Behavioral Economics

ECO 61 Microeconomic Analysis Udayan Roy December 2008

Main Topics
• Objectives and methods of behavioral economics • Departures from perfect rationality • Choices involving time • Choices involving risk • Choices involving strategy

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Motivations and Objectives
• The two main motivations for behavioral economics concern apparent weaknesses in standard economic theory:
– People sometimes make choices that are difficult to explain with standard economic theory – Standard economic theory can lead to seemingly unreasonable conclusions about consumer welfare

• Behavioral economics grew out of research in psychology • The objective is to modify, supplement, and enrich economic theory by adding insights from psychology
– Suggesting that people care about things standard theory typically ignores, like fairness or status – Allowing for the possibility of mistakes

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Methods
• Behavioral economics uses many of the same tools and frameworks as standard economics
– Assumes individuals have well-defined objectives, that objectives and actions are connected, and actions affect well-being – Relies on mathematical models – Subjects theories to careful empirical testing

• Important difference is use of experiments using human subjects • Behavioral economists tend to use experimental data to test their theories rather than drawing data from the real world

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Advantages of Experiments • Easier to determine whether people’s choices are consistent with standard economic theory by ruling out alternative explanations • Often easier to establish causality • Researchers can double-check their assumptions and conclusions by testing and debriefing subjects • Often possible to obtain information that isn’t available in the real world 13-5 .

thus not representative of the general population – Also inexperienced at making economic decisions • Scale of any given experiment is limited by the available resources 13-6 .Disadvantages of Experiments • Decisions made in the lab differ from decisions made in the real world • Introduce influences on decision-making that are hard to measure or control – Strong evidence that subjects often try to conform to what they think are the experimenter’s expectations • Most subjects are students.

Evaluating Behavioral Evidence • Critical questions about behavioral research that appears inconsistent with standard economic theory: – Is the evidence convincing? Was the experiment welldesigned? – Is the observed behavioral pattern robust? – What are the possible explanations? Can we reconcile this with standard theory? – If theory appears to fail in a significant situation. how should we modify the theory? 13-7 .

Are we predictably irrational? • It is not surprising that we are not always perfectly rational • But are our departures from perfect rationality completely random? • Or are these departures predictable? • If we can find predictable patterns of irrationality in human behavior. then we can improve economic theory .

60 – Chooses the low stakes bet • Include $3.40 and a high stakes bet at $3. no way to rank these three options from best to worst 13-9 .50 as a third choice.Incoherent Choices: Choice Reversals • Laboratory subjects sometimes display incoherent choice behavior • Circular choices indicate preferences that violate the Ranking Principle • Example: a participant in an experiment – Values a low stakes bet at $3.

1: Inconsistent Choices • Laboratory subjects sometimes display incoherent choice behavior • Circular choices indicate preferences that violate the Ranking Principle • Experiments suggest that these inconsistencies arise often 13-10 .Figure 13.

1: Inconsistent Choices • In 276 comparisons of high stakes and low stakes bets.Table 13. the value of the high stakes bet was considered higher! . people preferred the low stakes bet 99 times and the high stakes bet 174 times • But in 69 of the 99 cases in which the low stakes bet was preferred.

Figure 13.2: A Choice Reversal 13-12 .

by suggestion – Skeptics note that subjects had little experience purchasing the goods in the experiment – Might have been less sensitive to suggestion if used familiar products • Significance of anchoring effects for many economic choices remains unclear 13-13 .Incoherent Choices: Anchoring • Anchoring occurs when someone’s choices are linked to prominent but irrelevant information • Suggests that some choices are arbitrary and can’t reflect meaningful preferences • Example: experiment showing subjects’ willingness to pay for various goods was closely related to the last two digits of their social security number.

Anchoring • 55 subjects were shown a series of six common products with average retail price of $70 • For each product. the experiment had three steps: Each participant was asked – his/her SSN – whether he/she would buy the product at a price equal to the last 2 digits of SSN – The maximum he/she would be willing to pay .

Bias Toward the Status Quo: Endowment Effect • The endowment effect is people’s tendency to value something more highly when they own it than when they don’t • Example: experiment in which median owner value for mugs was roughly twice the median non-owner valuation • Some economists think this reflects something fundamental about the nature of preferences • Incorporating the endowment effect into standard theory implies an indifference curve kinked at the consumer’s initial consumption bundle – Smooth changes in price yield abrupt changes in consumption 13-15 .

Endowment Effect • Half the participants were given mugs available at the campus bookstore for $6 • The other half were allowed to examine the mugs • Each student who had a mug was asked to name the lowest sale price • Each student who did not have a mug was asked to name the highest purchase price • Supply and demand curves were constructed and the equilibrium price was obtained • Trade followed • There were four rounds of this .

3: Endowment Effect 13-17 .Figure 13.

