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Behavioral Economics chapter 13 Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-2 Learning Objectives Describe the objectives and methods of behavioral economics. Summarize, interpret, and evaluate evidence of systematic departures from perfect rationality. Explain why some economists modify the standard theory of decisions involving time and uncertainty. Discuss why it may be important to account for social motives when analyzing strategic decisions. Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-3 Overview Behavioral economics rely heavily on experiments with human subjects No one is completely rational all the time Behavioral economics adds to standard economic theory in several areas, particularly when choices involve time, risk, and strategy Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-4 Why Behavioral Economics? People sometimes make choices that are inconsistent with standard economic theory Example: the preferences implied by these circular choices violate the Ranking Principle Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-5 Behavioral Economics Methods In common with standard economics Assuming that each individual has objectives, that there is a connection between those objectives and actions, and that actions affect well-being Using mathematical models of behavior Testing theories using objective data, replicable methods, and standard statistical tools More emphasis on experiments using human subjects Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-6 Advantages of Experiments In a lab, all the influences on decision making are potentially knowable and controllable Easier to determine causality Researchers can double check their assumptions and conclusions by testing and debriefing subjects Often possible to obtain information that is unavailable in the real world Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-7 Disadvantages of Experiments Decisions made in the laboratory differ from decisions made in the real world Unfamiliar tasks Not much at stake Lab experiments introduce influences that are difficult to measure or control Most experimental subjects are college students Most experiments involve a small number of subjects Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-8 Rationality Choices Reversals An experimental subject who chooses a low stakes bet over a high stakes bet, but who attaches a higher dollar value to the high stakes bet, violates the Ranking Principle Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-9 Rationality Anchoring Anchoring: when someones choices are linked to prominent but plainly irrelevant information Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-10 Rationality Bias Toward the Status Quo Endowment effect: people tend to value something more highly when they own it than when they do not 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 Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-11 Rationality Narrow Framing Narrow framing: psychological tendency to simplify decisions by limiting the types of options and/or consequences considered Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-12 Rationality Salience Salience: people are more likely to consider a fact when its presentation is more attention- grabbing Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-13 Rationality Rules of Thumb Many economic decisions are so complex that thinking through all the possible consequences for every alternative is extremely difficult In such circumstances, many people rely on simple rules of thumb that have served them or others well in the past Example: how much to save Some economists think that irrational behavior in the laboratory sometimes occurs because experiments trick subjects into applying good rules of thumb to the wrong situations Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-14 Time Maintaining Self-Control A person is dynamically consistent if her preferences over the alternatives available at some future date do not change as that date approaches When this condition does not hold, preferences are dynamically inconsistent Present bias: a form of dynamic inconsistency involving a bias toward immediate gratification Example: people who suffer from present bias may have difficulty exercising the self-control required to save money Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-15 Time Maintaining Self-Control Solution = precommitment: 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 Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-16 Time Ignoring Sunk Costs Sunk cost fallacy: the belief that if you paid more for something, then it must be more valuable to you Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-17 Time Forecasting Future Tastes and Needs Projection bias: tendency to evaluate future consequences based on tastes and needs at the moment of decision making People sometimes have trouble anticipating how they will feel about future outcomes A temporary mood or state of mind can exert a powerful influence on decisions that have longer-term consequences Example: grocery shopping while hungry Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-18 Risk Trouble Assessing Probabilities Hot-hand fallacy: belief that once the event has occurred several times in a row, it is more likely to repeat Gamblers fallacy: belief that once an event has occurred, it is less likely to repeat Example: some investors assume that a rising stock will continue to rise (hot-hand fallacy), while others assume that a falling stock is due for a rebound (gamblers fallacy) Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-19 Risk Danger of Overconfidence Many people have overinflated views of their own abilities In the context of decisions involving risk, overconfidence causes people both to overstate the likelihood of favorable events and to understate uncertainty Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-20 Risk A Puzzle Involving Low Probability Events Choice Option A: Win $5 for sure Option B: Win $5,000 with odds of 1 in 1,000; else, win nothing In experiments, a majority of subjects choose option B This choice is puzzling because options A and B have the same expected payoff ($5), but option B clearly involves greater risk If subjects are risk averse, they should pick option A Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-21 Risk A Puzzle Involving Aversion to Very Small Risks Choice: Option C: Win $1,010 with 50% probability; else, lose $1,000 with 50% probability Option D: Win $10.10 with 50% probability; else, lose $10 with 50% probability Most people would take neither option. However, standard economic theory shows that a risk- averse individual should always be willing to accept a sufficiently small share of any gamble that provides a positive expected payoff. Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-22 Risk Prospect Theory Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-23 Risk Expected Utility Theory Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-24 Risk Prospect Theory Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-25 Risk Prospect Theory Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-26 Risk Prospect Theory Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-27 Strategy Game Theory Shortcomings Game theory tends to predict behavior most accurately once players have gained some experience with a game, particularly if the rules are relatively simple However, even experienced players of simple games sometimes make decisions that seem contrary to their own interests Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-28 Strategy Importance of Social Motives In social situations, monetary gains usually are not the only motive Some people are altruistic, some value fairness, while others are attracted to efficient outcomes that avoid waste Example: in the dictator game, one player divides a fixed prize between herself and another player, who is a passive participant If people care only for their own monetary payoffs, every dictator should keep the entire prize for herself However, most studies find evidence of significant generosity Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-29 Review Behavioral economists aim to modify, supplement, and enrich standard economic theory by adding insights from psychology Behavioral economics explains some departures from perfect rationality, particularly choices involving time, risk, and strategy Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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13-30 Looking Forward Next, we will go back to the standard economic approach and focus on how competitive markets enhance efficiency Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.