Behavioral Economics

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Behavioral Economics

• So far, we have assumed utility maximizing
  behavior or profit maximizing behavior on the
  part of economic agents.
• Economic agents make mistakes. Do we learn from
  those mistakes? Mistakes do not necessarily
  violate the assumption of utility or profit
  maximization.
• However, if we continue to make the same
  mistakes, or, if people make mistakes in the same
  way, then the assumptions of utility maximization
  or profit maximization may be suspect.
• Behavioral economics is an attempt by some
  researchers to redefine economic decision-making
  with a psychological foundation.
• Behavioral economics accounts for behavior like
  procrastination, self control, envy, revenge,
  love, the madness of crowds, bandwagon effects,
  snob effects, etc.

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Some researchers in behavioral economics and
behavioral finance

• Daniel Kahneman (economist) and Amos Tversky
  (psychologist) Econometrica (1979) Prospect
  Theory An Analysis of Decision under Risk in
  Kent Library
• Richard Thaler (economist)- The Winners Curse
  Paradoxes and Anomalies of Economic Life - in
  Kent Library..Nudge, In Kent Library.
• Robert Shiller (financial economist)-Irrational
  Exuberance -in Kent Library
• Matthew Rabin-(economist) Incorporating Fairness
  into Game Theory and Economics The American
  Economic Review, 1993. In Kent Library

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Some perceived regularities in decision-making
that seem to be inconsistent with utility
maximization.

• Framing Effects-frame is the combination of
  beliefs, values, attitudes, mental models, and so
  on which we use to perceive a situation. We
  effectively look through this frame in the way we
  would look through tinted spectacles. The frame
  significantly effects how we infer meaning and
  hence, understand the situation.
• Kahneman and Tversky defined a decision frame as
  the decision-makers conception of the act,
  outcomes and contingencies associated with a
  particular choice.

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• Tversky and Kahneman told people to assume there
  was disease affecting 600 people and they had two
  choices 
• Program A, where 200 of the 600 people will be
  saved .
• Program B, where there is 33 chance that all 600
  people will be saved, and 66 chance that nobody
  will be saved. Expected value of program B is
  200 lives saved (and 400 people will die).
• The majority of people selected A, showing a
  preference for certainty or risk aversion.
• They then offered them another two choices
• Program C, where 400 people will die, 200 people
  live.
• Program D, where there is a 33 chance that
  nobody will die, and 66 chance that all 600
  people will die. Expected value of D is 200
  people live and 400 people die. Same as program
  B.
• Most people now selected D, seeking to avoid the
  loss of 400 people.
• Notice how the framing makes the difference.
  Prospects A and C are the same, and B and D are
  the same.
• Framing the prospect as a gain makes people risk
  averse. Framing the prospect as a loss makes
  people risk takers.

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• Anchoring effects-Initial impressions become
  reference points that anchor subsequent thoughts
  and judgments.
• Salesperson has three items for sale-expensive,
  medium high priced, and cheap. Show the customer
  the expensive item first, which acts as an
  anchor. Makes it easier to sell the medium high
  priced item.
• Dramatic or easy-to-recall events often become
  strong anchors. For example, the vividness of the
  horrible events of September 11 caused many to
  view airline travel as too risky, but many
  experts believe that travel has never been safer.

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• The endowment effect-Once people possess an item
  they frequently will not accept a money amount
  greater than the amount the individual originally
  paid for the item. An example Some people
  wont throw away junk, but store it in storage
  units etc.

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• Endowment effect often arises because of loss
  aversion.
• Loss Aversion The disutility of giving up an
  object is greater than the utility associated
  with acquiring it.
• Examples
• People are often reluctant to sell a stock that
  has performed poorly until it is back to the
  price it was originally bought at.
• Battered women often return to jerks who beat
  them.
• You want to sell your house which you bought for
  105,000. However, given current market
  conditions, your house is only worth 100,000.
  You receive an offer for 100,000. Interest
  rates are 7. You turn down the offer. You
  correctly assume you will receive an offer for
  106,000 one year from today.

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• Status Quo Bias One implication of loss aversion
  is that individuals have a strong tendency to
  remain at the status quo, because the
  disadvantages (or disutility) of leaving it loom
  larger than advantages (utility).
• An implication of the endowment effect is that
  people treat opportunity costs differently than
  out-of-pocket expenses.
• Foregone gains are less painful than perceived
  losses.

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• Fairness and the Pareto Principle
• The Pareto principle if a trade makes at least
  one person better off and no one worse off then
  the trade is Pareto improving.
• Experiment two individuals have to decide how
  to distribute a given amount of money between
  themselves. If they can agree, they get to
  divide the money as to their agreement.
• Person D (the dictator) makes a proposal. Person
  C (the citizen) either agrees or disagrees. If C
  agrees with the proposal then the proceeds are
  divided. If C disagrees, then C and D get
  nothing.

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• Prospect theory vs. Expected utility theory
• Expected utility theory suggests that individuals
  can determine expected values of risky prospects
  and make choices consistent with utility
  maximization.
• Prospect theory-people are not good intuitive
  statisticians. Likely outcomes are estimated to
  be less probable than they really are and
  outcomes that are quite unlikely are typically
  estimated to be more probable than they are.
  Furthermore, people often behave as if extremely
  unlikely, but still possible, outcomes have no
  chance whatsoever of occurring.

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Linda is 31 years 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 she
participated in anti-nuclear demonstrations.
Which of the following statements are more
probable?

