Chapter Two
Introduction to
Behavioral Economics
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Behavioral Economics
• The model of economic behavior we have considered in this chapter is restrictive
in a number of ways
• Economic agents are assumed to be perfectly rational
• Agents are assumed to perfectly understand risk and uncertainty
• Agents are assumed to be “self-interested”
• In reality, people exhibit a number of departures from this “rational agent” model
of decision-making
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Cont --
Behavioral economics – Branch of economics that incorporates insights from human
psychology into models of economic behavior.
• Used to help us understand why our models may not make the predictions we think they
should in some cases.
• Behavioral economics is concerned with systematic departures from rational choice.
• Behavioral economists attempt to identify systematic “biases”
• Departures from rational choice can inform the development of more general,
descriptive models of economic behavior.
• Models can be used to develop testable hypotheses and predict economic behavior.
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When Human Beings Fail to Act the Way
Economic Models Predict
Some systematic departures from rational choice are:
• Bias 1: Generosity and Selflessness
• Bias 2: Paying Attention to Sunk Costs
• Bias 3: Overconfidence
• Bias 4: Self-Control Problems and Hyperbolic Discounting
• Bias 5: Falling Prey to Framing – introduction example
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Bias 1: Generosity and
Selflessness
Economic model of rational choice assumes “rational self-interest,” many people
often engage in acts of generosity and exhibit altruism (humanity).
Acts motivated primarily by a concern for the welfare of others; Donations to
charity are the most obvious example
• Economists have tried to include this in the model for example by adding
someone else’s consumption into your utility function.
• For example, the parent’s utility depends on the child’s consumption
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Bias 2: Paying Attention to Sunk Costs
• Rational decision makers think at the margin and only consider opportunity costs.
• Sunk Cost Fallacy: However, in reality, people are influenced by sunk costs in their
decision-making.
• 1985 Experiment: randomized how much people paid for seasons tickets to Ohio
University Theater ($9, $13, $15).
• If the the sunk cost doesn’t matter (price of ticket) then the percent of people who
go to the show from each group should be the same.
• But it wasn’t. Those who paid more were 25 percent more likely to go than
those who got a discount.
• Businesses or gov’t can make similar mistakes by keeping on implementing a
project that is way over cost and they can’t afford even though they may be just 10
percent into the project and would be better of abandoning the project.
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Bias 3: Overconfidence
• Individuals believe their skill level and judgment are better than they truly are, or
they expect that outcomes are better for them are more likely to happen then they
truly are.
• Numerous studies have shown that humans tend to overestimate positive attributes
about themselves
• In one survey, 93% of college students said they were “better than average”
drivers
• On a popular dating website, 73% of individuals describe themselves as
having “very good” or “better than average” physical attractiveness
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Bias 3: Overconfidence
• Problem: our models assume people have a realistic expectations and base their decisions
on facts.
– Company managers confident in their own abilities maybe more inclined to make
bigger investments and take on more risk in the overconfident view they will succeed.
How Economic Markets Take Advantage of Overconfident People
• Firms take advantage of overconfidence
Consider gym memberships: Why do gyms charge monthly memberships instead of
per-visit fees?
• Individuals who sign up for a health club tend to be far too optimistic about the prospects
of sticking to their exercise goals
• Health clubs tailor their offerings to exploit such over optimism
• Charging monthly fees allows health clubs to extract surplus from over-optimistic clients
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Bias 4: Self-Control Problems and Hyperbolic Discounting
• People have a strong preference for NOW
• A 10% discount rate implies that $1.00 today is equivalent to $0.90
next year.
• There is evidence that many people have a much higher discount rate
when making decisions about immediate consumption
Hyperbolic discounting – Tendency of people to place much greater
importance on the immediate present than even the near future when
making economic decisions
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Bias 4: Self-Control Problems and
Hyperbolic Discounting
Problem: Decisions stop being time-consistent
• Consistencies in a consumer’s economic preferences in a given economic
transaction, whether the economic transaction is far off or imminent
• When consumers are not time-consistent, they will, for instance, specify their
preferred exercise and diet routine for next week now, but then when they get to next
week, they won’t want to stick with the plan they set up
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Does Behavioral Economics Mean Everything
We’ve Learned Is Useless?
• While the rational-choice model is not perfect, it does an excellent job of
predicting human behavior in many circumstances
• This model can often be generalized or otherwise extended to account for
behavioral anomalies (irregularities).
