Topic 1

Introduction
 Why Behavioral Economics? ECON &
HUMAN
• These are depictions – some would say caricatures – of the two types of mind
thought to be important in behavioural economics. Mainstream economics
emphasizes ECON (homo economicus): the cold, rational, calculating, self-
interested; psychology focuses on HUMAN (homo psychologicus): the flesh-and-
blood being who is limited in processing capacity and prone to a number of
biases, errors, and influences, and who is emotionally warm, and sometimes
hot, in how they make decisions.
Supposedly Irrelevant Factors, SIFs
• Example 1: 72/100 or 96/137?

• Example 2: saving $10

• Example 3: A bat and ball cost $1.10 in total. The bat costs $1.00 more
than the ball. How much does the ball cost?
 The Evolution
• Contributors of Classical Tradition
• Adam Smith, 1723 – 1790
• David Ricardo, 1772 – 1823
• Jeremy Bentham, 1748 – 1832, utilitarianism
• Thomas Robert Malthus, 1766 – 1834
• Jean-Baptiste Say, 1767 – 1832
• John Stuart Mill, 1806 – 1873, opportunity cost
• William Stanley Jevons, 1835 – 1882, marginality

• Eminent Neo-classicals
• Thorstein Veblen, 1857 – 1929
• J M Keynes, 1883 – 1946
• John Kenneth Galbraith, 1908 – 2006
Why Behavioral Economics?
• Behavioral economics increases the explanatory power of economics
by providing it with more realistic psychological foundations –
Camerer and Loewenstein (2004)

• It is important to emphasize that the behavioral economics approach

extends rational choice and equilibrium models; it does not advocate
abandoning these models entirely – Ho, Lim and Camerer (2006)
 Definitions
Behavioral economics is about understanding economic behavior and its
consequences. It’s about understanding why someone buys a hotdog, goes to
work, saves for retirement, gives to charity, gets a qualification, sells an old car,
gambles on a horse race, cannot quit smoking, etc. It’s also about understanding
whether people make good or bad choices, and could be helped to make better
choices.

• Behavioral economics is about testing the standard economic model on

humans, seeing when it works and when it does not, and asking whether it can
be tweaked, or given an overhaul, to better fit what we observe.

• Behavioral economics is about applying insights from laboratory experiments,

psychology, and other social sciences in economics.
 Rationality
• In neoclassical economics, rationality mainly refers to the utility-maximizing,
consistent behavior of self-interested homo economicus (Econ) who focuses on their
own personal utility, and now.
• Completeness Individuals entertain a preference ordering across all alternative
courses of action that they face.
• Transitivity Individuals make consistent choices, in the sense that if A is preferred to
B, and B is preferred to C, then a rational individual will prefer A to C.
• Monotonicity more of an economic good is preferred to less of it, ceteris Paribus.
• Convexity mixture of goods (averages) are preferred to extremes.
• The assumption of perfect knowledge.
• All these culminates into
• Utility maximization
• Bayesian probability estimation
von Neumann & Morgenstern Expected
Utility Theory (EUT)
• The von Neumann– Morgenstern utility theorem shows that, given a number
of axioms (assumptions), a rational decision maker faced with risky or
uncertain (i.e., probabilistic) outcomes of different choices should behave in a
manner to maximize ‘expected value’, or utility.
• Consider two situations.
• Situation 1: In a game the probability of winning ₹1000 is 1 in 80. The other
more likely outcome is of getting nothing.
• Situation 2: you are given ₹12, a sure gain
• Which one would you choose and why?

• A rational thinker following neo-classicals would choose situation 1 as

recommended by the EUT.
 Check on The Assumption of
Transitivity
Bill is 34 years old. He is intelligent, but unimaginative, compulsive, and generally
lifeless. In school, he was strong in mathematics but weak in social studies and
humanities.
Rank the following statements from most probable to lease probable
A. Bill is a physician who plays poker for a hobby
B. Bill is an architect
C. Bill is an accountant
D. Bill plays jazz for a hobby
E. Bill surfs for a hobby.
F. Bill is reporter
G. Bill is an accountant who plays jazz for a hobby
H. Bill climbs mountains for a hobby. (Taversky & Kahnman –
 Check on The Assumption of
Transitivity
Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a
student, she was deeply concerned with issues of discrimination and social justice, and
also participated in anti-nuclear demonstrations.
Rank the following statements from most probable to least probable.
A. Linda is a teacher in elementary school
B. Linda works in a bookstore and takes yoga classes
C. Linda is active in the feminist movement
D. Linda is a psychiatric social worker.
E. Linda is the member of the League of Women Voters
F. Linda is a bank teller.
G. Linda is an insurance salesperson.
H. Linda is a bank teller and is active in the feminist movement.
(Taversky & Kahnman – 1983)
 Outcome
• It challenges the assumption of transitivity in rational decision making.

