*ECN374Behavioural EconomicsDr. Ghazala Azmat

Monday 12th January 2015

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*InformationContact Info:Office: CB313Office hours: Wednesday 9.00-11.00 Email: g.azmat@qmul.ac.uk

Other Info:Last two weeks will be taught by replacement teacher (w/c 23rd March and 30th March)

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*Todays LectureIntroduction to Behavioral Economics

Course Overview and Structure

Links to Game Theory (topic 1)

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*Introduction to Behavioral (or Experimental) Economics

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1. What is Behavioral Economics?

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Behavioral Economics IBehavioral economics is a subfield of economics that seeks to increase the explanatory power of traditional models by incorporating more realistic psychological foundationssocial, cognitive, and emotional factors on the economic decisions of individuals and institutions. Behavioral models integrate insights from psychology and microeconomic theoryNB: Behavioral economics does NOT imply a rejection of the traditional approach to economics, such as utility maximization, equilibrium and efficiency.

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Behavioral Economics IIExperimental economics is essentially a method of empirical investigation. If successful the method will become a standard instrument in economists toolbox

Behavioral game theory analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology. E.g., testing deviations from typical simplifications of economic theory such as the independence axiom, neglect of altruism, fairness etc

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*2. What are Economic Experiments?

*Experiments IExperiments are a form of play

Play is fun but it is also adaptive and serves and important purpose: it helps us learn

We playfully engage the world and thus come to understand it better

We design and run an experiment and record the results in order to learn about the world

This form of learning is the essence of science

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*Experiments IIExperiments mainly associated with the Natural Sciences (dating back to 1600s)Physics: Galileo engaged in constructing pendulums of various weights and lengthsChemistry: Lab experiments that tested predictions of new molecular theoryBiology: Pasteurs germ theory experiments

Experiments in Economics started to emerge in the 1960s

*Why use Experiments in Economics?Economic models in game theory, industrial organizations, social choice offered competing ways to understand micro dataUsing theory and logic, one can generate predictions about the worldThe predictions tell you what to look for and tell you which observations are surprisingIn some cases multiple equilibria appearTo distinguish among the many alternatives, Economists started to use experiments

*The Lab in EconomicsThe typical way Experimental Economists conduct experiments is by using laboratory techniquesThe Economics lab should not to be confused with the Chemistry lab (no burners!)Economic experiments are usually done in the classroom involvingQuestion of interestPaymentRepeated trials Traditionally, experiments were done using pen and paper and now they are mostly done using computer programs

*Todays Lab

*Experiments in EconomicsA controlled situation in which individuals take actions according to some pre-specified rules

These actions determine their payoffs.

Most experiments are strategic: Own payoffs depend on your actions and other individuals actions.

Most frequent reward: Monetary payoffs.

Allows to observe Maximizing behaviour.

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*Economic ExperimentsEverywhere!Theory:MacroeconomicsMicroeconomicsEmpirical:Macroeconomics: Finance, InflationMicroeconomics: Labour, MigrationExperiments:Macroeconomics (especially in Development)Microeconomics:PreferencesBeliefsDecision RulesMapping of Institutions (mechanisms) to outcomes

*3. Why not use existing data?

*Happenstance DataHappenstance data observations that already exist sometimes include just what you need to test a crucial predictionBut it is rareNaturally occurring processes often do not allow you to:Observe a key variableSeparate the effects of different variables Infer causalityIn an experiment, you actively engage the world and create a learning opportunity that would otherwise not exist

*Let the QUESTION determine the DATA and not the other way around

*Lab Data versus Field DataTraditional econometrics works with happenstance data, which occur naturallyLaboratory data is created in an artificial environmentTraditional econometrics works with uncontrolled processes, as opposed to controlled processes Think of lab data as experimental (i.e., properly controlled) and field data are happenstanceField experiments are becoming increasingly important in recent yearsThe idea here is to impose some controls on naturally occurring processes

*Comparative Advantage of Lab and FieldCost:Field data already collected and compiled are the least costly, but it is typically very expensive to collect new dataLab data are generally in between, depending on the subject pool.

