EC201: Microeconomic Principles I

1.7 Behavioural economics I

What is behavioural economics?
• “A method of economic analysis that applies psychological insights
into human behaviour to explain economic decision-making”
• or economics with “real humans”
• brings economics and psychology closer together
• has already resulted in two Nobel prizes

• Heavily motivated by lab and field experiments

• Many phenomena under the heading “behavioural economics”
• We explore some of these (from what is now a huge field)

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Behavioural economics I
• Today: core ideas in behavioural economics
• What if people do not behave in their own best interests?
• ‘Decision’ vs ‘experience’ utility; affective forecasting
• What corrective measures can make the market work better for defective
decision-makers? Government intervention?

• Topic 1.8 – Decision-making under uncertainty

• Standard expected utility framework and demand for insurance
• Then further issues in behavioural economics: anomalies in decision-
making; prospect theory

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Motivating example
• Consider a consumer with income 𝑚 facing prices 𝑝! = 𝑝" = 1 with utility
function 𝑢 𝑥! , 𝑥" = 𝜃𝑥! + 𝑥" , so perfect substitutes

!"#
!#$ $$
• 𝑀𝑅𝑆 = !"# = 𝜃, relative price =1
!#% $%

x2 x2 x2
●

●
0 x1 0 x1 0 x1
𝜃<1 𝜃=1 𝜃>1 4
Motivating example
Decision utility:
• When making the consumption decision the consumer believes her utility
function is 𝑢 𝑥! , 𝑥" = 𝜃% 𝑥! + 𝑥" , where 𝜃% > 1
• “Hot State”: where 𝑥! is valued a lot – buys only good 1

Experience utility:
• At the time of consumption itself the utility function is: 𝑢 𝑥! , 𝑥" = 𝜃& 𝑥! + 𝑥" ,
where 𝜃& < 1
• ”Cold State”: where 𝑥! is valued less – would like good 2 but bought good 1!

• You can think of the consumer as having two selves: the “hot self” who likes
good 1 and the “cold self” who likes good 2
Hot and cold states
• Hot and cold refer to emotional (not physical) states

• Effect of emotional states

• getting excited
• feeling down

• Being distracted by payoff-irrelevant cues

• you associate the colour of an object with something nice

• Acting on instinct
• using intuitions rather than thinking things through
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Thinking fast and slow
Danny Kahneman (1933 -)

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Fast or slow?

• This is a metaphor for many instinctive choices we make

• Many are reliable and make us much more efficient
• But they have limited domains of applicability
• And if we make them in the wrong context, they fail us

• So we need to work out when decision-making is reliable and when it

makes big mistakes

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Hot and cold states
• The hot state is when you order unhealthy food
• The cold state is when you are eating and it gradually dawns on you that
you should be eating healthily and hence regret your order

Why have you have made the “wrong choice”?

• Because decision utility differs from experience utility…and well-being is
based on your experience utility.
• You would like to make decisions in the cold state but cannot
• Time-inconsistency
• Affective forecasting - the prediction of one's affect (emotional state) in
the future; prone to bias (see Kahneman and Thaler, 2006)
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Welfare
• If decision-making is in the hot state and consumption in the cold state, the
consumer is in trouble…

• Cold state utility is the true “experience utility”: 𝑢 𝑥! , 𝑥" = 𝜃& 𝑥! + 𝑥"
'
• Actually selected 𝑥! = = 𝑚, so utility is 𝜃& 𝑚 < 𝑚
$$
'
• Should have selected 𝑥" = = 𝑚, to get utility 𝑚
$%

• The welfare optimising consumption bundle is 𝑥! , 𝑥" = 0, 𝑚

• Potential argument for government intervention?

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Implications?
• Free choices made in a market need not be optimal
• we may end up regretting our purchases

• Worse still, markets can take advantage of the way we make decisions
• creating “tempting” products which are bad for us but we buy anyway

• Advertisers understand how to frame-decisions to make us like products

• creating “imagery” to enhance our decision utility

• And some businesses use high-pressure sales tactics to get us to buy

something before we have thought it through
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What solutions?
• Are there market solutions?
• Finding ways of avoiding decisions in the wrong context

• Are there government solutions?

• banning/taxing some products
• regulating ‘choice architecture’
• taxes on high sugar drinks
• “cooling-off” clauses which allow you to change your decision
e.g. cancelling motor insurance, a mobile phone contract or a loan
without penalty within 14 days

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Internalities and market intervention
• We can think of the problem above as an “internality”, a negative externality
on ones future self
• The behaviour of a consumer in the hot state is lowering the utility of their
future self in the cold state

• Back to our example, where in the hot state the consumer buys only good 1
while future self would like to consume only good 2. What can we do?
• Tax good 1 or even ban it?
• Extreme solution… it would have to be really bad for you.
• Requires the state to know best and act in the interests of citizens…
• What about consumers who are not prone to bias?

