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ECO374: Behavioral Economics

Punarjit Roychowdhury
Shiv Nadar University, Delhi NCR
 © Punarjit Roychowdhury
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without permission is a punishable offence.

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 You move to campus in a new town, and are looking for lunch.
You randomly pick one of the unknown lunch places. Since that
time, you have tried some of the other restaurants nearby, and
some are very good, but you most often eat at that same
restaurant (although it is not the nearest to your apartment)

 You are looking for car insurance but are bewildered by all the
different policies. The salesman suggests the “standard” policy,
but allows you to make changes. After a bit of thought, you take
the standard policy as is. Later, when you have the chance to
reexamine your policy upon renewal, you opt to continue with
the standard package

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 In past, you have invested in certain mutual funds or fixed
deposits. You are aware of the protection that the FD offers. Your
friend tells you that having money in a liquid fund is much
better. You think about it. You notice the difference in interest
rates. But even though investment in liquid fund seems
reasonably attractive, you decide to continue with your FD. It
just keeps more comfortable to keep your money where it is!

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 First story  A single decision (or even a chance event) can set
up habitual behavior that continues for long periods of time –
status quo bias

 Second and third story  A default option is selected which

leads to the status quo bias
 Often the default option is suggested by the situation when the
decision maker is unable to make an explicit choice

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 Defaults and resulting status quo bias restricts you to reach the
optimum
 Just restricting yourself from exploring new options is not a
good idea
 You might be missing out on better investment opportunities,
better restaurants, etc.

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 Rational consumers should not be influenced by “default”
options and should not exhibit any cognitive errors like status
quo bias
 They should consider all possible options and choose the best one
(i.e., the option with the highest utility)
 Naming/making an option “default” should not matter to a rational
consumer in terms of choice
 However, in contrast to the prediction of the rational model of
consumption, it seems that defaults influence us all the time and
we frequently exhibit default option bias and status quo bias

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 The Model of Prospect Theory can explain why the status quo
or the default are powerful attractors in individual choice

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 In what follows, we will look at the following questions:
1. How does status quo matter?
2. How does default matter?
3. How do/can governments and businesses take advantage of
these effects?

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 https://www.youtube.com/watch?v=V7TUFH6udHA

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 Experiment (Johnson and Goldstein, 2003)
 Lack of suitable organ donors creates a constant problem in
many countries
 Variation in rates of willingness to donate organs is remarkable
among various European countries

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 Based on the effective consent rates for organ donation,
countries can be grouped into two categories:
 Group 1 having an organ donation rate of 4-27%
 Denmark, Netherlands, UK, Germany
 Group 2 having an organ donation rate of 85-99%
 Austria, Belgium, France, Poland, Portugal

 Why?
 In group 2 countries, do people care more about each other?
 Unlikely – countries in groups 1 and group 2 are culturally very
similar

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 Explanation:
 In Group 1 countries you have to fill up a form having a section:

□ Check the box if you want to participate

in the organ donor program.

 In Group 2 countries you have to fill up a form having a section:

□ Check the box if you do not want to
participate in the organ donor program.

 People in both groups of countries don’t check!

 In other words, the countries where the default option is organ

donation, organ donation rates are extremely high in those

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 An online experiment (Johnson and Goldstein, 2003) where
people were hypothetically asked if they had to either opt-out
or opt-in had 82% versus 42% donation rates

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 Rational model of choice supposes that people have well-
formed and consistent preferences
 However, in reality, people may have unformed preferences for
many choices
 The default option fills the void of preferences in such cases by
providing an ‘anchor’ to subsequent decision making
 It does so, by providing suggestion to a person who has unformed
preferences
 The next experiment demonstrates how anchoring aids
decision making when consumers have unformed preferences

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 55 students of the Sloan School MBA program were shown six
products (computer accessories, wine bottles, luxury
chocolates, and books), which were briefly described without
mentioning market price
 The average retail price of the items was about $70
 After introducing the products, subjects were asked to write
down the last two digits of their social security number (SSN) as
if it was the price of the item
 If the last two digits were 11, then the bottle of wine was priced at
$11
 After this, they stated their dollar maximum willingness-to-pay
(WTP) (or bid) for the product

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 In spite of the realism of the products and transaction, the
impact of the social security number on stated WTP was
significant in every product category
 Subjects with above-median social security numbers stated
values from 57 percent to 107 percent greater than did subjects
with below-median numbers
 The effect is even more striking when examining the valuations
by quintiles of the social security number distribution

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 Evidently, these subjects did not have, or were unable to
retrieve personal values for ordinary products
 They were likely anchoring and adjusting

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 People anchor on conveniently available numbers when
forming new beliefs
 They then adjust that number up or down accordingly
 Anchoring devices like the SSN becomes a simple tool to help
create a set of preferences

 More on Anchoring…..
 https://www.youtube.com/watch?v=NFiDdbquWJY
 https://www.youtube.com/watch?v=R2cgoZWWxVs

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 In fact, default option functions much like an anchor
 They can help individuals create preferences
 Additionally, the naming of a default can have the effect of
framing the decision
 When organ donation is the default option, one might consider the
notion of retaining one’s organs after death to be relatively small
given the loss in benefits to others

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 Default options – by serving as the reference point
– can influence individual preferences

 In the next figure, we display indifference curves resulting

from two possible reference points….

