What is Behavioral Economics
An Illustration: Guess the Number Game
• The Decision: Choose a number between 0 and 100
• Goal: Win the game by choosing the number closest to 2/3 of the average of
the guesses.
• Complete knowledge, Self-Interested Nash Equilibrium: All guess zero
• Typical average: 19, so a winning guess might be 13 rather than zero.
• Best choice depends upon your ability to judge how others will think
• One possibility: All pick at random, so average is 50. Then the best guess
for you is 33.
• But, you should pick 22 if you think others will pick 33. As in chess,
deeper thinking by others requires even deeper thinking by you for
success.
An Illustration: Hyperbolic Discounting
• Which do you prefer?
• $100 today, or $105 a week from now.
• $100 a year from now, $105 a year and a week from
now
An Illustration: Frame
Question: Will you have the surgery?
Frame 1: Of 100 people having surgery, 90 live through the postoperative period, 68 are alive at the end of the first year and 34 are
alive at the end of five years.
Frame 2: Of 100 people having surgery, 10 die during surgery or the
post-operative period, 32 die by the end of the first year, and 66 die
by the end of five years.
O
Behavioral Economics Definitions
• Behavioral economics is the name we give to the research enterprise that seeks to
augment and amend the existing body of classical and neoclassical economic theory to
achieve a more realistic picture of economic process. (Herbert Simon)
• The introduction of insights drawn from social psychology into (macro) economic
behavior (George Katona )
• A research approach to economics which (1) rejects the notion that positivism is the sole
methodological foundation for economic research, (2) refuses to accept the use of
deductive reasoning as a sufficient basis for a (social) science, (3) dislikes static analysis
of equilibrium as representing outcomes relative to disequilibrium processes, and (4)
object to the simplistic economic model of rational agents exhibiting optimizing
behavior (1984, p. 1).(Gilad, Kaish, and Loeb)
• Behavioral economics is a school of thought distinguished by the fact that it is much less
narrow, rigid, intolerant, mechanical, separate, and individualistic than mainstream
economics (Tomer).
Key Contributors to Behavioral Economics
• George Katona: Starting in late 1940, used surveys to support the idea that the level of
consumption spending has a highly psychological component. Referred to by some as
the Father of Behavioral Economics.
• Herbert Simon (Nobel Aureate) : In 1950s, replaced maximization assumption with
satisficing assumption. Limited cognitive capacity typically precludes maximization,
spawning the term bounded rationality. Under bounded rationality, behavior is
determined by a pair of scissors, where one blade is the decision maker’s cognitive
limitations and the other blade is the particular environment.
• James March and Richard Cyert: Developed a theory of how firms behave using
bounded rationality as the underlying basis.
• Gerd Gigerenzer: Heuristics are developed that are tailored to particular decision
making environments that effectively allow the decision maker to effectively cope with
limited cognitive capacity.
• Reinhard Selten (Nobel Aureate) : Game theory applications of limited cognitive
capacity.
• Harvey Leibenstein: Applications of bounded rationality to understanding the efficiency
and inefficiency that may exist within a firm.
• Daniel Kahneman (Nobel Aureate) and Amos Tversky: People predictably violate
rationality axioms when the outcome of a choice is uncertain and when the decision
context changes in certain ways.
Key Contributors to Behavioral Economics
• Richard Thaler: Identified biases in behavior relative to that predicted by traditional
economic theory. Many practical applications of behavioral economics.
• George Akerlof (Nobel Aureate) : Applications of bounded rationality to labor market,
savings, education. A theory showing how identity can influence economic behavior,
connecting economics and sociology.
• Vernon Smith (Nobel Aureate) : A pioneer of experimental economics, including much
thought about behavioral issues.
• Richard Nelson and Sidney Winter: Applications of evolutionary theory to explain
development of habits and routines.
