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ECO674: Behavioral Economics

Punarjit Roychowdhury
Shiv Nadar University, Delhi NCR
 Representativeness Heuristic, Base Rate Neglect and
Conjunction Bias
 The Law of Small Numbers and Rabin’s Model
 Availability Heuristic

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Experiment (Kahneman and Tversky)
 Problem: A cab was involved in a hit and run accident at night.
There are two cab companies that operate in the city, a Blue Cab
company, and a Green Cab company.You are given the following
data: (a) 85% of the cabs in the city are Green and 15% are Blue.
(b) A witness at the scene identified the cab involved in the
accident as a Blue Cab. This witness was tested under similar
visibility conditions and made correct color identifications in 80%
of the trial instances.What is the probability that the cab involved
in the accident was a Blue Cab rather than a Green one?

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Experiment (Kahneman and Tversky)
 Problem: A cab was involved in a hit and run accident at night.
There are two cab companies that operate in the city, a Blue Cab
company, and a Green Cab company.You are given the following
data: (a) 85% of the cabs in the city are Green and 15% are Blue.
(b) A witness at the scene identified the cab involved in the
accident as a Blue Cab. This witness was tested under similar
visibility conditions and made correct color identifications in 80%
of the trial instances.What is the probability that the cab involved
in the accident was a Blue Cab rather than a Green one?

Most believe the probability that being Blue is 80% (which is the
prob that the witness identifies the correct color of the cab under
similar conditions)
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Experiment (Kahneman and Tversky)
 Problem: A cab was involved in a hit and run accident at night.
There are two cab companies that operate in the city, a Blue Cab
company, and a Green Cab company.You are given the following
data: (a) 85% of the cabs in the city are Green and 15% are Blue.
(b) A witness at the scene identified the cab involved in the
accident as a Blue Cab. This witness was tested under similar
visibility conditions and made correct color identifications in 80%
of the trial instances.What is the probability that the cab involved
in the accident was a Blue Cab rather than a Green one?

 This is, however, wrong!

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 P(blue) = 0.15
 P(Witness says blue | blue ) = 0.80

 P(Witness says blue) = P(Witness says blue | blue ) P(Blue) +

P(Witness says blue | green) P(green) =

0.8*0.15+0.2x0.85=.29
0.80×0.15
𝑃( Blue ∣ Witness says Blue ) = ≈ 0.41
0.29

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 People neglect the baseline/prior probability of observing a
Blue car
 If this is taken into account, it is actually more likely that the cab
was Green even if the witness identified the cab was Blue

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Experiment (Grether)
Design: Three bingo cages. The first had six balls numbered 1
to 6. The second had 6 balls - 4 marked N and 2 marked G. The
third had 6 balls - 3 N and 3 G
The experimenter first secretly drew a ball from cage 1; if the
ball’s number was less than equal to 2, then a series of 6 balls
would be drawn from cage 2; if the ball’s number was more than
2, then a series of six balls would be drawn from cage 3
With each draw, the letter on the ball was announced (N or G)
and the ball was replaced into the cage
Subjects had to guess which cage the six balls came from

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Experiment (Grether)
Results: People’s guesses were not in line with Bayes’ rule
Consider the case where 4 balls were drawn marked N, and 2
balls were drawn marked G
 In this case, the same heavily resembles the distribution of
balls in cage 2
 So majority ended up saying that these balls were drawn from
cage 2

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Experiment (Grether)
 However, Bayes’ rule would predict:
𝑃(4𝑁2𝐺 ∣ Cage 2)𝑃( Cage 2)
𝑃( Cage 2 ∣ 4𝑁2𝐺) =
𝑃(4 N2G ∣ Cage 2)𝑃( Cage 2) + 𝑃(4 N2G ∣ Cage 3)𝑃( Cage 3)

(2/3)4 (1/3)2 (1/3)

= ≈ 0.41.
(2/3)4 (1/3)2 (1/3) + (1/2)4 (1/2)2 (2/3)

So people forgot to look at the underlying/prior probability of

drawing from cage 2 (which is much lesser than the probability
of drawing from cage 3)!
Since they forgot to take into consideration the relatively low
probability of drawing from cage 2, they ended up calculating a
higher prob of cage 2 being drawn:
(2/3)4 (1/3)2
𝑃( Cage 2 ∣ 4𝑁2𝐺) = = 0.58
(2/3)4 (1/3)2 + (1/2)4 (1/2)2 10
 Behavior in both of these examples show what has become to
be known as the representativeness heuristic (“learning too
much” from a given information)
 Individuals who display the representativeness heuristic
determine the probability of an event by the degree to which
the event (i) is similar in essential characteristics to its parent
population; and (ii) reflects the salient features of the process
by which it is generated
 The draw of 4N2G looks like (or is representative of) the distribution of
balls in cage 2 – hence the draw must be from cage 2!
 In Bayes’ rule terms, individuals displaying the
representativeness heuristic demonstrate base rate neglect (or
they discount the base rate)
 Like in the bingo experiment or the Taxi experiment
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 Generalized Bayes’ rule formula:

