The Behavioural Economics

Revolution?

Chris Starmer

TSU Short course in Experimental and Behavioural

Economics, 5-9 November 2012
 Overview of Sessions
1. The Behavioural Revolution in Econ
2. The Experimental Economist
3. Individual Decisions
4. Strategic Decisions
5. Markets
 Rules of Engagement
• Do ask questions if you want
• Access to slides
• References
Behavioural Economics is Popular
• Gaining momentum
– Economic theory, Applied economics, Policy
circles, Media discussions, Private enterprise
• So what is it?
– How does it differ from conventional Econ?
• Is it the future of economics (or a fad)?
• Should we welcome it?
 So What is BE?
• No single definition
– For e.g’s - Google: Colin Camerer, Richard
Thaler, George Loewenstein
• Common assertions – what it is:
– More ‘realistic’ psychological foundations for
economics
– Bounded Rationality
• Common claims – what it does:
– More ‘realistic’ theories
– Improved prediction of human behaviour
– Useful policy tools (cheap/effective)
 Popular science summaries

Great summary

Implications for Policy

 BE - Scientific Revolution?
• Changing character of economics
• How, as economists, we think
about:
–Evidence
–Theory
–Rationality
 Evidence
“Experimental Turn” in Economics
– Explosion in Experimentation (since 1980s)
– Fundamental to development of BE

“It is rarely, if ever, possible to conduct

controlled experiments with the
economy. Thus economics must be a
non-laboratory science.”
Richard Lipsey (1979) An Introduction to
Positive Economics
Two classic experiments
• Individual preferences
– The endowment effect
• Social Preferences
– The pull of the crowd

• Both very simple

– Maybe you could
have done it if you’d
thought of it first!
 Jack Knetsch
(American Economic Review, 1989)
What proportion of people prefer
mugs to chocolate bars?

Give up mug to get chocolate?

(89% prefer mugs, n=76)

Give up chocolate to get mug?

(10% prefer mugs, n=87)

“Endowment Effect”
 Pull of the crowd
• Bryan, J.H. and Test,
M.A. (1967) “Models
and helping:
naturalistic studies in
aiding”, Journal of
Personality and Social
Psychology, 6, 400-7.
 Impact of Experimentation
• Produced Many ‘ANOMALIES’
• Patterns of behaviour
• Influences on behaviour
– Surprising (relative to std Econ Theory)
• Examples
– Time and Risk Responses
– Social Preferences (altruism, reciprocity)
– Myopia, Status quo bias
– Partial information
– Context sensitivity of choice
– Experience matters
From anomaly to (behavioural) theory

Anomalies New Theories

(many)

Experiments testing
new theories

Some successes
e.g. “Prospect Theory”
Kahneman/Tversky
Leading to New Breed(s) of Theory

• Empirically Grounded (vs axiomatic)

• More “realistic” psychological foundations

• Bounded Rationality vs Full Rationality

More ‘realistic’ assumptions

Realistic about what?

Two key dimensions –

Preferences and Reasoning
 Preferences
• Individual • Social preferences
preferences – Egoism
– Risk – Fairness
– Time – Reciprocity

e.g. ‘prospect theory’ e.g. ‘Theory of fairness,

Kahneman & competition and
Tevrsky cooperation’ Fehr &
(Econometrica,1979) Schhmidt (QJE, 1999)
 Reasoning
• Cognitive limitations • Abilities
– Calculating ability
– Speed
– Myopia
– Memory – Adaptability

Bounded Rationality:

Herbert Simon , ‘How to decide what to do’, Bell Journal, 1978.

Giggerenzer, Tod, ABC, Simple Heuristics That Make us Smart,

Oxford, UP 2000.
Bounded Rationality in a Nutshell
• Because of:
– Limits of computational capacity (e.g. Memory)
– Costs of deliberation (e.g. time)
• Agents develop/use:
– decision heuristics, rules of thumb
• Rules of thumb, help agents navigate complex world
• Sometimes
– Rules of thumb lead to suboptimal decisions
– But also support fast effective decisions
Who’s the best driver: economicus or
heuristicus?