• A. Linda is a teacher in an elementary school.
• B. Linda works as a bank teller.
• C. Linda is active in the feminist movement.
• D. Linda works in a bookstore.
• E. Linda is a member of the League of women
  voters.
• F. Linda takes yoga classes.
• G. Linda is an insurance salesperson.
• H. Linda works in a bookstore, takes yoga
  classes, and is active in the feminist movement.

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• Perceptual Contrasting Effects-When we make
  decisions, we tend to do it by contrasting
  between the decision item and reference items.
  When two things appear close to one another, we
  will tend to evaluate them against one another
  more than against a fixed standard.
• When you meet two other people, you are likely to
  compare each against the other on several
  dimensions to decide whom you prefer. This may
  include physical beauty, similarity of interests,
  and various personality factors. 
• A simple physical way of illustrating perceptual
  contrast is to put one hand into hot water and
  the other into cold water, then move both hands
  to lukewarm water. The cold hand will feel hot
  and the hot hand will feel cold.
• To make something look good, first show something
  of inferior quality. Or, to get someone to buy
  something expensive, first show them something
  even more expensive.

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• Self control and gift giving-The economics of
  Christmas-
• Some economists (but not me) would argue that
  there is a deadweight loss to Christmas. People
  prefer money so they can buy what they want,
  rather than the gift which frequently has a lower
  marginal utility value than money.

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• Consider the dilemma of a couple who enjoy
  drinking a bottle of wine with dinner. They might
  decide that they can afford to spend only 10 a
  night on wine and so limit their purchases to
  wines that cost 10 a bottle on average, with no
  bottle costing more than 20.
• This policy might not be optimal in the sense
  that an occasional 30 bottle of champagne would
  be worth more than 30 to them, but they don't
  trust themselves to resist the temptation to
  increase their wine budget unreasonably if they
  break the 20 barrier.
• An implication is that this couple would greatly
  enjoy gifts of wine that are above their usual
  budget constraint.
• Instead the mental accounting analysis suggests
  that the best gifts are somewhat more luxurious
  than the recipient normally buys, consistent with
  the conventional advice (of non-economists),
  which is to buy people something they want, but
  wouldn't buy for themselves.

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Other self-control problems

• If we expand the choice set (the budget set) that
  individuals face are they better or worse off?
• Is it appropriate to give gifts of food to a
  person who is trying to diet and lose weight?
• Should we offer an alcoholic a drink?
• Should we take a compulsive gamble to a casino to
  see a show?

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Public Policy and Self-Control

• Programs such as food stamps and other welfare
  programs expand the choice set of individuals who
  receive those benefits.
• Does it make them better off?
• Many poor individuals have the worst problems
  with self-control.
• They have very high discount rates and care about
  the present more than the future.

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Current consumption
B
C
A
U15 utils
U10 utils
Future Consumption
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• Welfare programs expand an individuals choice
  set.
• If the person is already at B because they
  irrationally (or irresponsibly) make decisions,
  then an expansion of their budget set might allow
  them to be even more irrational and move toward
  C.

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• Time inconsistency
• Hyperbolic discounting-people generally prefer
  smaller, sooner payoffs to larger, later payoffs
  when the smaller payoffs would be imminent but
  when the same payoffs are distant in time, people
  tend to prefer the larger, even though the time
  lag from the smaller to the larger would be the
  same as before.
• When given a choice, some people would prefer 50
  today to 100 one year from now, but would choose
  100 six years from now versus 50 five years
  from now.
• Eat, drink, and be merry, for tomorrow you may
  die.

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• Lots of people want the IRS to withhold more than
  they owe in taxes so they get a big refund check.
  This behavior amounts to giving the IRS an
  interest free loan.
• School teachers who work 9 months are given the
  option of receiving their salary over 9 months or
  over 12 months. Many choose the 12 monthly
  checks because they dont trust themselves.
  They lose interest income.
• Before you choose a college think of the
  reputation the college has is it a diploma mill
  or does it require hard work?
• Most people prefer the college to have a good
  reputation, but once they arrive, they often
  prefer easy classes.

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• Availability bias-Kahneman and Tversky-People
  seem to judge the odds of a given event occurring
  based on how readily an example comes to mind.
• Acquiring information is costly and people look
  for shortcuts.
• Imagine a situation in which gifts are being
  distributed in red and blue boxes. You don't
  know what the boxes contain, but everyone is
  asking for a red box. Therefore, you ask for a
  red box too, assuming they must know something
  you don't and because you want to appear "in the
  know" too.
• This case is rational herding or kind of like the
  band-wagon effect. Now, consider that everyone
  was thinking just like you, and that the chain
  began only because a prominent individual was
  seen picking a red box.

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• When asked to rate the probability of a variety
  of causes of death people tend to rate
  "newsworthy" events as more likely.
• People often rate the chance of death by plane
  crash higher after plane crashes, and death by
  natural disaster as too likely only because these
  events are reported more often than common causes
  of death.

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• Confirmation bias-People look for examples and
  anecdotes that confirm their prior beliefs.
• Example I think that my dreams and nightmares
  foretell the future. I have a dream and the next
  day it comes true confirming my prior belief.
  However, I ignore all the times my dreams dont
  come true.
• After people buy a new car they eagerly read the
  advertisements for that car  - the ads, of
  course, confirm that their purchase was a good
  one.

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A Non-exhaustive summary of behavioral effects

• Framing Effects
• Endowment Effect
• Fairness and the Pareto Principle
• Prospect Theory
• Perceptual Contrasting Effects
• Self-control and gift giving
• Time Inconsistency
• Availability bias
• Confirmation bias