Validity:Good lab techniques ensure that lab data are internally valid:Replicable by any other competent investigatorGood lab techniques cannot ensure external validityRegularities observed dont necessarily generalise well to the larger, ongoing economy outside the labField data have automatic external validity in their native habitat

*4. Purpose of Experiments

*1. Speaking to theoristsWhat is the theoretic solution and does behavior conform with theory? (better use of theory: serves as benchmark)in the short runin the intermediate term (convergence)in the long run (convergence)What are the causes of this failure? bounded rationality, other regarding preferences, coordination failure, non expected utility, emotion, framing etc. Calculation costs; difficulty of task[Also : bad design? redesign of experiment ]

*2. Searching for factsEstablishing regularities - parsimonious models that describe deviation from theory? non-expected utility modelsmodels of fairnessmodels of adaptation and learningmodels with errorFormulating new theories to explain newly observed regularitiesDevising new experiments to help distinguish among such theories

*3. Whispering in the ears of PrincesEvaluation of policy proposal How to decide on pollution rights, etc.Matching problems (schools-students)

Comparison of institutions, use the lab as a test-bed for institutional designdifferent auctionsdifferent mechanisms (e.g. for matching markets)different bargaining models, etc.

*5. Criticisms of Experiments

*Criticism of Experiments in EconomicsWrong incentives (e.g. the stakes are too low)

Experts behave differently than students (the usual subject pool)

External Validity: how can laboratory experiments help us decide in the real world?

Having many repetitions is unrealistic

Some mechanisms dont exist in the real world

*Course Overview and Structure

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*Course ContentLinks to Game TheoryExperimental Design Simple Bargaining Trust and Social PreferencesPublic Goods Co-ordinationField ExperimentsFeedback Information and ExperimentsGender and ExperimentsNeuroeconomics

*Evaluation of CourseMidterm Tests (30%)Midterm I (Monday 9th February)Midterm II (Monday 9th March)

Final Exam (70%)

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*Lectures and ClassesLectures will cover the theory of the topicsBasic modelsPredictionsExperimental findingsExtensionsClasses will varyGame solvingRun simple (pen and paper) experiments related to topicsStatistical analysis of data

*TOPIC 1: Game Theory and Behavioral Economics

*Game Theory A large number of decisions in every day life require strategic decision makingwhat happens to one person is affected by another person

Economists have developed a broad array of tools to understand how people make decisions in such situations

These set of tools are called Game Theory

*Games in everyday life ITennis players deciding whether to serve to the forehand or backhand of their opponent

The only bakery in town offering a discounted price on pastries just before it closes

Employees deciding how hard to work when the boss is away

Arab rug seller deciding how quickly to lower the price when haggling with a tourist

A bidder making an offer for a piece of art in an auction

*Games in everyday life IIAll examples illustrate game theory

In all situations, a person (or firm) must anticipate what others will do

ANDWhat others will infer from the persons own actions

*Pioneers of Game TheoryEconomists have developed a large body of theory enables us to understand and analyze the nature of the interaction between players

A lot of what we know can be traced back to John von Neumann and Oskar Morgenstern in 1944

As well as John Nash, Reinhard Selten and John Harsanyi

The latter three together won the Nobel Prize in Economics in 1994

*Game Theory TodayGame theory is used extensively in economics, other social sciences and all branches of business-related disciplines (e.g., management and marketing)

In economics, game theory is used (for example) to:analyze behaviour of firms that worry about what their competitors dounderstand how workers behave in firms (e.g., reaction of CEOs or salespeople to incentive contracts)understand spread of social convention or practice

*Games and Behavioral Econ IBehavioral or Experimental Game Theory is increasingly popularRefers to experiments whose goal is to learn about general principles of strategic behaviour [Other types of experiments may be to learn about the performance of specific institution ]Experiments are now an important tool for the analysis of strategic behaviour The emergence of experimental game theory can be traced to two factors:The need for empirical information about principles of strategic behaviourThe advantages of experiments in providing it

*Games and Behavioral Econ IITraditionally, game-theoretic custom of trying to predict behaviour entirely by theoryapplying notions of equilibrium and refinements to the structure of the game. This custom admits a role for empirical knowledge aboutplayers preferencesfeasible decisionsinformation just as in nonstrategic microeconomicsBut it precludes any role for empirical input about the principles that determine how players respond to a given game.

