Behavioral Economics chapter 13 Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 2
13-2 Learning Objectives Describe the objectives and methods of
behavioral economics. Summarize, interpret, and evaluate evidence
of systematic departures from perfect rationality. Explain why some
economists modify the standard theory of decisions involving time
and uncertainty. Discuss why it may be important to account for
social motives when analyzing strategic decisions. Copyright 2014
McGraw-Hill Education. All rights reserved. No reproduction or
distribution without the prior written consent of McGraw-Hill
Education.
Slide 3
13-3 Overview Behavioral economics rely heavily on experiments
with human subjects No one is completely rational all the time
Behavioral economics adds to standard economic theory in several
areas, particularly when choices involve time, risk, and strategy
Copyright 2014 McGraw-Hill Education. All rights reserved. No
reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Slide 4
13-4 Why Behavioral Economics? People sometimes make choices
that are inconsistent with standard economic theory Example: the
preferences implied by these circular choices violate the Ranking
Principle Copyright 2014 McGraw-Hill Education. All rights
reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Slide 5
13-5 Behavioral Economics Methods In common with standard
economics Assuming that each individual has objectives, that there
is a connection between those objectives and actions, and that
actions affect well-being Using mathematical models of behavior
Testing theories using objective data, replicable methods, and
standard statistical tools More emphasis on experiments using human
subjects Copyright 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Slide 6
13-6 Advantages of Experiments In a lab, all the influences on
decision making are potentially knowable and controllable Easier to
determine causality Researchers can double check their assumptions
and conclusions by testing and debriefing subjects Often possible
to obtain information that is unavailable in the real world
Copyright 2014 McGraw-Hill Education. All rights reserved. No
reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Slide 7
13-7 Disadvantages of Experiments Decisions made in the
laboratory differ from decisions made in the real world Unfamiliar
tasks Not much at stake Lab experiments introduce influences that
are difficult to measure or control Most experimental subjects are
college students Most experiments involve a small number of
subjects Copyright 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Slide 8
13-8 Rationality Choices Reversals An experimental subject who
chooses a low stakes bet over a high stakes bet, but who attaches a
higher dollar value to the high stakes bet, violates the Ranking
Principle Copyright 2014 McGraw-Hill Education. All rights
reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Slide 9
13-9 Rationality Anchoring Anchoring: when someones choices are
linked to prominent but plainly irrelevant information Copyright
2014 McGraw-Hill Education. All rights reserved. No reproduction or
distribution without the prior written consent of McGraw-Hill
Education.
Slide 10
13-10 Rationality Bias Toward the Status Quo Endowment effect:
people tend to value something more highly when they own it than
when they do not 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 Copyright 2014
McGraw-Hill Education. All rights reserved. No reproduction or
distribution without the prior written consent of McGraw-Hill
Education.
Slide 11
13-11 Rationality Narrow Framing Narrow framing: psychological
tendency to simplify decisions by limiting the types of options
and/or consequences considered Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 12
13-12 Rationality Salience Salience: people are more likely to
consider a fact when its presentation is more attention- grabbing
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reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Slide 13
13-13 Rationality Rules of Thumb Many economic decisions are so
complex that thinking through all the possible consequences for
every alternative is extremely difficult In such circumstances,
many people rely on simple rules of thumb that have served them or
others well in the past Example: how much to save Some economists
think that irrational behavior in the laboratory sometimes occurs
because experiments trick subjects into applying good rules of
thumb to the wrong situations Copyright 2014 McGraw-Hill Education.
All rights reserved. No reproduction or distribution without the
prior written consent of McGraw-Hill Education.