[𝑃(𝐵 ∣ 𝐴)]𝛽𝐿 [𝑃(𝐴)]𝛽𝑃

𝑃(𝐴 ∣ 𝐵) =
[𝑃(𝐵 ∣ 𝐴)]𝛽𝐿 [𝑃(𝐴)]𝛽𝑃 + [𝑃(𝐵 ∣ −𝐴)]𝛽𝐿 [𝑃(−𝐴)]𝛽𝑃

 where βP is the weight placed on the prior probability (or base

rate information) (e.g., ball drawn from cage 2), and βL is the
weight placed on the likelihood information
 A rational person should behave as if both were 1
 But a person displaying representative heuristic would behave
as if βP<<1 (close to zero) and βL >>1
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 Representativeness might lead to poor investment decisions
 A short streak of declines in the stock indices often leads people to
quickly to talk of a recession (or a bear market)
 They believe that a string of down days represents recession
 Nonetheless, people forget that bear markets are relatively rare
(i.e., probability of bear market is low), i.e., they neglect base rate
 This can cause them to take wrong investment decisions

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 Representativeness can also lead to conjunction bias

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Experiment (Tversky and Kahneman)
Design: Linda is a 31 year 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

a) Linda is a teacher in elementary school

b) Linda works in a bookstore and takes Yoga classes
c) Linda is active in the feminist movement
d) Linda is a psychiatric social worker
e) Linda is a member of the League of Women Voters
f) Linda is a bank teller
g) Linda is an insurance salesperson
h) Linda is a bank teller and is active in the feminist movement.

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Experiment (Tversky and Kahneman)
Design: Linda is a 31 year 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

a) Linda is a teacher in elementary school

b) Linda works in a bookstore and takes Yoga classes
c) Linda is active in the feminist movement
d) Linda is a psychiatric social worker
e) Linda is a member of the League of Women Voters
f) Linda is a bank teller
g) Linda is an insurance salesperson
h) Linda is a bank teller and is active in the feminist movement.
Result: People’s average rank: (c) = 2.1, (f) = 6.2 and (h) = 4.1

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 Item (h) is the intersection of (c) and (f), so its probability must
be less probable than (c) as well as (f) (i.e., (h)’s average rank
should be greater than 6.2)
 But that is not the case!
 In fact, around 90% of the participants ranked (h) as being
more probable than (f)

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 As participants rank these possibilities in their mind, they are
drawn to the description of Linda and tend to rank the items in
order of how representative of each item that description is
 Thus, participants might have felt that relatively few bank
tellers are deeply concerned with social justice, and thus this
outcome is thought to be improbable (6.2)
 But if we think about feminist bank tellers, this group is
probably much more concerned about social justice, and thus
people consider this event to be more likely (4.1)
 This is called the conjunction bias which arises due to the
representativeness heuristic

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 By intersecting relatively unrepresentative events (bank teller)
with very representative events (feminist), the conjunction of
the two is considered more probable than the unrepresentative
event because the description is more representative of the
combined events
 Such bias, which arises due to the representativeness heuristic,
could lead to stereotyping, bigotry and other potentially
undesirable phenomena

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 The law of large numbers tells us that when we have large
numbers of observations, this large sample should ‘look’ like
the underlying population (i.e., the properties of the sample
should resemble the population from which it is drawn)
 The law of small numbers (Tversky and Kahneman) is the
mistaken belief that a small sample should look like the entire
population
 For example, flipping a coin 4 times, it is more likely to not get 2
heads, than getting exactly 2 heads. But people believe that the
outcome with 2 heads will occur
 Again, it is a manifestation of the representativeness heuristic

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Performance in mutual funds
 Each year a list of mutual funds that had the highest return in
the last year is widely circulated in the financial press
 Many people select which mutual funds to purchase based
upon this list
 However, it is very seldom that the results of any year are good
predictors of performance in the future
 Only three of the top 10 mutual fund families for 2008 were also in
the top 10 for 2007
 Thus while selecting mutual funds people’s decision are often
guided by the law of small numbers

