Principles of Microeconomics 15. Psychology and Economics* Akos Lada August 13th, 2014 * Slide content principally sourced from N. Gregory Mankiw and David Laibson’s course slides.

Contents 1.A short questionnaire (plus a couple of fun “tests”) 2.Mind over money (documentary, fragment) 3.Behavioral economics (a taster) 4.The principles of economics revisited

1. A short questionnaire

A couple of fun tests Splitting $100: One person receives $100 dollars (in this case, of the imaginary kind…) He or she has to make a proposal as to how to split the money with the second person (e.g. 90 – 10). If the second person accepts the split, each get the $ that is agreed. If the second person doesn’t accept the both get nothing A small counting challenge: Another experiment (performed on others ):

2. Mind Over Money (documentary, fragment)

3. Behavioral Economics (a taster)

Behavioral Economics Behavioral economics : the subfield of economics that integrates the insights of psychology People aren’t always as rational as traditional economic models assume. Herbert Simon viewed humans as satisficers, people who make choices that are merely “good enough” rather than optimal. Other economists have suggested that people are only “near rational” or exhibit “bounded rationality.” Here are some examples of “bounded rationality”

Framing Framing matters: the same questions asked differently gives you different answers For example: people tend to take more risks when incentivized by fear of loss than when incentivized by the perspective of gains

Example: Saving People’s lives of letting people die? Life vs. Death…600 expected to die…two options in response: Game 1: Option A: 400 people die Option B: 0 people die with probability 1/3 600 people die with probability 2/3 Game 2: Option A: 200 people are saved Option B: 600 people are saved with probability 1/3 0 people are saved with probability 2/3 12

They are the same! But… Option A is equivalent in both games and same with option B, so rationally if you preferred A in game 1, you should also prefer A in game 2. But people choose (B) in the first game and (A) in the second game. Preferences of the class in Game 1: (A): (B): Preferences of the class in Game 2: (A): (B): Game 1: frame as losses Game 2: frame as gains

People Care About Fairness SPLITTING $100 Predicted outcome if both players rational A would propose a 99-1 split and B would accept, because $1 is better than nothing. Actual outcomes from experiments with real people B usually rejects lopsided splits like 99-1 as wildly unfair. Expecting this, A usually proposes giving $30 or $40 to B. B views this as unfair, but not so much as to abandon his self-interest, so B accepts. Average proposal in this classroom: $

Time-inconsistency (a.k.a.“dynamic inconsistency”) People Are Inconsistent Over Time: they tend to prefer instant gratification, even when delaying would increase the gratification. Result: People fail to follow through on plans to do things that are dreary, take effort, or cause discomfort. E.g., people often save less than they plan To help follow through, people look for ways to commit themselves to their plans. E.g., worker has money taken out of paycheck before he ever sees it

$100 or $102? A person offered the choice of getting $100 or $102 one day after should “rationally” chose the second. However, the answer varies depending on when the payments happen. If both payments are one year from now, people tend to choose the “rational” option If the first payment is “now”, people tend to prefer that. This classroom: $100 in one year: X% $102 in one year and one day: X% $100 now: X% $102 tomorrow: X% This tendency is known as “present bias”

A Nice Ending Thought This was a question asked to Dan Ariely, MIT behavioral economist and author of a recent popular book titled “Predictably Irrational”: Natasha Mitchell (of ABC Radio): “You suggest that we're pawns in a game whose forces we largely fail to comprehend -- our irrational selves in other words. I mean this is a very pessimistic view of human nature and capacity, surely.” Dan Ariely: Well I don't want to think about it as pessimistic, in some way the economic perspective is that the world is wonderful, that everybody is perfectly rational and the world is in equilibrium. And I look at the world and I see poverty and hunger and diseases and STDs and people drive badly and make repeatedly bad decisions. I don't want them to think this is equilibrium. I in fact want to think that we can do better. Now in economics we're perfect, we're rational and there's nothing we can do to make things better. In behavioural economics we are fallible and we make mistakes, and we're foolish and we're myopic and we're emotional. The good news is that if we understand those things we can actually create a better world.

4. The principles of Economics revisited