the good if they knew that were pessimistic
they would regret their purchase decision ex post

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Utilitarian Welfare

Suppose that we use the sum of “true” utilities:

Z U Z U
µ udG (u ) + (1 µ) udG (u ) + m
c /β c
c [1 µG ((c + t ) /β) (1 µ) G (c + t )]

Maximum welfare is
Z U
udG (u ) + m c [1 G (c )]
c

Welfare loss is higher if

β is further from one
µ is bigger
more people in the critical range where they may the “wrong” decision.

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So what?

Are markets the best way to make decisions about gym membership?
An omniscient planner would overrule the decisions of behavioural
consumers
“compelling” them to use u rather βu
But that would require the planner to know the exact u of every
individual
this seems implausible
More feasible government intervention
devices that act directly on β
taxes/subsidies which change p

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Acting on behavioural biases directly

Best policies is to …nd ways acting on β

Will tend to leave the behaviour of rational consumers una¤ected
Sometimes referred to as “Libertarian Paternalism”
This means changing the decision-making context
getting people to sample a good before buying
experience utility is then more salient.
inducing people to understand β before they choose
know your own biases
changing defaults
opt in versus opt out if biases are not symmetric

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Nudge (covered by Dimitra)
Can be thought of as changing β

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Opt Out versus Opt In
from https://www.pensionsadvisoryservice.org.uk/about-
pensions/pensions-basics/automatic-enrolment/opting-out

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Overoptimistic Gym Members
Suppose now that consumers all think that they will go to the gym
with β > 1
Della Vigna and Melmendier ran an experiment
Members were o¤ered a $10-per-visit package or a monthly contract
worth $70.
More chose the monthly contract and only went to the gym four times
a month.
As a result, they paid 70 percent more per visit than they would have
under the plan they rejected.
Why?
Because people are too optimistic that they can become gym rats,
which would make the monthly package "worth it".
i.e. β > 1
But paying per visit, may make individuals better able to align
experience and decision utility
raising the price of a good can then make sense to stop people joining
who will not use it.
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Market or Government

Does the market have an incentive to o¤er schemes that reduce β?

In our current model, they make zero pro…t, so why not
although if such schemes raise c, they make gym membership more
expensive for everyone
With imperfect competition producers will do whatever it takes to
increase pro…t
and this could mean increasing behavioural biases
we will explore this issue in this week’s class
Then we need to consider a regulatory framework
e.g. “cooling o¤ clauses” which allow you to change you decision.
UK government gives a right to individuals cancel certain transactions
such as motor insurance and consumer loans without penalty within 14
days.

And taxation can also play a role.

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The Sugar Tax (2018)

The Soft Drinks Industry Levy (SDIL), the tax puts a charge of 24p
on drinks containing 8g of sugar per 100ml and 18p a litre on those
with 5-8g of sugar per 100ml.

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Advanced Topic: Taxing Gym Membership

Then increase the price to p + t where t is the tax or subsidy

Welfare with the tax is
Z U Z U
µ [u c t ] dG (u ) + (1 µ) [u c t ] dG (u ) + m
(c +t )/β c +t

Revenue raised is

t [1 µG ((p + t ) /β) (1 µ) G (p + t )]

Suppose that revenue is rebated on an even per capita basis.

What is the welfare maximizing (optimal) tax rate?

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Advanced Topic: Optimal Taxation

Then the optimal tax maximizes

Z U Z U
µ [u c ] dG (u ) + (1 µ) [u c ] dG (u ) + m.
(c +t )/β c +t

Taking the …rst order condition, and solving for t the optimal tax rate
is
µ c +t
βg β
t= ( β 1) c
µ c +t
βg β + (1 µ ) g (c + t )
Can you derive it?
(See the note at the end.)
Note that
> >
t <0 as β < 1.

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Advanced Topic: Optimal Taxation

To interpret the formula, write

t = ω (β 1) c

where
µ c +t
βg β
ω= 2 [0, 1]
µ c +t
βg β + (1 µ ) g (c + t )

If ω = 1, then o¤set the distortion in decision making

behavioural consumers pay βc and buy only if u > c.
With 0 < ω < 1 the tax o¤sets some nut not all of the bias.
why?
because if “distorts” the behaviour of the rational consumers.

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Redistributive Implications

We have focused on market e¢ ciency

But there are often concerns about behaviourial biases among
“vulnerable” groups
then we might be concerned about distributional e¤ects
Example: switching to cheapest electricity tari¤
higher income and more educated seem to get better deals on energy
supply
To its implications requires a welfare function which re‡ected
distribution of β and income.
Interventions would then balance both equity and e¢ ciency concerns

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Take Home

Since markets rely on decentralized decision making by individuals

thus behavioural biases a¤ect the operation of markets
We have seen there can be Pareto inferior outcomes
and have also discussed ways of remedying these
market solutions
government solutions
But how far intervention is to proceed on this is still open to debate
as is the question of how far to take decisions out of the hands of
consumers
this will surely depend on the welfare losses from bad decisions

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Optimal Tax Details:

Formulating the objective function

Z U Z U
W (t ) = µ [u c t ] dG (u ) + (1 µ) [u c t ] dG (
(c +t )/β c +t
+m + tax revenue
Z U Z U
= µ [u c ] dG (u ) + (1 µ) [u c ] dG (u )
(c +t )/β c +t
Z U Z U
+m µ [ t ] dG (u ) + (1 µ) [ t ] dG (u )
(c +t )/β c +t
+tax revenue

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Optimal Tax Details:

Then the optimal tax maximizes

Z U Z U
W (t ) = µ [u c ] dG (u ) + (1 µ) [u c ] dG (u ) + m.
(c +t )/β c +t

To maximize set
∂W (t )
= 0.
∂t
Taking the …rst order condition, yields:

c +t c +t
c g (1 µ ) (c + t c ) g (c + t ) = 0
β β

So this means that

µ c +t cµ ( β 1) c +t
t g + (1 µ ) g (c + t ) =
β β β β

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Optimal Tax Details:

Solving for t gives the optimal tax rate as

µ c +t
βg β
t= (β 1) c
µ c +t
βg β + (1 µ ) g (c + t )

as above.

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