Behavioral Observations
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Anchoring
Cognitive Dissonance
Endowment Effect
Mental Accounting
Confirmatory Bias
Hindsight Bias
Status Quo Bias
Law of Small Numbers Bias
Vivid Information Bias
Framing effects
Learning
Use of Rules of Thumb in Decision-Making
Behavioral Observations
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Overconfidence
Wishful Thinking
False Consensus Effect
Curse of Knowledge
Preference Reversals
Fairness
Herding
Procrastination
Behavioral Theories/Models
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Loss Aversion
Endowment Effect
Hyperbolic Discounting
Social Preferences
Satisficing
Reference dependent utility
Diminishing Sensitivity
Reciprocity
Gift Exchange
Efficiency Wage
Internality
Sophisticated versus Naïve Discounters
Criteria for Evaluating Theories
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Prediction Accuracy (Stigler)
Generality (Stigler)
Tractability (Stigler)
Parsimony (Rabin)
Realism (Simon)
Positivism (Hume)
Falsifiability (Popper)
Existence of a Reasonable Competing
Theory (Lakatos)
Sample Applications
• Loss Aversion
o Consumers are more averse to lowering consumption in
response to bad news about income than they are to increasing
consumption in response to good news
• Fairness
o Subjects contribute to public goods more than can be
explained by pure self-interest
o Wage decreases are viewed with a special disdain, implying
wages are sticky in the downward direction, keeping
unemployment from being eliminated
• Reciprocity
o If others conserve water, you are more likely to conserve
o An employee who feels mistreated is more likely to sabotage
the firm.
Sample Applications
• Law of Small Numbers Bias
o We underestimate how often a good financial analyst will
be wrong a few times in a row. and how often a clueless
analyst will be right a few times in a row.
o People tend to generate spurious explanations for long
streaks that are determined by chance
o The gambler’s fallacy
• Anchoring
o Overestimate happiness gain from winning lottery
• Hindsight Bias
o Hearing the report of a mass shooting increases the
perceived probability of such an occurance
o “I knew it all along,” (but your really did not)
Sample Applications
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Hyperbolic Discounting
o Pay a Gym Trainer
o Christmas savings clubs
o In general, act to restrict your options
Confirmatory Bias
o We ignore information that does not support our initial
hypothesis
o Ambiguous information further affirms our initial
hypothesis
Status Quo Bias
o Libertarian Paternalism (Nudge)
 Savings plan opt-out rather than savings plan opt-in
 Put fruit in front of higher calorie desserts
Criticisms of Behavioral Economics
• Too many behavioral theories with too few
applications
• The many assumptions underlying behavioral
models need to be reduced to a smaller number of
more primitive assumptions
• Not clear how to identify equilibrium versus nonequilibrium behavior
How Economics May Become More Behavioral
• Model decision-making using learning processes, whereby a
decision maker becomes more sophisticated as learning
occurs.
• Environment dependent sophistication (or decision ability)
• Less representative agent models, more heterogeneity
• More use of our understanding of human cognition in
modeling decision making.
• More focus on developing theories that explain observations
(descriptive theories) and less focus on developing theories
that are axiomatically consistent (What Thaler calls
normative theories)
• More focus on how emotions influence choice
References
Fundenberg, Drew (September 2006) Advancing Beyond Advances in Behavioral Economics Journal
of Economic Literature 44, 694–711.
Hosseini, Hamid (2003). The Arrival of Behavioral Economics: From Michigan, or the Carnegie
School in the 1950s and the Early 1960s? Journal of Socio-Economics 32 (2003) 391–409.
Rabin, Mathew (March, 1998). “Psychology and Economics,” Journal of Economic Literature, 36: 1146
Thaler, Richard (Winter, 2000). From Homo Economicus to Homo Sapiens.” Journal of Economic
Perspectives 14(1), 133-141.
Thaler, Richard H. and Cass Sunstein (2003). “Behavioral Economics, Public Policy, and Paternalism:
Libertarian Paternalism,” American Economic Review, Papers and Proceedings 93: 175-179.
John Tomer, “What Is Behavioral Economics?,” Journal of Socio-Economics, 36(3), June 2007, 463479.