• 87% and 85% of the 88 UG students involved in the experiments violated

the transitivity assumption in the two cases, respectively; i.e. they stated

• Account > Accountant & plays Jazz > plays Jazz for Bill
• Feminist > bank teller & feminist > bank teller for Linda
 Why Still Rationality is Preferred?
• A Theory of Rational Choice claims to be both normatively as well as
descriptively correct.

• Descriptive vs. normative statements

Which of the following claims are descriptive and which are normative?
(a) On average, people save less than 10 percent of their income for
retirement.
(b) People do not save as much for retirement as they should.
(c) Very often, people regret not saving more for retirement.
Nature of the Neo-Classical Model:
Standard Model

• The utility function U(x | s) is defined over the payoff xit of individual i and
future utility is discounted with a (time-consistent) discount factor .
 What does it assume?
• Let's break the model into 4 components.

• Economic agents are rational: (1), (2), (3) and (4).

• Economic agents are motivated by expected utility maximization: (1), (3) and (4).
• An agent’s utility is governed by purely selfish concerns, in the narrow sense that it
does not take into consideration the utility of others: (4).
• Agents are Bayesian probability operators: (3)
• Agents have consistent time preferences according to the discounted utility model:
(2).
• All income and assets are completely fungible: (4).
 Application of the Standard Model
Decision State of the world Probability Payoff
(Bayesian priors)
Interesting 0.8 10
Coffee
Boring 0.2 2
Interesting 0.8 6
Beer
Boring 0.2 4

Discovered Preference Hypothesis – Plott (1966)

The standard economic model is a good predictor if people have had ample opportunity to
learn from experience.
 Two Major Types of Methods of Empirical Study
• Field experiments– economists; driven by what; study groups; find laboratory
experiments impractical; largely pioneered by Vernon Smith
• Examples of field experiments
• Choices involving buying different electrical appliances, where some are more expensive,
but save electricity and reduce costs during their lifetime
• Life-cycle saving behavior
• Choices of betting in horse races
• Investment choices, involving buying and selling stocks and bonds
• Choices of smokers and drug addicts which involve trade-offs between current benefits
and long-term costs
• Shopping choices where consumers respond to different promotional offers
• Features of field experiments
• Ecological validity versus conceptual validity
• Confoundedness
 Methods
• Laboratory Experiments – psychologists; driven by why
• Has the advantages of controlling or manipulating the relevant variables & can elicit
more information
• Both types of studies can be categorised as
• Between-subjects study
• Within-subjects study
• Issues with experimental methods used
• Experimental design
• The use of financial incentives in behavioral economics (and not in psychology)
• The use of deception
• Lack of control
• Interpretation of experimental results – ecological validity in terms of generalization; far-
reaching extrapolation; cherry-picking results and conclusions where the data supports the
theories
• A set of assumptions need to be evaluated as a whole
 Example of Field Experiment: 1998 study in Israel

• Lateness has a price and can be purchased like fruits, vegetables etc.
• Market like incentives crowd out social preferences
• Even when fines ended parents continued coming late
 Exercises
1. What are the two major types of experimental methods in behavioral economics?
2. Ecological validity is more with field experiment
3. Conceptual validity is more with laboratory experiment
4. We should do exercises on a regular basis – normative or descriptive?
5. All the students must attend all the classes – normative or descriptive?
6. The weather conditions are improving gradually in Roorkee – normative or
descriptive?
7. If money set aside for monthly grocery cannot be used to buy vegetables, this is an
example of fungibility – true or false?
8. Suppose, D charges ₹300 per hour and provides private tuition everyday in the
evening. His friends plan for a movie one day in the evening which will cause missing
out on 4 hours of tuition. What is D’s opportunity cost of watching the movie?
9. Construct a utility maximization problem by considering possible alternatives as
sources of satisfaction or dissatisfaction given the options of having dinner (e.g. in the
hostel mess or in the hostel canteen or outside in a friend’s party).
References
Wilkinson, Nick & Matthias Klaes – An Introduction to Behavioral
Economics, Palgrave
Philip Corr & Anke Plagnol – Behavioral Economics: The Basic.
Routledge
Erik Angner – A Course in Behavioral Economics, Macmillan
International