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 y

y1r

v  x, y | x1r , y1r   k1
y2r

v  x, y | x2r , y2r   k2

x1r x2r
x

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

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

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 Interesting to note, people make consistent choices when
choices are made simultaneously under the same reference
point
 Thus, once the reference point or anchor is set for a group of
decisions, the person reacts to tradeoffs in a way that mimics
rational decision making

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 Natural Experiment (Madrian and Shea, 2001)
 Inadequate savings by Americans is a huge problem – nearly
50% of Americans exhaust their savings before they die
 Madrian and Shea examined the enrollment of employees at a
particular firm in 401(k) retirement program (think of NPS for
India)
 Program requires some minimum level of contribution by
employees from their regular paycheck; matched by employer
 Design: Authors looked at a particular firm that changed their
retirement savings program default – from opt-out to opt-in
 Result: Changing the default increased participation by 50%

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 Default option bias is a special case of the status quo bias
 If people have been in a particular state for a long time, they might
take this state as the reference point (by default)
Research (Samuelson and Zeckhauser, 1988)
 Analysis of health insurance plan choices among employees at
Harvard University
 Over time. Harvard University had expanded the plan options
available to staff
 Of the continuing staff members, only 3% changed their plan in
any given year
 However, new employees were very likely to select plans that
were not previously available (the proportion was much more
than the continuing employees)
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 Switching Costs
 Exploration Costs
 Switching health plans can result in needing to find a new primary
care physician
 The investment of time and resources in developing a working
relationship with the previous physician would be lost

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 Notes:
 Using default options to shape behavior and preferences
might be useful from policy/business perspective but also has
limitations
 What if the default options were relatively onerous, if there
some hassle involved in switching options, or if the use of
defaults was so pervasive as to become an annoyance?
 You might become annoyed if, by default, your account was
debited Rs. 200 and you were delivered a chicken sandwich every
day at noon if you did not call by 7.00 AM to express your wish for
a different time
 Further, defaults are primarily effective where no preference
has been formed, or there is no strong preference between
the options

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 On the landing page, there are a couple of clear examples of default
selections:
 The option for ‘paperback’ has been pre-selected
 The option to buy the new version of the book is pre-selected, and
positioned far higher on the page than the option to buy a used version
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(this option is not in the screenshot)
 The next stage of the ecommerce process is the confirmation
stage. The page automatically redirects upon the user clicking
‘buy now’ on the product page
 The default choice on this page is more the absence of choice —
note the ‘this is a gift’ tick-box is unticked as standard.

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 Finally, Amazon is reducing friction by utilising automation to set
defaults for the consumer. Delivery address, payment card and
delivery options (usually Amazon Prime Delivery for members)
are all pre-selected for the consumer
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 By using carefully thought-out defaults, Amazon is not only
shortening the purchase journey time, the pre-populated
shortcuts also are reducing cognitive load
 Furthermore, by not asking the user to input their card details,
Amazon is tapping into the cashless effect — the ‘pain of
payment’ is eliminated by the assumptive use of a default
payment card

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 In the early 1980s, after years of soda supremacy,
Coca-Cola was rapidly losing market share to
Pepsi and diet soft drinks. The aging baby
boomers were turning to diet beverages to help
them stay in shape, and the younger generation
was gravitating towards Pepsi’s sweeter, smoother
taste. To save the company, Coca-Cola executives
needed to step into the future.
 After formulating their new recipe, they
conducted several blind taste tests, which were an
overwhelming success. By a wide margin, New
Coke’s sweeter taste was preferred to the classic
concoction. In fact, New Coke was so good that a
bottling company threatened to sue Coca-Cola if
they didn’t put out the drink. Proud of their
creation, Coca-Cola remodeled the bottle, paid
for an expensive advertising campaign, and
slapped the label “New!” on the top corner of
every bottle. 34
 Despite all of the metrics, industry experts,
and executives singing its praises, the release
of New Coke was a colossal failure. Shortly
after the release, the company’s hotline
received over 40,000 outraged calls, around
1100 more each day than before the change.
Public protests, boycotts, and critics that
ranged from David Letterman to Fidel Castro
all lambasted the change.
 How was this possible? According to
Samuelson and Zeckhauser (1985), status quo
bias was at fault. By all metrics, New Coke
was objectively better. However, the taste
tests the marketing department made were
blind, as consumers were not made aware of
which coke they were drinking. In the real
world, once the distinction of “New” was
made, Coke drinkers opted towards the
default Coke Classic 35
 Unlike the rational model, people’s choices often depend on
the current reference point, where their preferences are kinked

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1. How does default effects matter in programs to encourage
more milk drinking in children?
2. Why is it that people don’t change jobs very much even
though they could make more money?
3. Should a store offer in-store demonstrations or offer money
back guarantees?

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