Chapter 31 Behavioral Economics Key Concept: Heuristics and Biases

1. Chapter 31 Behavioral Economics • Key Concept: Heuristics and Biases

2. Behavioral economics uses some insights from psychology to study how consumers actually make choices. These choices may be at odds with the conventional “rational” models. • Economists first response: Can we rationalize them?

3. We will look at some phenomena that have been identified by behavioral economists.

6. Framing effect: People are strongly affected by how choices are presented to them or framed.

7. Consider this piece of chocolate (50g).

8. First answer: Would you be willing to pay an amount for this chocolate equal to the last two digits of your NTU student ID*10? • Ex: B05301078 →78*10=780

9. Write down the maximum amount that you are willing to pay for the chocolate.

10. Anchoring effect: People’s choices can be anchored.

11. Bracketing: the consideration of repeated as a set versus in isolation

13. Choice overload is a cognitive process in which people have a difficult time making a decision when faced with many options.

14. Psychologists think of preferences as being constructed. • Preferences are discovered through experiences of choices. • Once they are discovered, they determine later choices.

15. There are two hospitals. • In the larger hospital about 45 babies are born each day. • In the smaller hospital about 15 babies are born each day. • About 50 percent of babies are boys. However, the exact percentage varies from day to day.

16. For a period of 1 year, each hospital recorded the days on which more than 60 percent of the babies born were boys. • Which hospital do you think recorded more such days?

17. Look at a simpler example. • Large: 2 • Small: 1 • On each day, the prob of this event in the L hospital is 0.25. The prob of this event in the S hospital is 0.5.

18. People expect small samples to look like the distribution from which they are drawn. They underestimate the actual magnitude of the fluctuation in a sample.

19. Prospect theory: • Loss looms larger than gain.

20. Mental accounting: people group their assets into a number of non-fungible mental accounts.

21. People mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behavior as the accounts are largely non-fungible and marginal propensity to consume out of each account is different. • a small windfall vs regular summer income

22. Exponential Discounting: u(c1)+δu(c2) +δ2u(c3) • The MRS between period 2 and 3 viewed in period 1 is δu’(c2)/ δ2u’(c3). Viewing in period 2 is u’(c2)/ δu’(c3). So we are time consistent. • β-δdiscounting implies the former is βδu’(c2)/ βδ2u’(c3) while the latter is u’(c2)/ βδu’(c3). We therefore have time inconsistency.

23. Think about new year resolution. We run into the problems of self control a lot of times because we can renegotiate with ourselves easily. Because of this, there are some commitment devices evolved. For instance, we may hire an exercise instructor, buy the pass to a gym for the following year, publicly announce our new year resolution so that we will embarrass ourselves if failing to do it, etc.

24. Ultimatum game: the proposer is given 10 and asked to propose a division between himself and the responder. • The responder is then shown the division and asked whether to accept or reject. If he accepts, the division is carried out; if not, both walk away with nothing.

26. Impulse to reject unfairness is fundamental: cognitive control to suppress in order to accept • Pursuing self interest is more fundamental and this leads to acceptance: so we need cognitive control to implement the culture-dependent fairness

27. Fehr et al. show that disruption of the right, but notthe left, dorsolateral prefrontal cortex (DLPFC) by low-frequency repetitive transcranial magneticstimulation substantially reduces subjects’ willingness to reject their partners’ intentionally unfairoffers, which suggests that subjects are less able to resist the economic temptation to acceptthese offers.

28. Importantly, however, subjects still judge such offers as very unfair, which indicatesthat the right DLPFC plays a key role in the implementation of fairness-related behaviors.

30. The reason we use rulers and yardsticks is that we learn not to trust our own eyes. • TheMuller-Lyer optical illusion

32. In important decisions, you may want to consult the views of objective experts.

33. Chapter 32 Behavioral Economics • Key Concept: Heuristics and Biases