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From Neoclassical to Behavioral Economics

From Neoclassical to Behavioral Economics. W. Fred van Raaij, Tilburg University, The Netherlands Narva-Jõesuu , Estonia, November 2, 2018. Epistemology, the science of science.

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From Neoclassical to Behavioral Economics

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  1. FromNeoclassicalto BehavioralEconomics W. Fred van Raaij, Tilburg University, The Netherlands Narva-Jõesuu, Estonia, November 2, 2018

  2. Epistemology, the science of science Epistemology (έπιστήμη = knowledge) is thestudy of the way new knowledge is acquired and accepted in thescientific community and in society. • How are scientistseducated? Research masters and PhD programs. • How are research topics selected? Byscientists and/or by research funders and practitioners. • What are acceptable research methods? Qualitative/quantitative research, surveys, experiments. • How are scientificconcepts been operationalizedandmeasured? • How do scientistscommunicate with eachother? Journals, conferences, personal contacts. • What is ‘good’ science (and shouldbepublished)? Journal editors and referees. • How do scientistsproceed with theirwork, especially at the frontiers of science? • How to punish/ban/avoidmisconduct of scientists and falsification of data? Ethics.

  3. Deduction or induction • Mathematics starts with axiomas and is largely (but notcompletely) a deductivescience. • Astronomy and physics are hypothetico-deductive: Deduct a hypothesis fromtheory and performanempirical test of the hypothesis. • The hypothetico-deductivemethod is the most desirable model of scienceformanyeconomists and econometricians. • Socialsciences are mainlyinductive: factfinding and generalization of relatedfactsinto a model / framework / theory. Are socialsciences “pre-paradigmaticproto-sciences?” • Are economicsandeconometrics more at home with physicsthan with socialsciences?

  4. Approaches in epistemology • Wiener Kreis (Vienna Circle): Verifiability of data, analysis, and conclusions. Logical positivism/empirism. • Karl Popper, Logik der Forschung (1934): Falsifiability, in accordance with statistical theory of testing and rejecting hypotheses. • Milton Friedman, Essays in Positive Economics (1953). • Thomas Kuhn, Structure of Scientific Revolutions (1970). • Imre Lakatos, Scientific Research Programs (1968, 1970). • Thorstein Veblen, The Place of Science in Modern Civilisation (1919).

  5. Wiener Kreis (1920-1938) Wiener Kreis (Vienna Circle): Moritz Schlick, Ernst Mach, Rudolf Carnap, Hans Reichenbach, Herbert Feigl, Viktor Kraft, Ludwig Wittgenstein, Bertrand Russell. Neo-positivism / logicalempirism. Excludemetaphysical (religious, philosophical) origins and explanations. Use ‘observable’ / empirical data to test hypotheses. Uselogicalreasoning to explainresults. Emphasis onverifiability of data, analysis, and conclusions. Surveys and experimentscanbereplicated to assessthe ‘convergent validity’ (stability) of theresultsandconclusions. Science as gradually (evolutionary) developing sets (theories?) of ‘verified’ knowledge.

  6. Karl Popper (1902-1994) Logik der Forschung(1934). Hypothetico-deductive approach. Falsifiability: developfrom a theory hypotheses that canberejected, and try to rejectthem. Science is not to ‘proof’ relationships, but to disproofthem, just as in statistical tests. Science does notconsist of ‘proven knowledge’ but of ‘not disproven knowledge.’ Popper’sperspectiveevolvedfrom a ‘nihilisticfalsificationism,’ ‘anti-inductionism’ and ‘destructivetesting’ intoscience as an approach of ‘dialecticalsequences of conjectures & refutations.’ Popper is aware of the ‘tenacity’ of scientists to evadefalsification of theirtheories, forinstancebyintroducing (auxiliary) interveningconstructs.