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Who are the vulnerable consumers?
• Are behavioural biases linked to age, poverty or low education?
• Then intervention could be justified by helping these more deprived groups

• Poverty may also create more stress which impedes cognitive ability
• Poorer individuals may be more inclined to make faulty decisions with
damaging consequences
• Jennifer Sheehy-Skeffington and Jessica Rea at LSE have a very useful
review of the evidence on this
• Decision-making in contexts of poverty serves important immediate
functions, but may have negative consequences for long-term outcomes

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Internalities and market intervention
Individuals of type A:
• Hot State: 𝑢 𝑥! , 𝑥" = 𝜃% 𝑥! + 𝑥" , where 𝜃% > 1
• Cold State: 𝑢 𝑥! , 𝑥" = 𝜃& 𝑥! + 𝑥" , where 𝜃& < 1
“hot self” likes good 1 and “cold self” likes good 2

Individuals of type B:
• 𝜃% = 𝜃& > 1
• Both “hot self” and “cold self” likes good 1

• So taxing or banning good 1 harms type B consumers

• Pareto improvement is not possible
• We need a social welfare function to help us decide if should tax (…LT)
What about targeted interventions?

• Is there a way of influencing A without distorting B?

• Nudges:
• Create a default option of x1 = 0
• Allow A-types to opt out to choose x1 > 0
• Requires effort/thought, so helps one make the choice in the cold state

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The value of commitment
• The cold self would like a way to stop the hot self choosing 𝑥!

• But this means finding a way of prevent wrong decisions

• Maybe you choose a restaurant that only serves healthy food
• You leave your mobile phone in a different room when studying…

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The story of Odysseus and the Sirens

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Clocky
$39.99

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The example of savings
• Do you consume now or later?

• Last lecture we saw a model of borrowing and saving…but will the decision-
maker choose optimally?

• Surveys repeatedly find that the largest regret of older people was not
saving enough, or delaying saving...

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The example of savings
Suppose:
• preferences when young are:
𝑢 𝑐( , 𝑐! = 𝑐( )& 𝑐! !*)&
• preferences when old are
𝑢 𝑐( , 𝑐! = 𝑐( )' 𝑐! !*)'
where 0 < 𝜃& < 𝜃% < 1

• Being young and enjoying consumption now is like being in the “hot state”
• People who get to old age wish they had saved more when they were young!
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Recall:

• With Cobb-Douglas preferences 𝑢 𝑥! , 𝑥" = 𝑥! + 𝑥! !*+

• and budget constraint: 𝑝! 𝑥! + 𝑝" 𝑥" = 𝑚

' '
• Uncompensated demands are: 𝑥! = 𝛼 and 𝑥" = 1 − 𝛼
$$ $%

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Analogously:
• With Cobb-Douglas preferences 𝑢 𝑐( , 𝑐! = 𝑐( )& 𝑐! !*)&

,$ /$
• and budget constraint: 𝑐( + = 𝑦( +
!-. !-.

• Uncompensated demands:
/$
𝑐( = 𝜃% 𝑦( +
!-.
!*)& /$
𝑐! = $⁄ 𝑦( + !-. = 1 − 𝜃% 𝑦( 1 + 𝑟 + 𝑦!
$()

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So…
• When young: 𝑢 𝑐( , 𝑐! = 𝑐( )& 𝑐! !*)& , so chooses:
/$
𝑐( = 𝜃% 𝑦( + !-.
𝑐! = 1 − 𝜃% 𝑦( 1 + 𝑟 + 𝑦!
/$
Saving = 𝑦( − 𝜃% 𝑦( + !-.

• But when old: 𝑢 𝑐( , 𝑐! = 𝑐( )' 𝑐! !*)' , looks back and feels his young self
should have saved more for consumption in old age!
/$ /$
𝑐( = 𝜃& 𝑦( + < 𝜃% 𝑦( +
!-. !-.
𝑐! = 1 − 𝜃& 𝑦( 1 + 𝑟 + 𝑦! > 1 − 𝜃% 𝑦( 1 + 𝑟 + 𝑦!
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Regret
𝑐!
𝐸: endowment 𝑦( , 𝑦!
𝑦! + 1 + 𝑟 𝑦" 𝑌: actual 𝑐( , 𝑐! selected
●
𝑂 𝑂: the 𝑐( , 𝑐! would have
𝑐! ●𝑌 𝐸 preferred when old!
𝑦! ●

What can be done?

0 𝑦! 𝑐(
𝑐" 𝑦" 𝑦" +
1+𝑟
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A commitment savings product
https://www.poverty-action.org/study/commitment-savings-products-
philippines

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A commitment savings product
Experiment design:
• The Green Bank of Caraga (Philippines) designed and implemented a
commitment savings product called a SEED account (Save, Earn, Enjoy
Deposits)
• It restricted access to their savings, although each individual could define
a goal date or amount
• 1,777 were randomly assigned to three groups:
1. Commitment treatment
2. Marketing treatment
3. Control
• For the commitment savings group, average savings balance increased by
42% after six months and 82% after one year compared to the others.
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Default options
https://www.pensionsadvisoryservice.org.uk/about-
pensions/pensions-basics/automatic-enrolment/opting-out

• Individuals have to make a conscious choice

to exit the scheme

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What have we achieved?
• We have explored a framework where consumers do not use their “true”
utility function when making decisions. This has welfare consequences.
• Getting people to make the correct choices can lead to Pareto
improvements, but not always if some consumers are not biased.
• There may be “market” solutions that help people improve their decisions
i.e. commitment products.
• There are therefore trade-offs involved in government intervention…is it
worthwhile distorting non-biased consumers to help biased consumers?
• We need a social welfare function to help us decide whether to intervene
and how - we will explore these in Lent Term.

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