Chapter 13

Behavioral Economics

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics

Objectives and methods of behavioral economics

Departures from perfect rationalityChoices involving timeChoices involving riskChoices involving strategy

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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 reconcile

with standard economic theory Standard economic theory can lead to seemingly

unreasonable conclusions about consumer welfare Behavioral economics grew out of research in

psychology 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 causalityResearchers 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 controlStrong evidence that subjects often try to conform to

what they think are the experimenter’s expectationsMost subjects are students, thus not

representative of the general populationAlso inexperienced at making economic decisions

Scale of any given experiment is limited by the available resources

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Evaluating Behavioral Evidence

Critical questions about behavioral research that appears inconsistent with standard economic theory:Is the evidence convincing? Was the experiment

well-designed?Is the observed behavioral pattern robust?What are the possible explanations? Can we

reconcile this with standard theory?If theory appears to fail in a significant situation, how

should we modify the 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 experimentValues a low stakes bet at $3.40 and a high stakes

bet at $3.60Chooses 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 13.2: 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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Figure 13.3: Endowment Effect

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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:

Leading explanation in questions about losing $10 entering a theater vs. losing a theater ticket that cost $10

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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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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Figure 13.4: Dynamic Inconsistency in Saving

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Trouble Assessing Probabilities

People tend to make specific errors in assessing probabilities Hot-hand fallacy is the belief that once an event has occurred

several times in a row it is more likely to repeat Arises when people can easily invent explanations for streaks, e.g.,

basketball Gambler’s fallacy is the belief that once an event has occurred it

is less likely to repeat Arises when people can’t easily invent explanations for streaks, e.g.,

state lotteries Both fallacies have important implications for economic behavior,

e.g., clearly relevant in context of investing Overconfidence causes people to:

Overstate the likelihood of favorable events Understate the uncertainty involved

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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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Prospect Theory:A Potential Solution

Proposed in late 1970s by two psychologists, Kahneman (later won Nobel Prize in economics) and Tversky

An alternative to expected utility theoryMay 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 resourcesMultiplies 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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Choices Involving Strategy

Some of game theory’s apparent failures may be attributable to faulty assumptions about people’s preferencesMay not be due to fundamental problems with the

theory itselfMany applications assume that people are

motivated only by self-interestPlayers 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 recipientThe recipient is a passive participantUsually no direct contact during the gameStrictly 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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