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 Mathew Rabin has proposed a behavioral model of learning
which shows how law of small number works
 Suppose we are considering the repeated flipping of a fair coin
 We know the probability of heads/tails is 0.5 and that it does
not depend on whether heads/tails was drawn previously
 We have a belief of possible outcomes for the coin – this can be
represented as a distribution of balls in an urn containing N
balls (“mental urn”)
 Half of the balls in the mental urn are labeled “heads” and half
“tails” (representing probability of heads/tails)
 For each toss, this person draws each ball from the mental urn
 Every time we flip a coin and see heads (tails), we take out the ball
for heads (tails) 22
 Suppose the mental urn originally contained 6 balls – 3 heads,
3 tails
 Original beliefs are thus that the probability of a heads is 3/6 =
0.5
 Suppose the first coin is tossed, and heads comes up
 This removes one “heads” ball from the urn, so the beliefs for
the next toss are the probability of heads is 2/5 = 0.40
 Thus, when a heads is tossed, this person feels that it is more
likely that a tails will be tossed to balance out the sequence
 In this process, the number of balls in the mental urn
determines how biased the observer may be

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 Note:
 Lesser is the number of balls  more is the bias (law of small
numbers)
 More is the number of balls  less is the bias
 If there were 1000 balls (with 50% heads ball), after tossing one
heads the believed probability of heads becomes 499/999 = 0.499;
contrast this to the analogous probability when we had 6 balls
 In actuality, the probability is always 0.5 regardless of whether
a heads or tails has recently been tossed

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 Suppose Freddie is deciding on whether a mutual fund is a
good investment or not
 Suppose there are two types of mutual funds: good and bad
 A good mutual fund receives a good return 2/3 of the time and
bad return 1/3 of the time
 A bad mutual fund receives a good return 1/2 of the time and a
bad return 1/2 of the time
 Freddie believes that only 2/3 of mutual funds are good
 In examining the previous returns, he finds that a mutual fund
had the following performance over the past five years: good,
good, bad, bad, good (GGBBG)

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 Then by Bayes’ rule, if Freddie observes GGBBG, he can
calculate:

𝑃( Good Fund ∣ 3 Good 2 Bad ) =

𝑃(3 Good 2 Bad|Good Fund )𝑃( Good Fund )

𝑃(3 Good 2 Bad|Good Fund )𝑃( Good Fund ) + 𝑃(3 Good 2 Bad ∣ Bad Fund )𝑃( Bad Fund )

(2/3)3 (1/3)2 (2/3)

= ≈ 0.68.
(2/3)3 (1/3)2 (2/3) + (1/2)3 (1/2)2 (1/3)

 This is what Freddie would calculate if he was rational

 What if his behavior is driven by the law of small numbers?
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 Suppose Freddie believes in the law of small numbers and has
two mental urns
 One mental urn represents the probability of drawing good or
bad returns if the mutual fund is good
 The other mental urn represents the probability of drawing
good or bad returns if the mutual fund is bad
 Suppose that the good urn has 3 balls (2 good, 1 bad)
 And suppose the bad urn has 4 balls (2 good 2 bad)
 Suppose the urn is refilled and refreshed after every 2 draws

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 Then the probability of observing the sequence GGBBG from a
good fund is:
𝑃( Good Good Bad Bad Good ∣ Good Fund ) = (2/3)(1/2)(1/3)(0)(2/3) = 0

 And the probability of observing the same sequence from a

bad fund is:
𝑃( Good Good Bad Bad Good|Bad Fund ) = (1/2)(1/3)(1/2)(1/3)(1/2) = 1/72

 So by Bayes’ rule:
0×(2/3)
𝑃( Good Fund ∣ Good Good Bad Bad Good ) = 0×(2/3)+(1/72)×(1/3) = 0.

 Thus Freddie will conclude that the fund cannot be good!

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 Thus, if Freddie is a believer in the law of small numbers (i.e.,
his decision is based on only past 5 years of mutual funds
performance), he will think that the fund in question can never
be good; whereas in actuality, the probability of the fund being
good is 68%!
 Thus law of small number leads to biased decision making
since people like Freddie jump to conclusions from very little
information
 Small (or early) counts from a sample will be taken as overly
representative of the whole, leading to snap judgements

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 “A newly hired worker might do well to put in extra hours early
on when initial judgements are being formed” – how does the
representativeness heuristic and law of small numbers explain
this statement?
 The bias due to law of small numbers depends on (i) size of the
mental urns, and (ii) how often the urns refreshes. Check for
yourself.

