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

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, 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 $X 1 with probability P and $X 2 with probability 1 - P Will the consumer take this gamble? Expected utility theory: yes if – U(R) < [P  U(R + X 1 )] + [(1 – P)  U(R + X 2 )] Prospect theory: yes if – V(0) < [W(P)  V(X 1 )] + [W(1 – P)  V(X 2 )]

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