• Provides a basis for thinking about seemingly irrational behavior, often
illuminating rational motivations (e.g., conspicuous charitable donations that
improve reputation)
• Regardless of individual behavior, markets tend to be coldly rational
• Exposure to markets has been shown to reduce the presence of biased actors
and/or behavior
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Testing Economic Theories with Data: Experimental
Economics
• The evidence from psychology and behavioral economics has placed an even
greater emphasis on the importance of testing economic models with real data
• However, analyzing economic decisions in the real world is very difficult.
• In response, two subfields of economics have emerged as leaders in the evaluation
of economic models: econometrics and experimental economics
• Econometrics: Field that develops and uses statistical and analytical techniques to
test economic theory
• Experimental economics: Branch of economics that relies on experiments to
illuminate economic behavior
• These two fields have helped turn economics into a more evidence-based science
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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
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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, thus not representative of the general
population
• Also inexperienced at making economic decisions
• Scale of any given experiment is limited by the available resources
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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
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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 $3.40 and a high stakes bet at
$3.60
• Chooses the low stakes bet
• Include $3.50 as a third choice; no way to rank these
three options from best to worst
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Figure 13.1: 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
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Table 13.1: Inconsistent Choices
• In 276 comparisons of high stakes and low stakes bets, 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, the value of the
high stakes bet was considered higher!
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Figure 13.2: A Choice Reversal
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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, 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
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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
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Bias Toward the Status Quo: Default Effect
• When confronted with many alternatives, 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 $1.50 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 decision-making rise as number
of alternatives rises, increasing number of people who accept the default
• Retirement saving example illustrates the default effect when the stakes are high
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Narrow Framing
• Narrow framing is the tendency to group items into categories and, when making
choices, 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. losing the ticket on the way in
• Calculator and jacket example, decisions about whether to drive 20 minutes to save
$5
• These choices may be mistakes or may reflect the consumers’ true preferences
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Narrow Framing
• Q1: Imagine you have decided to see a play where
admission is $10. As you enter the theatre you discover
that you have lost a $10 bill. 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. Would you buy a new ticket to see the play?
• 88% say yes to Q1 and 56% to Q2
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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. 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. The calculator salesman informs you
that a store 20 minutes away offers the same calculator
for $120. Would you make the trip to the other store?
• 68% say yes to Q1 and 29% to Q2
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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, such as
expected future income
• Popular rules may be choices that are nearly optimal, using one is not necessarily a
mistake
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Choices Involving Time
• Many behavioral economists see standard theory of decisions involving time as
too restrictive, it rules out patterns of behavior that are observed in practice
• For example, 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, if you paid more for something, it must
be more valuable to you
• Projection bias is the tendency to evaluate future consequences based on
current tastes and needs
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The Problem of Dynamic Inconsistency
• Thought to reflect a bias toward immediate gratification, 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
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The Problem of Dynamic Inconsistency
• Save More Tomorrow (SMART) plans
• The earlier option is chosen more frequently the shorter the delay
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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, 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
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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, suggesting risk-averse preferences
• Option C: Win $5
• Option D: Win $5,000 with 1/1000 probability
• A sizable majority picks Option D over C, which is puzzling because
the choice suggests risk-loving preferences
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Extreme risk aversion
• Option A: Win $1,010 with 50% probability and lose $1,000 with 50%
probability
• Most people refuse this gamble
• Option B: Win $10.10 with 50% probability and lose $10.00 with 50%
probability
• Most people refuse this gamble too, suggesting extreme risk aversion
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Prospect Theory: A Potential Solution
• Proposed in late 1970s by two psychologists, 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, including
the two on previous slide
• Remains controversial among economists
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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
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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)]
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Prospect Theory
• W(P) is the weight (or, importance) a consumer assigns to the
probability P. 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. It is called the valuation
function.
• This is the same as the befit function in expected utility theory,
except that it is asymmetric. Loss aversion and diminishing
sensitivity are built in.
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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
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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, predictions based on
standard game theory are far off
• Assumptions about players’ preferences may be incorrect
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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, 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
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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, the pie is divided as specified; if she rejects, both players
receive nothing
• Theory says the proposer will offer a tiny fraction of the prize; the recipient will
accept
• Studies show that many subjects reject very low offers; the threat of rejection
produces larger offers
• In social situations, emotions such as anger and indignation influence economic
decisions
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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, 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, trustors received about $0.95 in return for every dollar invested
• Many (but not all) people do feel obligated to justify the trust shown in them by
others, thus many are willing to extend trust
• This game helps us understand why business conducted on handshakes and verbal
agreements works
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