  7. Milton Friedman (1912-2006) Essays in PositiveEconomics(1953). Economictheory starts fromassumptionsaboutconsumerandentrepreneurialbehavior. In Popper’s approach, assumptions do not matter somuch, as long as hypotheses are notrejected. Friedman’s F-twist: ‘unrealassumptions’ in economics are not a vice but a virtue, as long as predictions are correct. A veridicaldescription is not important. This is stronglycritizedbybehavioraleconomists. Negligibility, domain, and heuristicassumptions (Musgrave, 1981). As economictheorydevelops, assumptionswillgraduallybecome more descriptiveandveridical.

  8. Thomas Kuhn (1922-1996) Structure of ScientificRevolutions(1970). ‘Tenacity’ is nottheexception but therule. Scientistsworksteadily in the context of anacceptedparadigm. By accident, anomalies to theparadigm are obtained. A series of anomalies starts critical thinking and a new paradigmmay/shouldbedeveloped. The old and new paradigm are in conflict (revolution!), but mayexisttogetherfor a long period, forinstanceneoclassical and behavioraleconomics. A paradigm is a system of beliefs, values, techniques, etc., shared by a group of scientists, that cannotbefalsified. Young scientists are usuallythe first to accept a new paradigm. Olderscientistsmayexperienceconversionto a new paradigm as a ‘religiousconversion’. Young scientistsadheringthe new paradigmmay have problems in gettingtheir papers acceptedby editors and referees adheringtotheoldparadigm.

  9. Imre Lakatos (1922-1974) Criticism and theGrowth of Knowledge (1970, with Alan Musgrave). A Scientific Research Program is anorganicunity of ‘hard core,’ ‘positiveheuristic,’ and ‘protective belt.’ The hard core and positiveheuristic are essentialforan SRP. The protective belt is changeable; progressive changes are welcomed, if more phenomenacanbeexplained. Hard core: fundamentalcharacteristics of the SRP (cf. Kuhn’sparadigm) that cannotbefalsified. Positiveheuristic: set of imperativeshowthe SRP shouldunfold, whatfallswithin or outsidethe SRP, howthe SRP shouldbedefended. Research programs maydegenerate, forinstanceastrology, or innovated, such as physicsandeconomics. Is behavioraleconomicsan SRP?

  10. Thorstein Veblen (1857-1929) ThorsteinVeblen (1919)’s new research program in economics: • Methodsfromthebehavioralsciences (psychology, sociology). • Realisticdescriptiveassumptions. • Focus of actualbehavior and motivations. • Middle-level, empiricallygroundedtheories. Avoid abstract generaltheories. • Empiricaltestingforexplanation, prediction, and control. • Systematicempiricalgeneralizations. • Go beyondprices and exchange value, and examinethe impact of market and non-market forces on economic and social welfare. • Replacestaticbydynamictheories, accounting for change. • Includesocialforces on economicbehavior. 1-5 = hard core; 6-7 = positiveheuristic; 8-9 = problem shift of the new program. Simple hedonism (pleasure/pain) is rejected as a validtheory of psychology.

  11. Veblen’s revolution failed, but … Slutzky (1915): Economicsshouldbe independent of philosophical hypotheses (verifiability) andpsychologicalassumptions (predictivevalidity is sufficient). Slutzky-Hicks-Allen’sindifference curve analysis. After WWII, the formalist revolution in economics was neededfortheeconometric approach. The attackers lost. The hard core of economics was reinforced: The assumption of ‘economic man’ was replacedby ‘rationality’ and ‘logic of choice.’ The protective belt was strengthenedbyelimination of unnessessary hypotheses. George Katona (1953) and Herbert Simon (1963) reopenedthedebate (second ‘attack’ bybehavioraleconomics). We are now in thethird ‘attack.’ Recognition and Nobel prizesfor Herbert Simon (1978), Daniel Kahneman (2002), and Richard Thaler (2017).

  12. Herbert Simon (1916-2001) • Carnegie Mellon University, Pittsburgh, USA. • economics, organizationscience (administrativebehavior), psychology, AT (artificial intelligence), computer science. • Nobel prizeEconomics 1978. • Boundedrationality. • Problemsolving. • Decision making. • Satisficingratherthanmaximizing.

