Behavioral Economics

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Behavioral Economics

• ECO 61 Microeconomic Analysis
• Udayan Roy
• December 2008

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Main Topics

• Objectives and methods of behavioral economics
• Departures from perfect rationality
• Choices involving time
• Choices involving risk
• Choices 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 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 peoples 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 isnt
  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 experimenters
  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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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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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 ChoicesChoice 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 ChoicesAnchoring

• Anchoring occurs when someones choices are
  linked to prominent but irrelevant information
• Suggests that some choices are arbitrary and
  cant 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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Anchoring

• 55 subjects were shown a series of six common
  products with average retail price of 70
• For each product, the experiment had three steps
  Each participant was asked
• his/her SSN
• whether he/she would buy the product at a price
  equal to the last 2 digits of SSN
• The maximum he/she would be willing to pay

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Bias Toward the Status QuoEndowment Effect

• The endowment effect is peoples tendency to
  value something more highly when they own it than
  when they dont
• 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 consumers initial consumption bundle
• Smooth changes in price yield abrupt changes in
  consumption

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Endowment Effect

• Half the participants were given mugs available
  at the campus bookstore for 6
• The other half were allowed to examine the mugs
• Each student who had a mug was asked to name the
  lowest sale price
• Each student who did not have a mug was asked to
  name the highest purchase price
• Supply and demand curves were constructed and the
  equilibrium price was obtained
• Trade followed
• There were four rounds of this

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Figure 13.3 Endowment Effect
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Bias Toward the Status QuoDefault 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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Default effect retirement

• Prior to April 1, 1998, the default option was
  nonparticipation in the retirement plan
• After April 1, 1998, all employees were by
  default enrolled in a plan that invested 3 of
  salary in money market mutual funds
• Only the default option changed

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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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Why you cant get a cab in NYC when you really
need one

• On any given day, the length of a cab drivers
  shift was negatively related to hourly earnings
• Total daily income remained the same

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Salience

• Imagine a disease is expected to kill 600 people
• Under program A, 200 people will be saved
• Under program B, there is a 1/3 probability that
  600 people will be saved and a 2/3 probability
  that no people will be saved
• Under program C, 400 people will die
• Under program D, there is a 1/3 probability that
  no one will die and a 2/3 probability that 600
  people will die
• 72 prefer A to B and 78 prefer D to C

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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 dont 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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The Problem of Dynamic Inconsistency

• People often waste expensive gym memberships
• The LIU gym plan for faculty

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Figure 13.4 Dynamic Inconsistency in Saving
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We should ignore sunk costs but often do not

• Uncomfortable shoes
• Bad movie rentals
• Season ticket discounts lead to lower initial
  attendance

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Projection bias in forecasting future tastes and
needs

• Hungry shoppers tend to buy more than sated
  shoppers when shopping for the week ahead
• People tend to underestimate their adaptability
  to change

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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
• Gamblers fallacy is the belief that once an
  event has occurred it is less likely to repeat
• Arises when people cant 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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Hot-hand fallacy

• Philadelphia 76ers, 48 home games, 1980-81 season

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Gamblers fallacy

• A study of nearly 1800 daily drawings between
  1988 and 1992 in a New Jersey lottery showed that
  after a number came up a winner, bettors tended
  to avoid it

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Overconfidence

• In one study of US students with an average age
  of 22, 82 ranked their driving ability among the
  top 30 of their age group
• In the manufacturing sector, more than 60 of new
  entrants exit within five years nearly 80 exit
  within ten years

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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 persons
  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 TheoryA 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) lt P ? U(R X1) (1 P) ? U(R X2)
• Prospect theory yes if
• V(0) lt 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 theorys apparent failures may be
  attributable to faulty assumptions about peoples
  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 players 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 MotivesThe 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 MotivesThe 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 MotivesThe 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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