Slide 14
13-14 Time Maintaining Self-Control A person is dynamically
consistent if her preferences over the alternatives available at
some future date do not change as that date approaches When this
condition does not hold, preferences are dynamically inconsistent
Present bias: a form of dynamic inconsistency involving a bias
toward immediate gratification Example: people who suffer from
present bias may have difficulty exercising the self-control
required to save money Copyright 2014 McGraw-Hill Education. All
rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
Slide 15
13-15 Time Maintaining Self-Control Solution = precommitment: 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 Copyright 2014 McGraw-Hill Education. All
rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
Slide 16
13-16 Time Ignoring Sunk Costs Sunk cost fallacy: the belief
that if you paid more for something, then it must be more valuable
to you Copyright 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Slide 17
13-17 Time Forecasting Future Tastes and Needs Projection bias:
tendency to evaluate future consequences based on tastes and needs
at the moment of decision making People sometimes have trouble
anticipating how they will feel about future outcomes A temporary
mood or state of mind can exert a powerful influence on decisions
that have longer-term consequences Example: grocery shopping while
hungry Copyright 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Slide 18
13-18 Risk Trouble Assessing Probabilities Hot-hand fallacy:
belief that once the event has occurred several times in a row, it
is more likely to repeat Gamblers fallacy: belief that once an
event has occurred, it is less likely to repeat Example: some
investors assume that a rising stock will continue to rise
(hot-hand fallacy), while others assume that a falling stock is due
for a rebound (gamblers fallacy) Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 19
13-19 Risk Danger of Overconfidence Many people have
overinflated views of their own abilities In the context of
decisions involving risk, overconfidence causes people both to
overstate the likelihood of favorable events and to understate
uncertainty Copyright 2014 McGraw-Hill Education. All rights
reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Slide 20
13-20 Risk A Puzzle Involving Low Probability Events Choice
Option A: Win $5 for sure Option B: Win $5,000 with odds of 1 in
1,000; else, win nothing In experiments, a majority of subjects
choose option B This choice is puzzling because options A and B
have the same expected payoff ($5), but option B clearly involves
greater risk If subjects are risk averse, they should pick option A
Copyright 2014 McGraw-Hill Education. All rights reserved. No
reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Slide 21
13-21 Risk A Puzzle Involving Aversion to Very Small Risks
Choice: Option C: Win $1,010 with 50% probability; else, lose
$1,000 with 50% probability Option D: Win $10.10 with 50%
probability; else, lose $10 with 50% probability Most people would
take neither option. However, standard economic theory shows that a
risk- averse individual should always be willing to accept a
sufficiently small share of any gamble that provides a positive
expected payoff. Copyright 2014 McGraw-Hill Education. All rights
reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Slide 22
13-22 Risk Prospect Theory Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 23
13-23 Risk Expected Utility Theory Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
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Slide 24
13-24 Risk Prospect Theory Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 25
13-25 Risk Prospect Theory Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 26
13-26 Risk Prospect Theory Copyright 2014 McGraw-Hill
Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.
Slide 27
13-27 Strategy Game Theory Shortcomings Game theory tends to
predict behavior most accurately once players have gained some
experience with a game, particularly if the rules are relatively
simple However, even experienced players of simple games sometimes
make decisions that seem contrary to their own interests Copyright
2014 McGraw-Hill Education. All rights reserved. No reproduction or
distribution without the prior written consent of McGraw-Hill
Education.
Slide 28
13-28 Strategy Importance of Social Motives In social
situations, monetary gains usually are not the only motive Some
people are altruistic, some value fairness, while others are
attracted to efficient outcomes that avoid waste Example: in the
dictator game, one player divides a fixed prize between herself and
another player, who is a passive participant If people care only
for their own monetary payoffs, every dictator should keep the
entire prize for herself However, most studies find evidence of
significant generosity Copyright 2014 McGraw-Hill Education. All
rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
Slide 29
13-29 Review Behavioral economists aim to modify, supplement,
and enrich standard economic theory by adding insights from
psychology Behavioral economics explains some departures from
perfect rationality, particularly choices involving time, risk, and
strategy Copyright 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Slide 30
13-30 Looking Forward Next, we will go back to the standard
economic approach and focus on how competitive markets enhance
efficiency Copyright 2014 McGraw-Hill Education. All rights
reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.