50 participation fee rather than trading it for a more valuable prize when the list of prizes to choose from was lengthened • Possible explanation is that psychological costs of decisionmaking rise as number of alternatives rises. people sometimes avoid making a choice and end up with the option that is assigned as a default • Example: Experiment showing that more subjects kept $1. increasing number of people who accept the default • Retirement saving example illustrates the default effect when the stakes are high 13-18 .Bias Toward the Status Quo: Default Effect • When confronted with many alternatives.

Default effect: retirement • Prior to April 1. all employees were by default enrolled in a plan that invested 3% of salary in money market mutual funds • Only the default option changed . 1998. 1998. the default option was nonparticipation in the retirement plan • After April 1.

Narrow Framing • Narrow framing is the tendency to group items into categories and. when making choices. decisions about whether to drive 20 minutes to save $5 • These choices may be mistakes or may reflect the consumers’ true preferences 13-20 . losing the ticket on the way in – Calculator and jacket example. to consider only other items in the same category • Can lead to behavior that is hard to justify objectively • Examples: – Far more people are willing to pay $10 to see a play after losing $10 entering a theater vs.

Would you buy a new ticket to see the play? • 88% say yes to Q1 and 56% to Q2 . Would you still buy a ticket to see the play? • Q2: Imagine you have bought a $10 ticket to see a play. As you enter the theatre you discover that you have lost the ticket. As you enter the theatre you discover that you have lost a $10 bill.Narrow Framing • Q1: Imagine you have decided to see a play where admission is $10.

Would you make the trip to the other store? • Q2: Imagine you are about to buy a jacket for $15 and a calculator for $125. Would you make the trip to the other store? • 68% say yes to Q1 and 29% to Q2 . The calculator salesman informs you that a store 20 minutes away offers the same calculator for $120.Narrow Framing • Q1: Imagine you are about to buy a jacket for $125 and a calculator for $15. The calculator salesman informs you that a store 20 minutes away offers the same calculator for $10.

the length of a cab driver’s shift was negatively related to hourly earnings • Total daily income remained the same .Why you can’t get a cab in NYC when you really need one • On any given day.

200 people will be saved – Under program B. 400 people will die – Under program D. there is a 1/3 probability that no one will die and a 2/3 probability that 600 people will die • 72% prefer A to B and 78% prefer D to C . there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved – Under program C.Salience • Imagine a disease is expected to kill 600 people – Under program A.

such as expected future income • Popular rules may be choices that are nearly optimal. using one is not necessarily a mistake 13-25 .Rules of Thumb • Thinking through every alternative for complex economic decisions is difficult • May rely on simple rules of thumb that have served well in the past • Example: saving – In economic models finding the best rate of savings involves complex calculations – In practice people seem to follow rules of thumb such as 10% of income – These rules appear to ignore factors that theory says should be important.

it must be more valuable to you – Projection bias is the tendency to evaluate future consequences based on current tastes and needs 13-26 . if you paid more for something.Choices Involving Time • Many behavioral economists see standard theory of decisions involving time as too restrictive. theory rules out these three observed behaviors – Preferences over a set of alternatives available at a future date are dynamically inconsistent if the preferences change as the date approaches – The sunk cost fallacy is the belief that. it rules out patterns of behavior that are observed in practice • For example.

know as present bias – A person with present bias often suffers from lapses of self-control • Laboratory experiments have documented the existence of present bias • Precommitment is useful in situations in which people don’t trust themselves to follow through on their intentions • Precommitment is a choice that removes future options – Example: A student who wants to avoid driving while intoxicated hands his car keys to a friend before joining a party 13-27 .The Problem of Dynamic Inconsistency • Thought to reflect a bias toward immediate gratification.

The Problem of Dynamic Inconsistency • Save More Tomorrow (SMART) plans • The earlier option is chosen more frequently the shorter the delay .

The Problem of Dynamic Inconsistency • People often waste expensive gym memberships – The LIU gym plan for faculty .

4: Dynamic Inconsistency in Saving 13-30 .Figure 13.

We should ignore sunk costs but often do not • Uncomfortable shoes • Bad movie rentals • Season ticket discounts lead to lower initial attendance .

Projection bias in forecasting future tastes and needs • Hungry shoppers tend to buy more than sated shoppers when shopping for the week ahead • People tend to underestimate their adaptability to change .

g.Trouble Assessing Probabilities • People tend to make specific errors in assessing probabilities • Hot-hand fallacy is the belief that once an event has occurred several times in a row it is more likely to repeat – Arises when people can easily invent explanations for streaks.. basketball • Gambler’s fallacy is the belief that once an event has occurred it is less likely to repeat – Arises when people can’t easily invent explanations for streaks. e. e..g. e.g.. clearly relevant in context of investing • Overconfidence causes people to: – Overstate the likelihood of favorable events – Understate the uncertainty involved 13-33 . state lotteries • Both fallacies have important implications for economic behavior.

48 home games. 1980-81 season .Hot-hand fallacy • Philadelphia 76ers.