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 Suppose a biologist wanted to test the effect of a chemical A on
a particular bacteria B. She would take samples of bacteria B in
controlled conditions with and without A
 Then she would use a t test statistic
𝜇ƶ 1 − 𝜇ƶ 2
𝑡=
𝑛1 𝑆12 + 𝑛2 𝑆22 1 1
+
𝑛1 + 𝑛2 − 2 𝑛1 𝑛2

 to test if the mean of the bacteria sample is the same under the
treatment as under the control
 if t > 2.00 or t < -2.00 then there is less than a 5% chance the
two are equal
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 Kahneman and Tversky wanted to see if the law of small
numbers played a role in scientists’ understanding of how
replication works
 They asked 75 psychologists to consider a result reported by
a colleague
 The result was obtained by running 15 subjects through an
experiment yielding a test statistic of t=2.46 (α=0.0275) that
rejects the initial null hypothesis
 However, a replication by another investigator with another
15 subjects fails to reject the same hypothesis at the α=0.05
level; the obtained t value is 1.70
 Psychologists said, “thus, the second study contradicts the
first study and the replication is not successful (first study’s
findings are questionable)” – Really?
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 The first study has a t-statistic of

1
𝜇ƶ11 − 𝜇ƶ 2 1
𝑡 = = 2.46
15𝑆12 + 15𝑆22 2
28 15
 The replication has a t-statistic of

2
𝜇ƶ 12 − 𝜇ƶ 22
𝑡 = = 1.70
15𝑆12 + 15𝑆22 2
28 15
 Then, the combined t-statistic (i.e., if data from first and second studies were
combined) is

2.46 + 1.70 15𝑆12 + 15𝑆22 2 15𝑆12 + 15𝑆22 2

𝜇ƶ1 − 𝜇ƶ 2 = = 2.08
2 28 15 28 15

15𝑆12 + 15𝑆22 2
2.08 28 15
𝑡= = 2.99 > 2.46
30𝑆12 + 30𝑆22 2
58 30

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 Thus, if we conducted a new study and found 𝑡 = 1.70, this
should strengthen our confidence in the results of the previous
study, now being able to reject the null hypothesis at 𝛼 = 0.0056
 Instead the scientists believed that the second study
contradicts the first
 Owing to the belief in the law of small numbers, they believe
that if the first study were true, the second study should have an
extremely high probability of producing a test statistic which is
close to the original test statistic
 In fact, they exaggerate this probability due to the law of small
numbers bias!

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Representativeness heuristic can lead people to believe in
causal effects that are nonexistent
Consider the following story:
You run a flight training school
Psychologists have suggested that pilots’ performance should
improve if they are given rewards
Hence you decide to reward the trainees after a good flight
After several months of this policy, you find reward after a good
performance never improves performance; in fact, the reward
winners tend to do worse in their next flight
Now, instead of rewarding pilots after good flights, you start
punishing pilots after bad flights
You see that pilots almost always improve after a punishment
So you conclude psychologists are wrong – rewarding is not an
effective policy, but punishment is 35
 In reality, neither rewards nor punishment was actually
affecting the performance (progress takes a long time!)
 The big changes in performance are most likely due to random
variation in conditions (e.g., weather, rest, alertness, etc.) rather
than change in skills
 Thus a particularly good or bad flight is almost certainly due to
a lucky draw
 Suppose the probability of a particularly good (bad) flight was
0.10; thus following any such particularly good (bad) flight,
there is 90% probability that the next flight would be bad
(good)
 So it should not be surprising that a pilot performs worse after
a particular good flight, and performs better after a bad flight
 This is called mean reversion (“performance near the mean is
the most probable outcome” )
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 If we don’t recognize mean reversion, we might mistakenly
believe the punishment works and rewards don’t, although in
reality it might be that neither punishment nor reward is
affecting pilots’ subsequent performances
 Even without rewards, a pilot’s performance would decline, and
even without punishment, a pilot’s performance would improve

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In watching a basketball game, it is hard not to be amazed by
the long streaks of shots made by the players
Often sportscasters keep track of how many shots a particular
player has made in a row without missing
In fact, 91% of basketball fans believe that after a player has
made one shot, he has a higher probability of making the next
shot
This leads to 84% of basketball fans to believe that it is
important to get the ball into the hands of a player who has
made several shots in a row

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In actuality, is the probability of making a basket higher after having
just made a basket (“hot hand theory”)?
No. Streaks or hot hand theory is an illusion that arise due to the law
of small numbers
Each shot is essentially independent of the previous shot; they are
unrelated draws from the same distribution
Gilovich, Vallone and Tversky using data from an entire basket season,
found that if a player had hit one shot, he hit only 51% of the next shot; if he
hit two shots in a row, he hit only 50% of the third shot; on the other hand, a
player who missed one shot, he hit 54% of his next shots!
No correlation between the outcome of one shot and next

