Behavioral Economics Goals: 1.Take a critical look at the assumptions we’ve made so far. 2.Take a break from the math! 3.Work on writing and oral communication.

Behavioral Economics

Goals:1.Take a critical look at the assumptions we’ve made so far.2.Take a break from the math!3.Work on writing and oral communication skills.4.Apply economics to public policy & business operations issues.

Behavioral EconomicsAgenda:

I. Objectives

II. Review: what is “rational” in Neoclassic economics?

III. “Economics Anonymous” – confessions about our irrational decisions.

IV. Chicago Man vs. K&T Man

V. A mathematical model

VI. Examples of

1. Time inconsistency & hyperbolic discounting

2. Loss aversion & the asymmetric value function

3. Framing

4. Probability Weighting

VI. Policy Implications: normative vs. positive

“All models are wrong, but some are useful.”

-- George Box

What does “rational” mean to a Neoclassic economist?

1. Preferences are complete2. Preferences are transitive

To make the math work, we also assumed:3. Preferences are convex (we prefer variety)4. More is better than less

Hi, my name is _____, and I made an irrational decision…..

“De Gustibus Non Est Disputandum”American Economic Review (1977) 67(2):76 - 90

“On the traditional view, an explanation of economic phenomena that reaches a difference in tastes between people or times is the terminus of the argument: the problem is abandoned at this point to whoever studies and explains tastes (Psychologists? Anthropologists? Phrenologists? Sociobiologists?). On our preferred interpretation, one never reaches this impasse: the economist continues to search for differences in prices or incomes to explain any differences or changes in behavior…

…the establishment of the proposition that one may usefully treat tastes as stable over time and similar among people is the central task of this essay.” p. 76.

“There is no accounting for tastes”

George J. Stigler Gary S. Becker

Amos Tversky Daniel Kahneman

“Prospect Theory: An Analysis of Decisions Under Risk,”

Econometrica (1979) 47:263 – 291.

http://en.wikipedia.org/wiki/Behavioral_economics http://nobelprize.org/nobel_prizes/economics/laureates/2002/kahnemann-lecture.pdf http://harvardmagazine.com/2006/03/the-marketplace-of-perce.html

“The Framing of Decisions and the Psychology of Choice,”

Science (1981) 211:453 - 458.

“…the research that Tversky and I conducted was guided by the idea that intuitive judgments occupy a position … between the automatic operations of perception and the deliberate operations of reasoning…we held a two-system view, which distinguished intuition from reasoning.” -- Kahneman’s Nobel Lecture

http://en.wikipedia.org/wiki/Chicago_school_of_economics#Friedrich_von_Hayek

James Heckman, left, Roger Myerson, Gary Becker and Robert Lucas are among the Nobel laureates in economics from the University of Chicago.

“This work has both fascinated and dismayed economists; it has been like watching master carpenters construct the scaffold for your hanging.”

McFadden (1999) p. 8

ChicagoMan

K-T Man

Complete, transitive and convex set of preferences on bundles of commodities that stay constant, and the ability to accurately compute the probability and thereby the expected utility of uncertain events.

Reference dependent (preferences aren’t constant), loss averse with a systematic tendency to overweight small probabilities and underweight large ones. Makes decisions by “rules of thumb” or “heuristics” that are not necessarily optimal.

Rational Actor Imperfectly Rational Actor

Classification of deviations from the “Chicago Man”Adapted From DellaVigna (2009)

1. Nonstandard preferences

2. Nonstandard decision making

Inconsistent Time Preferences (self control, pre-commitment)

Inconsistent Risk preferences (loss aversion, endowment effect)

Inconsistent (not transitive) preferences (framing)

Social preferences (altruism)

Probability weighting (law of small numbers)

Heuristics (rules of thumb)

Social pressure and emotion

1 1

( ) ( ) ( )T N

ij ij i ij ij iji j

E U M p v M s

Time inconsistency

Probability weighting

Framing with a reference point

Loss aversion: “Asymmetric Value Function”

ijvs

Choice under certainty

Choice with un-certaintyVNM Expected Utility

Behavioral Model

Mathematical Models

1

T

T i ii

U u M

1

( ) ( )N

i ii

E U M p u M

Discount rate

probability

time possibilities

Time Inconsistency: Hyperbolic DiscountingA “time inconsistent” discount rate that discounts near time periods more.

