Behavioral Economics

Behavioral Economics ECO 61 Microeconomic Analysis Udayan Roy December 2008

Main Topics • Objectives and methods of behavioral economics • Departures from perfect rationality • Choices involving time • Choices involving risk • Choices involving strategy 13-2

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 13-3

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 13-4

Advantages of Experiments • Easier to determine whether people’s 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 isn’t available in the real world 13-5

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 experimenter’s 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 13-6

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? 13-7

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

Incoherent Choices:Choice 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 13-9

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 13-10

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!

Figure 13.2: A Choice Reversal 13-12

Incoherent Choices:Anchoring • Anchoring occurs when someone’s choices are linked to prominent but irrelevant information • Suggests that some choices are arbitrary and can’t 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 13-13

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

Bias Toward the Status Quo:Endowment Effect • The endowment effect is people’s tendency to value something more highly when they own it than when they don’t • 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 consumer’s initial consumption bundle • Smooth changes in price yield abrupt changes in consumption 13-15

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

Figure 13.3: Endowment Effect 13-17

Bias Toward the Status Quo:Default 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 13-18

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

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 13-20

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

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

Why you can’t get a cab in NYC when you really need one • On any given day, the length of a cab driver’s shift was negatively related to hourly earnings • Total daily income remained the same

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

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 13-25

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 13-26

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 don’t 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 13-27

The Problem of Dynamic Inconsistency • Save More Tomorrow (SMART) plans • The earlier option is chosen more frequently the shorter the delay

The Problem of Dynamic Inconsistency • People often waste expensive gym memberships • The LIU gym plan for faculty

Figure 13.4: Dynamic Inconsistency in Saving 13-30

We should ignore sunk costs but often do not • Uncomfortable shoes • Bad movie rentals • Season ticket discounts lead to lower initial attendance

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

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 • Gambler’s fallacy is the belief that once an event has occurred it is less likely to repeat • Arises when people can’t 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 13-33

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

Gambler’s 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

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

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 person’s willingness to take larger financial risks 13-37

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

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

Prospect Theory:A 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 13-40

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 13-41

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) < [P  U(R + X1)] + [(1 – P)  U(R + X2)] • Prospect theory: yes if • V(0) < [W(P)  V(X1)] + [W(1 – P)  V(X2)]

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.

Choices Involving Strategy • Some of game theory’s apparent failures may be attributable to faulty assumptions about people’s 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 13-44

Voluntary Contribution Games • In a voluntary contribution game: • Each member of a group makes a contribution to a common pool • Each player’s 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 13-45

Importance of Social Motives:The 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 13-46

Importance of Social Motives:The 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 13-47

Importance of Social Motives:The 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 13-48

Behavioral Economics