  13. Daniel Kahneman, born 1934 • Prospect theory. • Evaluation of gains and losses. • Loss aversion. • Heuristics. • Systems 1 and 2. Daniel Kahneman, 1934- Nobel prize Economics 2002 (with Vernon Smith, experimental economics). Amos Tversky, 1937-1996, co-author D. Kahneman & A. Tversky, Prospect theory: An analysis of decisionunder risk. Econometrica, 47, 1979, 263-291.

  14. Richard Thaler, born 1945 • University of Chicago, USA. • behavioral economist, • Nobel prizeEconomics 2017. • Behavioralfinance. • Investingbehavior. • Endowment effect (with Jack Knetsch and Daniel Kahneman). • Pension saving, “Save more Tomorrow” (with ShlomoBenartzi). • Nudge (with CassSunstein).

  15. Behavioral economics Is behavioraleconomics a: • Paradigm (Kuhn)? • Scientific Research Program (SRP; Lakatos)? • Set of anomalies (Thaler)? Does behavioraleconomics have a new theory? Yes, prospect theoryexplains part of theanomalies. No, there is no general, dynamictheory of behavioraleconomics. Behavioraleconomics: • Largely a set of anomalies. • New paradigm without a new theory. • SRP, started in micro-economicsanddevelopinginto macro-economics (Katona). Let’s look to a number of anomalies.

  16. Saving and borrowing Gathergood & Weber (2014): Co-holding puzzle: In the U.K., 12% of households co- hold £ 3800 high-costrevolving credit, whilehaving > £ 5000 low-yield liquid savings. In the U.S., 33% of households have consumerdebtandsavings. For instance, Mr. & Mrs. Sepp have € 30,000 savings(receivean interest rate2%). Theyfinancetheircar with a loan of € 25,000 (payan interest rate 7%). Whatwould you do, if you were in theirposition? Whatmaybethereason(s) for Mr. & Mrs. Sepp to co-hold credit andsavings? • Lack of financial literacy? Mistake? • Self-control? Plannedbehavior? Controlling impulsivespendingand/or saving. • Holding a financial buffer foremergencies? • Is co-holding temporary or permanent?

  17. Conjunction fallacy Tversky & Kahneman (1983): 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 participated in anti-nuclear demonstrations. Which option is more probable? A. Linda is a teacher. B. Linda is active in the feminist movement. C. Linda is a teacher and active in the feminist movement. Most people select option C. However, the probability of two events occurring together (in ‘conjunction’) is always less than or equal to the probability of either one occurring alone. Formally, for two events A and B, this inequality could be written as Pr (A∧B) ≤ Pr (A) and Pr (A∧B) ≤ Pr (B). A B A∧B

  18. Attraction effect 1 The magazine The Economist offers three options for an annual subscription: • Online subscription for € 45. • Subscription print version for € 90. • Subsciption print + online version for € 90. Which option do you prefer? In a sample, 16% chooses option A and 84% chooses option C. No one chooses option B (C > B; C dominates B). If option B is deleted, 68% chooses option A and 32% chooses option C (preference reversal). Deleting option B (a non-selected option) changes the choice between A and C. Option B is a decoy option, present to make option C more attractive. This is a presentation bias, often present in the assortment of catalogs and supermarkets.

  19. Attraction effect 2 Addition of asymmetrically dominated alternatives. Assortment of insurances A and B. We add insurance C. Which insurance becomes more attractive? We add insurance D. Which insurance becomes more attractive?

  20. Numericalpriming1 Ekkehard Stephan Numerical priming (Ekkehard Stephan, 2005) in a study for the Süddeutsche Klassenloterie: • In a telephone conversation, people were asked whether a lottery ticket of the Süddeutsche Klassenloterie is cheaper or more expensive than € 30 (in the other condition: € 60). • Then the price of a lottery ticket was mentioned: € 45. • The willingness to buy a lottery ticket was higher in the € 60 condition than in the € 30 condition. An explanation is the order of the prices. The price of € 45 is more attractive/ acceptable, after a higher price has been mentioned.