Do you want $50 now or $100 next year? Let’s assume a high 10% interest rate:

1

$100$90.91

(1.1)PV

Do you want $50 in four years or $100 in five years, 10% interest

PV(50) = $34.15PV(100) = $62.09

Check out this cool interactive graph comparing hyperbolic and exponential discounting:http://economicsnetwork.ac.uk/archive/poulter/hyperbolic_versus_exponential_discounting.htm

Try this: use the PV formula and get these answers

yourself!

Time Inconsistency is like having a split personality!

Odesseus and the Sirens

http://www.stickk.com/

Are you more afraid of dying in an airplane or a car accident?

Odds of death:Car: 1:100,000 miles

Plane: 1.6:100,000,000,000 miles

Car: 1:10,000,000 tripsPlane: 1: 720,000,000 trips

Probability Weighting

Overweight small probabilities

Under weight large probabilities

Availability, Anchoring, Representativeness: we assign a higher probability to things we see, things we are more familiar with or are more horrific.

Asymmetric Value Function

1. We value losses more than gains2. We evaluate events separately rather than as a whole

Job A: Base salary of $50,000 with $5,000 bonusJob B: Base salary of $55,000 with $5,000 claw back

Practical Examples of Loss Aversion

Holding on to losing investments

“The disposition effect”

Ignoring sunk costs in economic decision making

Not knowin’ when to fold ‘em

Holding on to losers:http://www.forbes.com/2009/08/11/commentary-regret-aversion-intelligent-investing-ervolini.html

Example #1: There is an outbreak of an infectious diseaseOption A: 200 people will be savedOption B: There is a 1/3 probability that 600 people will be saved and a 2/3 probability that no one will be saved.

72% chose AExample #2: There is an outbreak of an infectious diseaseOption C: 400 people will dieOption D: There is a 1/3 probability that no one will die, and a 2/3 probability that 600 people will die. 78% chose D

Framing: How things are presented changes how you see them.

“A Short Course on Behavioral Economics”http://www.edge.org/discourse/thaler_sendhil_index.html

http://online.wsj.com/article/SB10001424052748704869304575103980232739138.html http://www.economist.com/node/21551032

“Economic Policy ‘Nudge’ Gives Way to ‘Shove’” 3/8/10

“The opening weeks of the Obama administration were a coming-out party for economists who hold that incomplete information, subtle obstacles to participation and confusion tend to make people act in economically irrational ways. Economic policy can "nudge" people and institutions into more efficient, economically beneficial behavior without heavy-handed command-and-control measures in regulation and legislation, they argue.”

Austan Goolsbee, Council of Economic Advisors

"Institutional decision-making is much closer to a rational economics than individual decision-making, no question," Mr. Orszag said. (Director of the Office of Management and Budget (OMB))

Example: Sin TaxesOne policy, two economic perspectives…

http://www.nytimes.com/2008/12/17/nyregion/17sugartax.html

Test yourself:

1. Take the list of decisions we made at the beginning of class and classify each as a non-standard preference or non-standard decision making. Feel free to add new examples of your own or from anything we’ve read or discussed.

2. Then try to take the next step and identify the parameter (symbol) in the behavioral model that would change if you were to model your decision making process.

Extra credit point for handing in at least five (5) examples spanning at least three (3) categoriescorrectly classified with notation!!

http://www.cato.org/pubs/journal/cj28n3/cj28n3-12.pdf http://www.worldchanging.com/archives/008141.html

“Dust has been kicked in the face of the old guard…Down with equations – this new generation proclaims – experimentation is the Economics’ new currency! Yet, for all of the joys of experimenting, poking holes in the old theory doth not a new one make.” (emphasis added) -- Coco Krumme, Worldchanging Book Review.

“…invite us into an alternative world, one that takes our humanness as given. They show that by knowing how people think, we can design choice environments that make it easier for them to choose what is best for themselves…” (emphasis added)http://www.nudges.org

What is the prognosis for Chicago Man??

“Chicago Man is an endangered species.” p. 31

“…On the other hand…careful attention to the processes that consumers use to define tasks…may allow one to look behind the superficial errors to uncover stable principles, attitudes, and preferences upon which a new economic analysis may be built.” p. 31 (emphasis added)

Daniel McFadden