BEHAVIORA
L
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” 2
model of decision making
BEHAVIORAL
ECONOMICS
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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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 4
can only choose one due to resource constraints.
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 response A for
program 1 while 78% choose response D
for program 2.
Why? Framing. By manipulating how
alternatives were framed researchers could
alter choices dramatically.
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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
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BIAS 2: PAYING ATTENTION
TO SUNK COSTS
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.
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BIAS 2: PAYING ATTENTION
TO SUNK COSTS
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.
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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.
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BIAS 3:
OVERCONFIDENCE
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 15
extract surplus from over-optimistic clients
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 18
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 19