Simple Heuristics That Make Us Smart

Gigerenzer et al, OUP, 1999
 Session 1 - Part II

Behavioural Economics in Action

(i) A classic Theory
(ii) Some Applications
 (i) A classic model in
Behavioural Economics
Prospect Theory, Kahneman and
Tversky, Econometrica, 1979
Prospect theory - Background
• Theory of Decision Under Risk
• Competitor to Expected Utility Theory
• One of most highly cited papers in economics
– (Google Scholar: 24k+ Cites, Nov 2012)
• Often cited as key development in ‘behavioural
economics”
– Kahneman shared Nobel prize, 2002
• Aspects of prospect theory becoming
‘mainstream’? (e.g. loss aversion)
A thoroughly behavioural theory
• Built from experimental evidence
– Anomalies relative to standard theory
• Informed by psychological theory
– E.g. Psychophysics of perception
• Features assumptions about both
– (limitations of) Reasoning
– Non-standard preferences
• Claims improved predictive power
– Relative to expected utility theory
 Structure of PT
• Theory of choice among risks or “prospects”
– Prospect is prob. Dist. over consequences
(p1, x1; p2, x2.........pn, xn)

• “Two Step” Theory

– Step 1: ‘editing’
– Step 2: ‘evaluation’
 Editing Step

• Before evaluating prospects individuals

‘edit’ choice set
• Editing involves (simplification)
heuristics:
• e.g.1. rounding outcomes/probs
• e.g.2 ignoring v. small prob events
• e.g.3 elimination of (transparent) dominance
 Example: Choose A or B
Option A
90% white 6% red 1% green 3% yellow
$0 win $45 win $30 lose $15
Option B
90% white 7% red 1% green 2% yellow
$0 win $45 lose $10 lose $15
Tversky and Kahneman, 1986: 58% chose A
Rearrange the information
90% white 6% red 1% green 1% blue 2% yell

A: $0 win $45 win $30 lose $15 lose $15

B: $0 win $45 win $45 lose $10 lose $15

Easy to see that B dominates A

Using second ‘framing’ everyone chose B (n=88)
 Evaluation Step
Uses (Non-standard) preference function
applied to edited choice set

(Roughly) Max V(q) =  (pi)v(xi)

(pi) is a “probability weighting” function

v(xi) a utility function on outcomes

EUT is Special case where

(pi)=p and V(.) is vNM utility function
 Evaluation is….
Model of maximisation, but…..
Incorporating (empirically grounded)
assumptions about human perception:
1) probability ‘distortion’
2) loss aversion
Common interpretation is that these are
‘biases’ relative to optimal decisions
 Probability distortion
(p)
• PT assumes
Overweigthing ‘small’ p
Underweighting ‘large’ p
Support
Psychophysics
Field evidence
Gambling
Risk assessment
Provides fit to ‘anomaly
evidence’

p
 The Value Function
• Built on three main ‘psychological’
assumptions:
– Carriers of value are changes relative to a
reference point
– Gains and losses evaluated separately
– “Loss aversion”
• losses loom larger than gains
 Value of Δx
on gain scale

-Δx
+Δx
Value of Δx
on loss scale
Assessment of Prospect theory
• More ‘realistic’ decision model
– surely, people do simplify complex decisions
– Considerable evidence of loss aversion,
probability distortion
• Some additional predictive content
– More complex model
• Spawned a large research programme
– Developing and testing PT
– Using it to explain field phenomena
 Applications

Behavioural Economics in the wild

 Prospect theory in the Wild:
Predicting Investment
• The Equity Premium • Benartzi/Thaler,
Puzzle Quart. J. Econ, 1995.
– Excess return of stocks – Loss Aversion
over bonds (long run) – Myopia
– Why do people invest
so much in safer
assets?
 BE and Public Policy
Policy makers have become interested in BE
Because maybe it helps explain why people do
‘suboptimal things’
–Not save enough, drink too much, drive too
fast, waste things (Energy, water, food)
•Might help identify (cheap but effective)
new tools for policy intervention
–The ‘Nudge’ agenda
“Our government will find intelligent ways to
encourage, support and enable people to make
better choices for themselves.”
Benartzi and Thaler, JPE, 2004
• Companies concerned re low level of employee
savings
– not increasing in line with income growth
• Prescriptive savings program (Smart)
– based on findings of behavioural economics
• “Status quo bias”
– pre-commit to savings increases out of future income
growth
• Opt out facility (instead of opt in)
• Increased savings rate from 4% to 12% over 2 year
period
Encouraging repayment of court fines CabinetOffice
Behavioural Insights Team

Source: Behavioural Insights Team & HMCTS, 2012

Encouraging repayment of court fines CabinetOffice
Behavioural Insights Team

Source: Behavioural Insights Team & HMCTS, 2012

 That’s it

Tomorrow – the experimental

economist