  21. Numericalpriming2 Ekkehard Stephan Unconscious activation of a scheme/mindset of a low vs. high price. After activation of a high price, the lower price will be perceived as a gain. The result is a higher willingness to pay (WTP) than when first a lower price has been activated. The price is a relevant prime. Even an irrelevant prime (‘You are the 87th/7th person we call today’, thus an irrelevant high/low number), activates a scheme/mindset of high/low prices and thus a higher/lower WTP (willingness to buy a lottery ticket).

  22. Framing, prospect theory 1 Suppose Estonia prepares for the Asian flu that probably will take the lives of 600 people. There are two inoculation programs (A and B) available: A. 200 out of 600 people will be saved. B. A probability of 1/3 that all 600 people will be saved, and a probability of 2/3 that nobody will be saved. Which program do you select, A or B? There are two other inoculation programs (C and D) available: C. 400 out of 600 people will die. D. A probability of 1/3 that nobody will die, and a probability of 2/3 that all 600 people will die. Which program do you select, C of D?

  23. Framing, prospect theory 2 A. 200 of 600 people will be saved. B. A probability of 1/3 that all 600 people will be saved, and a probability of 2/3 that nobody will be saved. Most frequent answer: A C. 400 of 600 people will die. D. A probability of 1/3 that nobody will die, and a probability of 2/3 that all 600 people will die. Most frequent answer: D Note that A and C are identical: 200 people will be saved. And B and D are identical: 0 or 600 people will be saved. Positive/negative framing. Preference reversal? Losses loom larger than gains.

  24. ‘Free’ bias In an experiment by Shampanier, Mazar & Ariely (2007) two types of chocolate were offered (Lindt truffels and Hershey kisses) for the following prices: ‘Free’ has no downside. There is no trade-off between utility/preference and price. There is no ‘loss’, no payment aversion. ‘Free’ is obviously always possible without any risk or consequence. This is another example of preference reversal. ‘Third product free’ is more attractive than ’33% discount’. Choosing between a free voucher of € 10 or a voucher of € 20 for the price of € 7, most people choose the free voucher. Why? People may not be sure to use the voucher in the future.

  25. Endowment effect 1 Thaler (1980): Removing a good from one’s endowment/possession (loss) is more painful than that adding the same good (gain) to one’s endowment is pleasant. Consequently, goods that are included in the endowment will be more highly valued than those not in endowment. WTA > WTP. The willingness to accept (WTA, compensation) to give up an item in possession is higher than the willingness to pay (WTP) to obtain the same item. Ratios vary from 2:1 to 6:1. • WTA: minimum amount willing to accept a loss (sell). • WTP: maximum amount willing to pay for a gain (buy). Few transactions between sellers and buyers.

  26. Endowment effect 2 Knetsch (1989): Product evaluation of threegroups: • Received a coffee mug. • Received a chocolate bar. • Receivednothing. WTA > WTP. Preferencedepends on currentownership. Keep yourbelongings. Low willingness to trade (10/11%). Explanation of endowment effect: • Lossaversion; high WTA. • Owners/sellers a have different mindset thanbuyers.

  27. Endowment effect 3 Knetsch & Sinden (1984): Lottery tickets more highlyvaluedbyownersthanby non-owners. Explanations: lossaversion, anticipatedregret. Endowment effect forgoods (coffee mugs, chocolate bars), tokens (lottery tickets), goodsforresale?, services?, money?

  28. S-shaped value function of prospect theory positive value 125 100 losses -40 -20 0 20 40 gains • Gains and losses in relation to reference point. • Value of loss is 1.5 to 2 times larger than the value of gain (in absolute terms). • Loss aversion is stronger than obtaining a gain. -150 -200 negative value

  29. Time preference Discountedutility model of Samuelson (1937) as anexplanation of discountingfutureincome (with a constant discount factor). How muchcompensation do you accept (WTA) to receiveanamount of € 15 a month, a year, or 10 years later? Receivinganamount later is conceived as a loss. The WTAs are higherthan interest + inflation, and canbebest fittedby a hyperbole: hyperbolic discounting. The WTA becomes more realistic with a longer time interval. hyperbolic exponential

  30. Reference points in time How much you want to accept (WTA) to receive an amount later? How much are you willing to pay (WTP) to receive an amount earlier? (Loewenstein, 1988). WTA > WTP. More compensation desired (WTA) for a delay than people are willing to pay (WTP) for an equal (same duration) speed-up (delay/speed-up asymmetry). How can this be explained by prospect theory? Delay is a loss. Speed-up is a gain. More compensation required for a loss.