Gambler’s fallacy • A study of nearly 1800 daily drawings between 1988 and 1992 in a New Jersey lottery showed that after a number came up a winner. bettors tended to avoid it .

more than 60% of new entrants exit within five years.Overconfidence • In one study of US students with an average age of 22. 82% ranked their driving ability among the top 30% of their age group • In the manufacturing sector. nearly 80% exit within ten years .

some subjects appear risk loving in gambles with very high payoffs with very low probabilities • Aversion to very small risks: – Many people also appear reluctant to take even very tiny shares of certain gambles that have positive expected payoffs – Implies a level of risk aversion so high it is impossible to explain the typical person’s willingness to take larger financial risks 13-37 .Preferences Toward Risk • Two puzzles involving observed behavior and risk preferences • Low probability events: – Experimental subjects exhibit aversion to risk in gambles with moderate odds – However.

which is puzzling because the choice suggests risk-loving preferences . suggesting riskaverse preferences • Option C: Win $5 • Option D: Win $5.Low probability events grab all the attention • Option A: Win $2.500 • Option B: Win $5.000 with 1/2 probability • Most choose Option A over B.000 with 1/1000 probability • A sizable majority picks Option D over C.

suggesting extreme risk aversion .010 with 50% probability and lose $1.10 with 50% probability and lose $10.00 with 50% probability • Most people refuse this gamble too.Extreme risk aversion • Option A: Win $1.000 with 50% probability • Most people refuse this gamble • Option B: Win $10.

Daniel Kahneman (later won Nobel Memorial Prize in economics) and Amos Tversky • An alternative to expected utility theory • May resolve a number of puzzles related to risky decisions.Prospect Theory: A Potential Solution • Proposed in late 1970s by two psychologists. including the two on previous slide • Remains controversial among economists 13-40 .

Prospect Theory • Expected utility theory: – Evaluates an outcome based on total resources – Multiplies each valuation by its probability • Prospect theory: – Evaluates an outcome based on the change in total resources. judges alternatives according to the gains and losses they generate relative to the status quo – Uses a weighting function exhibiting loss aversion and diminishing sensitivity 13-41 .

Prospect Theory • Consumer starts out with $R • A gamble pays $X1 with probability P and $X2 with probability 1 .P • Will the consumer take this gamble? • Expected utility theory: yes if – U(R) < [P  U(R + X1)] + [(1 – P)  U(R + X2)] • Prospect theory: yes if – V(0) < [W(P)  V(X1)] + [W(1 – P)  V(X2)] .

It is called the weighting function – Note that people tend to assign disproportionate weight to low-probability outcomes • V(X) is the value of $X to the consumer. except that it is asymmetric. Loss aversion and diminishing sensitivity are built in.Prospect Theory • W(P) is the weight (or. – This is the same as the befit function in expected utility theory. It is called the valuation function. importance) a consumer assigns to the probability P. .

Choices Involving Strategy • Some of game theory’s apparent failures may be attributable to faulty assumptions about people’s preferences – May not be due to fundamental problems with the theory itself • Many applications assume that people are motivated only by self-interest • Players sometimes make decisions that seem contrary to their own interests 13-44 .

predictions based on standard game theory are far off • Assumptions about players’ preferences may be incorrect 13-45 .Voluntary Contribution Games • In a voluntary contribution game: – Each member of a group makes a contribution to a common pool – Each player’s contribution benefits everyone • Creates a conflict between individual interests and collective interests • Like a multi-player version of the Prisoners’ Dilemma • Game theory predicts the behavior of experienced subjects reasonably well • For two-stage voluntary contribution game.

not really a game! • Most studies find significant generosity. a sizable fraction of subjects divides the prize equally • Illustrates the importance of social motives: altruism. fairness. status 13-46 .Importance of Social Motives: The Dictator Game • In the dictator game: – The dictator divides a fixed prize between himself and the recipient – The recipient is a passive participant – Usually no direct contact during the game – Strictly speaking.

emotions such as anger and indignation influence economic decisions 13-47 .Importance of Social Motives: The Ultimatum Game • In the ultimatum game: – The proposer offers to give the recipient some share of a fixed prize – The recipient then decides whether to accept or reject the proposal – If she accepts. if she rejects. the recipient will accept • Studies show that many subjects reject very low offers. the threat of rejection produces larger offers • In social situations. the pie is divided as specified. both players receive nothing • Theory says the proposer will offer a tiny fraction of the prize.

trustors received about $0. theory says that trustees will be untrustworthy and trustors will forgo potentially profitable investments • Studies show that – Trustors invested about half of their funds – Trustees varied widely in their choices – Overall. thus many are willing to extend trust • This game helps us understand why business conducted on handshakes and verbal agreements works 13-48 .95 in return for every dollar invested • Many (but not all) people do feel obligated to justify the trust shown in them by others.Importance of Social Motives: The Trust Game • In the trust game: – The trustor decides how much money to invest – The trustee divides up the principal and earnings • If players have no motives other than monetary gain.