Note, (mistaken) perception of the hot hand affects the betting

markets for teams that are on winning streaks
Can be explained by Rabin’s mental urn
Basketball coaches were not amused
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 When playing the roulette wheel at a casino, a wheel with red
and black sections is spun, and gamblers place bets on the
color of the section that will come to rest under a pointer
After 4 or more red (black) spins on a roulette wheel, people
start betting against the streak.
 People bet 50% red/black with streaks up to 3.
 58% bet red after a streak of 4 black
 65% bet red after a streak of 5 black
 85% bet red after a streak of 6 black

 This is called gambler’s fallacy – people, according to the law of

small numbers, (mistakenly) believe that the draws should even
out to the correct proportions over time
 Thus they start betting more ad more heavily on the outcome
that has appeared least
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A standard roulette wheel has 18 red sections, 18 black
sections, and 2 green sections
Prob of red and black is 47% each
In this case, the gambler knows the content of the mental urn
he is drawing from, but uses the remaining contents of the urm
to predict future outcomes
Thus more the red draws, fewer the red balls in the mental urn,
which automatically inflates the probability of black on the next
draw!
Note: Same thing happens in the play of state lotteries: after a
winning number is drawn, the number of people choosing that
number in the next day’s lottery falls substantially!

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 The availability heuristic refers the tendency to judge the
likelihood (probability) of an event based on the difficulty one
has in recalling the event
 It naturally leads people to exaggerate the probability of
events that are easily recalled and underestimate the
probability of events that are difficult to recall
 Newspaper coverage of violent deaths could lead one to believe
that such deaths are common despite violent deaths being rare
 The lack of coverage of news coverage for deaths by disease could
lead one to judge these deaths to be uncommon although the
reality might be different
 Related is the false consensus effect. People assume others hold
the same opinions as themselves  thus, they exaggerate the
extent to which their views and actions are normal
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 Most people (80%) believe accidental deaths are more likely
than death by stroke, when in fact, in actuality, you are twice
as likely to die by stroke as you are from all accidental
sources combined; you are 15 times more likely to die from
disease than accident
 70% believe that homicides are more common than suicides,
when the opposite is true
 News coverage and availability heuristic is responsible for
this (Litchenstein)

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 Experiment (Tversky and Kahneman)
 In the English dictionary, are there more words that begin with
R or words that have R as the third letter?
 Most people think that there are more words the begin with R
 In fact, however, there are more with R as the third letter
 The bias arises due to the availability heuristic
 If you were to write down as many words as you know that begin
with the letter R, you would likely fill the list rather easily; if you
were asked to construct a list of all words you know that had R as the
third letter, the list would be considerably shorter
 This happens because we tend to classify words by their first letter

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 On October 17, 1989, a major earthquake struck the San
Francisco Bay area in California
 The quake killed dozens of people and caused several billions
of dollars in damage
 After this event, earthquake insurance stock prices went up
(meaning the insurance companies started performing very
well!)
 This was puzzling: after a earthquake insurance companies is
responsible for restoring all damaged properties hence they
have to pay out a lot of money + insurance demand should fall
since right after one earthquake in an area, the probability of
earthquake declines in that area (earthquake relieves some
pressure on the fault line)
 So why did the insurance companies start performing well?
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 Shelor, Anderson and Cross showed that people started
buying more insurance right after the earthquake
 The availability heuristic led them to take biased/suboptimal
decision
 The increase in demand for insurance more than offset the
billions of dollars in losses that the insurance companies
suffered
 That caused the companies to do well, and hence their stock
prices rose!

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Bertrand and Mullainathan sent out identical resumes of
fictitious individuals to different firms in the US but varied the
name (Darnell or Jamal versus Todd or Brad)
White sounding names had a 9.5% chance of callback, black
sounding names had a 6.5%
Why would employers do this? They regularly advertise that
they are equal opportunity employers; additionally, employers
should just look at the resume and not race if they want to
maximize profit/productivity of the organization
In fact, after the study was published, many employers were
surprised to know that they engage in such practices, meaning
they did not discriminate intentionally!

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 Availability heuristic may be responsible for such (non-
intentional) racial discrimination
 Large number of news articles talk about blacks doing worse
than white in terms of academic achievement, crime rates,
etc.
 This may inadvertently alter the treatment of black people

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1. How might false consensus affect an investor’s beliefs about
his invention?
2. How to think about win streaks in baseball?
3. How to interpret trends in stock prices?

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