  31. Constant andhyperbolic discounting Present-time versus future-time orientation.

  32. Procrastination Procrastination: Starting too late with a task and running the risk of not completing the task on time. For instance, studying for an exam, or starting too late with pension saving. What are the reasons of procrastination? • Task is unattractive. • Task is very important and needs careful attention. • Smaller tasks go first. • It is uncertain how much time the task will take. • Task is perceived in abstract terms. If the task is seen in concrete terms, it is more clear what has to be done.

  33. Procrastination Reasons for procrastination are: • Small and attractive tasks get priority. • Task aversiveness; unattractive task. • Task difficulty; task requires effort and mental resources. • Task importance; task should be done carefully. • Size of the task; many hours or many days to complete the task. • Task uncertainty; uncertain how long it will take to finish the task. • Procrastination may lead to poor performance: stress, mistakes. • Procrastination may lead to better performance (arousal). • Procrastination improves mood in the short term. • Delaying attractive tasks is a sign of self-control. Recommendations: De-emphasize importance of the task. Partition the task in a sequence of (small) parts/steps. Facilitate starting the task (SMarT) (Zeigarnik effect).

  34. Partitioning Dividing a ‘big’ task into smaller subtasks: • Saving. • Paying off loans. • Stepwise procedures for entering a pension plan. • Stepwise procedures for purchasing on the internet. Saving or paying off € 3000 a year looks like an insurmountable task, but € 60 a week is a manageable task. Not taking a ‘latte’ of € 4,90 at Starbucks is an insignificant contribution to saving € 3000 a year, but is a realistic contribution to saving € 60 a week. 0,16% versus 8,2%.

  35. SMarT program Thaler & Benartzi (2004): Save More Tomorrow. How to get peopleto start pension saving? • Lossaversion: savingmaybeseen as a loss (lessspending). • Procrastination: inertia, delayingto start saving. • Present-time orientation: later pay-offs have a lowervaluethan present pay-offs. How tocircumvent these inhibiting factors? • Get the consent toopt-in a pension saving program (procrastination, default option). • Start saving at a later moment in time (hyperbolicdiscounting). • Start saving at a pay-raise (lossaversion). • Increasesaving at the next pay-raise. • Opt-out is possible, but is notthe default.

  36. SMarT program Thaler & Benartzi (2004): Save More Tomorrow. How to get peopleto start pension saving? • Lossaversion: savingmaybeseen as a loss (lessspending). • Procrastination: inertia, delayingto start saving. • Present-time orientation: later pay-offs have a lowervaluethan present pay-offs. How tocircumvent these inhibiting factors? • Get the consent toopt-in a pension saving program (procrastination, default option). • Start saving at a later moment in time (hyperbolicdiscounting). • Start saving at a pay-raise (lossaversion). • Increasesaving at the next pay-raise. • Opt-out is possible, but is notthe default.

  37. Types of biases/heuristics Biasesand heuristics in behavioraleconomics: Mistakes, shortcomings: conjunctionfallacy, planning fallacy, availability bias, representativeness bias. Subconsciouseffects: attraction effect, numericalpriming, framing. Default: opt-in versusopt-out, SMaRT. Lossaversion: ‘free’ bias, endowment effect, SMarT, framing. Self-control: co-holding debt-savings, procrastination, SMarT. Time orientation: hyperbolicdiscounting, SMarT. Whichelementsshouldbeincluded in a new theory of behavioraleconomics? • Gainversusloss. • Promotion versus prevention. • Present versusfuture. • Concrete versus abstract mindset/construal. • Self-control.

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