Behavioural

economics
 Behavioral
Economics
The model of economic behavior we have considered in this
course is restrictive in a number of ways
• Economic agents are assumed to be perfectly rational
• Agents are assumed to perfectly understand risk and
uncertainty
• Agents are assumed to be “self-interested”

In reality, people exhibit a number of departures from this

“rational agent” model of decision making

Behavioral economics – Branch of economics that incorporates

insights from human psychology into models of economic
behavior
Used to help us understand why our models may not make the
predictions we think they should in some cases.

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 3

Question for discussion (in

group of 1 to 4 students)
 Introduction
Exercise
• You work for Centers of Disease control
and you need to keep American safe.
• There is a sudden and usually flu-like
disease that breaks out.
• Your best estimate is that 600 Americans
will die from the disease if no
government action is taken.
• You are given a choice between 2
programs to address the crisis:
– Pick what you would do for each
program. There are 2 possible
responses to the crisis for each
program and each cost the same
amount, but can only choose one
due to resource constraints.

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 Introduction
Exercise
Program 1:
Response A will save 200 people.
Response B is risky. It has a one-third
chance to save all 600 people but a
two-thirds chance to save no one.
Which do you choose?

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 Introduction
Exercise
Program 2
Response C 400 people will die
for certain.
Response D there is a one-third
chance that no one will die and
a two-third chance that
everyone will die.
Which do you choose?

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 Introduction Exercise

The framing was different in the two programs but the

content for each choice in a program the same.

Consistent response was A and C, or B and D

Experiment, 73% picked Why? Framing. By

response A for program 1 manipulating how
alternatives were framed
while 78% choose response D researchers could alter
for program 2. choices dramatically.
 Behavioral
Economics
Behavioral economics is concerned
with systematic departures from
rational choice

Behavioral economists attempt to

identify systematic “biases”

Departures from rational choice can

inform the development of more
general, descriptive models of
economic behavior
Models can be used to develop
testable hypotheses and predict
economic behavior

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 When Human Beings Fail
to Act the Way Economic
Models Predict
Some systematic departures from rational
choice are:
• Bias 1: Generosity and Selflessness
• Bias 2: Paying Attention to Sunk Costs
• Bias 3: Overconfidence
• Bias 4: Self-Control Problems and
Hyperbolic Discounting
• Bias 5: Falling Prey to Framing –
introduction example

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 Bias 1: Generosity
and Selflessness
Economic model of rational choice
assumes “rational self- interest,” many
people often engage in acts of
generosity and exhibit altruism
• Acts motivated primarily by a
concern for the welfare of others
• Donations to charity are the most
obvious example
Economists have tried to include this
in the model for example by addition
someone else’s consumption into your
utility function.
• Parent’s utility depends on child’s
consumption
 Bias 2: Paying
Attention to Sunk
Costs
• We learned sunk costs do not matter for economic
decision making.
• Rational decision makers think at the margin and only
consider opportunity costs.
• Sunk Cost Fallacy: However, in reality people are
influenced by sunk costs in their decision making.
• 1985 Experiment: randomized how much people paid
for seasons tickets to Ohio University Theater ($9, $13,
$15).
• If the the sunk cost doesn’t matter (price of ticket) then
the percent of people who go to the show from each
group should be the same.
– But it wasn’t. Those who paid more were 25
percent more likely to go than those who got a
discount.
• Businesses or gov’t can make similar mistakes by keeping
on implementing a project that is way over cost and they
can’t afford even though they may be just 10 percent
into the project and would be better of abandoning the
project.
 Bias 3:
Overconfidence
• Individuals believe their skill level and
judgment are better than they truly are, or
they expect that outcomes are better for
them are more likely to happen then they
truly are.
• Numerous studies have shown that
humans tend to overestimate positive
attributes about themselves
• In one survey, 93% of college
students said they were “better than
average” drivers
• On a popular dating website, 73% of
individuals describe themselves as
having “very good” or “better than
average” physical attractiveness

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 Bias 3:
Overconfidence
• Problem: our models assume people have a realistic
expectations and base their decisions on facts.
– Company managers confident in their own
abilities maybe more inclined to make bigger
investments and take on more risk in the
overconfident view they will succeed.
How Economic Markets Take Advantage of
Overconfident People

• Firms take advantage of overconfidence

 Consider gym memberships: Why do gyms
charge monthly memberships instead of per-visit
fees?
• Individuals who sign up for a health club tend to be far
too optimistic about the prospects of sticking to their
exercise goals
• Health clubs tailor their offerings to exploit such over
optimism
• Charging monthly fees allows health clubs to extract
surplus from over-optimistic clients

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 Bias 4: Self-Control
Problems and
Hyperbolic
Discounting
• People have a strong preference for
NOW
• A 10% discount rate implies that
$1.00 today is equivalent to $0.90 next
year
• There is evidence that many people
have a much higher discount rate
when making decisions about
immediate consumption

Hyperbolic discounting – Tendency of

people to place much greater importance
on the immediate present than even the
near future when making economic
decisions

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 Bias 4: Self-Control
Problems and
Hyperbolic
Discounting

Problem: Decisions stop being time-

consistent
• Consistencies in a consumer’s
economic preferences in a given
economic transaction, whether the
economic transaction is far off or
imminent
• When consumers are not time-
consistent, they will, for instance,
specify their preferred exercise
and diet routine for next week
now, but then when they get to
next week, they won’t want to
stick with the plan they set up

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 Does Behavioral
Economics Mean
Everything We’ve
Learned Is Useless?

While the rational-choice model is not

perfect, it does an excellent job of predicting
human behavior in many circumstances
• This model can often be generalized or
otherwise extended to account for
behavioral anomalies
• Provides a basis for thinking about
seemingly irrational behavior, often
illuminating rational motivations (e.g.,
conspicuous charitable donations that
improve reputation)

Regardless of individual behavior, markets

tend to be coldly rational
• Exposure to markets has been shown to
reduce the presence of biased actors
and/or behavior

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Testing Economic
Theories with Data:
Experimental
Economics

The evidence from psychology and behavioral

economics has placed an even greater emphasis
on the importance of testing economic models
with real data

However, analyzing economic decisions in the

real world is very difficult. In response, two
subfields of economics have emerged as leaders in
the evaluation of economic models:
econometrics and experimental economics
• Econometrics: Field that develops and
uses statistical and analytical techniques to
test economic theory
• Experimental economics: Branch of
economics that relies on experiments to
illuminate economic behavior

These two fields have helped turn economics into

a more evidence-based science

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 Discussion

• At least nine Palestinians killed as Israel raids West Bank

cities - BBC News
• Ukraine says it controls 100 Russian settlements after three-
week incursion - BBC News
• Read the news above and probably others, and suggest any
behavioural economics theory to explain the phenomenon
we have seen in the war.

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