Behavioral and Personal Finance

Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 03 : Economics of decision making
 Economics of decision making
 The utility theory
Economics of Decision Making
Neoclassical economics
Individuals as self-interested agents who:
• Attempt to optimize to their best ability in the face of constraints on resources;
• Determine the value/price of an asset subject to the influences of supply and demand.

Underlying fundamental assumptions:

1. People have rational preferences across possible outcomes or states of nature.
2. Economic agents (i.e., people or firms) maximize utility (e.g., happiness or profits).
3. People make independent decisions based on all relevant information.
Economics of Decision Making
Neoclassical economics
Three states of rational preferences:
• One choice is strictly and always preferred (≻) to another;
• Two choices are valued the same, indicating indifference (~) between choices.
• The person has weak preference (≽), that is, is unsure of strict preference or indifference.
People’s preferences are complete:
• All possible choices compared before preference or indifference.
Transitivity exists:
• When confronted with a choice among three outcomes: x, y, and z, where x ≻ y and
y ≻ z, then x ≻ z.
Economics of Decision Making
Neoclassical economics
Utility maximization:
• Used to describe preferences, denoted as u(•) as a utility function;
• Utility as the satisfaction received from a particular outcome.
• Ex.: u(1 Oreo cookie, 2 cups of milk) > u(2 Oreo cookies, 1 cup of milk).
In financial decision-making:
• Making a choice between:
• Spending more now and save less for future, versus
• Spending less now and save more for future.
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 04 : Economics of decision making (cont.)
Economics of Decision Making
Neoclassical economics
In its simplest form, a utility function can be specified mathematically as a logarithmic function.
• E.g., the utility derived from wealth level w is u(w) = ln(w);
Wealth (in $10,000s) U(w) = ln(w)

1 0
2 0.6931
5 1.6094
7 1.9459
10 2.3026
20 2.9957
30 3.4012
50 3.9120
100 4.6052
Economics of Decision Making
Neoclassical economics
Relevant Information:
• People maximizing their utility use full information of the choice set.
• Information available to all economic agents, but for free?
• Not only are there costs associated with acquiring information, but there are also costs of:
• Assimilating and understanding information at hand.
• Bounded rationality (Simon, 1957)
Economics of Decision Making
Expected Utility Theory (EUT)
Decision making under risk and uncertainty
• John von Neumann and Oskar Morgenstern (vNM): attempt to define rational behavior when
people face uncertainty.
• Normative theory: how people should rationally behave.
• Behavioral theory: considering how people actually behave.
• EUT set up to deal with risk, not uncertainty:
• Risky situation: outcome(s) known and we can assign a probability to each outcome.
• Uncertainty: not sure about a list of possible outcomes, cannot assign probability.
• Examples: stock market investments, job interviews, weather forecast.
• Basic idea of utility-based approach of decision making
• Utility theory and economic decision making
• Normative versus positive behavior of economic agents
• Decision-making under risk
• Expected utility theory
• Uncertain situations