*Games and Behavioral Econ IIIExcluding such input is not important in nonstrategic settingswhere rationality, in the sense of, expected-utility maximization provides a reasonably reliable guide to behaviour once preferences, decisions, and information have been identified. Exclusion is important in strategic settingswhere rationality alone seldom yields definite predictions, reliable or not, and there is no consensus on how to strengthenIn turn, most games of interest in economic applications raise questions about strategic behaviour Likely to be resolved only by combining theory and empirical knowledge.

*Recap: A couple of examples

*Example I

*Social Dilemma:Contributing to a charitable causeYou want to build a park in your locality that would be open to everyone

You decide to approach the families in the area and ask them to donate a certain amount

*Social Dilemma:Contributing to a charitable causeNot everyone has to contribute for the park to get built

As long as some of the families contribute you will have enough money for the park

What are the chances that you will be able to raise enough money?

*Social Dilemma:Contributing to a charitable causeLet us assume that, by and large, people are self-interested and care (mostly) about their own welfare

Think about an individual trying to decide whether to contribute or not

If she does not contribute and the park does not get built then she is neither better nor worse off

But suppose she does NOT contribute but enough money is raised to build the park

*Social Dilemma:Contributing to a charitable causeThis person cannot be prevented from going to the park once it is built

She has not contributed anything but still gets to enjoy a walk in the park

This person is then strictly better off

*Social Dilemma:Contributing to a charitable causeWhether the park gets built or not for an individual who cares primarily about her own self-interest the thing to do is not to contribute any money

We call this free-riding

But if everyone reasoned along the same lines then no one will contribute!

We can use experiments to see how people would actually respond.

*The Prisoners DilemmaImagine the following scenario:

A crime is committed. The police have no evidence but want to get a conviction. So they arrest a couple of likely characters, A and B, and put them in different cells.

*The Prisoners DilemmaThe police say to each suspect: If you rat on your mate and blame him for the crime and he doesnt rat on you, then we can convict him and he will get 7 years in prison, and we will let you go free.

So what if I dont rat and nor does he? asks A (or B). Then you cant convict, can you?

*The Prisoners DilemmaNo we cant, admits the detective. But then well pin an obstruction of justice charge on both of you. One year in the slammer each.

And if we both rat on each other?

Then it gets a bit messy and you both get 5 years, says the detective.

*The Prisoners DilemmaSo what will happen? Let us figure out the options from As point of view.

Being economists, we will assume that A is rational meaning that he will do the best he can in his own self-interest

A considers each possible action by B, and figures out his best reaction in each case

*The Prisoners DilemmaSo if B rats on A, then As best move would be to rat on B (get five years instead of seven)

And if B doesnt rat, then As best move is..

again, to rat! (go free instead of one year in prison)

*The Prisoners DilemmaSo As rational decision must be to rat on B.

And, similarly, Bs best move is to rat on A

So we predict this is what will happen and they both will go to prison for five years

But if only both could have kept their mouths shut, they would both be better off!!!

*The Prisoners Dilemma:Payoff Matrix

BADont RatRatDont Rat A: 1 year B: 1 yearA: 7 years B: freeRatA: free B: 7 yearsA: 5 years B: 5 years

*The Prisoners DilemmaThe problem is that even if one prisoner does the right thing and keeps quiet, the other has an incentive to cheat on him(Rat,Rat) is the Nash Equilibrium(Dont Rat, Dont Rat) is globally optimal but it is not stable

Similarly in the case of the park: it would be better if everyone contributes, but self-interested individuals have an incentive not to do soBut if no one contributes then the park does not get built

*Game Theory Experimental Evidence

*Experimental Evidence It turns out that people often choose the cooperative strategy in Prisoners Dilemma type situations

People contribute to public charities

The puzzle of course is why since that behavior is not in accordance with individual self-interest

*Implications of Cooperation The issue of cooperation goes beyond economics and has ramifications for other disciplines including theories of evolution

Biological theories suggest that those who act altruistically or cooperatively in such situations will lose out to those who act in their own self-interest

Over time the self-interested types will come to dominate the population

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