Supply and Demand, Consumer Choice, and Behavioral Economics
Economics looks at the world from a perspective of choices we make given our limited
resources.
Economics - the study of how society manages its scarce resources
Or the study of how to detect unintended consequences.

People face tradeoffs
Scarcity-- Limited nature of society's resources (unlimited wants, limited resources)

The cost of something is what you give up
Opportunity Cost - the highest valued alternative to choosing an action
Health economics studies how resources are allocated to and within the health economy.
There are special challenges to healthcare
1. The central roles of risk and uncertainty – both the incidence of illness and the
effectiveness of care are described in terms of probabilities. These change our behavior.
Even the correct therapy, provided the right way may carry some risk of failure.
2. The complexities created by insurance – because of risk and uncertainty, most consumers
have medical insurance. This puts a wedge between the payer and the user and has a
huge impact on incentives. It also complicates even the simplest transaction – now there
are at least three parties involved in any transaction.
3. The perils of information asymmetries – not only is there incomplete information
(uncertainty), there is also often asymmetric information. This can lead to a type of
market failure known as adverse selection – or death spiral.
4. The problems posed by not-for-profit organizations – multiple stakeholders mean
multiple goals. Thus, organizations become harder to manage and managerial
performance becomes harder to assess. How do nonprofits and for profits compete in the
same market?
5. The rapid and confusing course of technical and institutional change – Technology is
widely credited as the main driver for increasing health care costs. But is this driven by
demand or supply?
6. The move from volume to value
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Supply and Demand
Demand
The Law of Demand
There is an inverse relationship between the price of a good and the amount of it consumers
choose to buy
Two effects of a price change:
Income effect – lower price means that a consumer’s real purchasing power increases,
which increases the consumption of the good and likewise for a price reduction.
Substitution effect – when the price of one good falls, the consumer has an incentive to
increase consumption of that good at the expense of the other, now relatively more expensive
goods.
Determinants of individual Demand
1. Income
2. Prices of related goods
3. Tastes
5. Expectations
Demand Schedule and Demand Curve
Price
D
Quantity
Market Demand vs. Individual Demand
-- market demand is horizontal summation of individual demand curves
Shifts in the Demand Curve
Change in prices of related goods
Change in income (normal and inferior goods)
Change in tastes
Change in Expectations
Price elasticity of demand and its determinants
Defn:
Price elasticity of demand -- a measure of how much the quantity demanded of a good
responds to a change in the price of that good.
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Determinants:
Necessities vs. luxuries
Availability of close substitutes
Definition of the market
Time horizon
Variety of Demand Curves
Supply
There is a direct relationship between the price of a good and the quantity supplied
Determinants of individual Supply
1. input prices
2. technology
3. expectation
The Supply Schedule and the Supply Curve
Price
Supply
Quantity
Market Supply vs. individual Supply
Shifts in the Supply Curve
Change in the price of inputs
Change in technology
Change in the number of suppliers
Price Elasticity of Supply
3
Supply and Demand Together
Price
Equilibrium
Supply
75
50
25
Demand
50
100
150
Quantity
Note that the only stable price here is 50. If the price is set at, say 75, then the quantity
demanded will be 50 and the quantity supplied will be 150 so there will be a surplus of 100 units
of the good. This would put downward pressure on the price (firms trying to unload unsold
goods). Likewise if the price is set at, say 25, then the quantity demanded will be 150 while the
quantity supplied will be only 50 so there will be a shortage of 100 units. This will put upward
pressure on the price (consumers scrambling to try and get one before they are sold out). The
only place price will stay put is at 50 – here quantity demanded just equals quantity supplied –
everyone who wants to buy at a price of 50 is able to, and everyone who wants to sell at 50 is
able to. Thus, there is no tendency to change – equilibrium.
Is this equilibrium good?
Allocative efficiency – we are producing the right amount of this good from society’s
standpoint.
Consumer Surplus – a measure of how much better off consumers are because this market
exists. This is represented by the area above the price but below the demand curve. Eg—the
consumer would have paid 75 for the 50th unit, yet they only paid 50. So they are $25 better off.
Do this for all units between 0 and the equilibrium quantity (100) and you get consumer surplus.
Producer Surplus – a measure of how much better off producers are because this market exists.
If the firm had no fixed costs this would be equal to profit. This is represented by the area below
the price but above the supply curve. Eg – the firms would have sold the 50th unit for 25, yet
they got 50 for it, so they are $25 better off. Do this for all units between 0 and the equilibrium
quantity (100) and you get consumer surplus.
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Total welfare = Producer + Consumer Surplus
Note that under the market equilibrium total welfare is maximized. Thus what the free market
produces is the “best” amount to produce from society’s standpoint – it is allocative efficient.
But there are some pretty big assumptions we are making to get here – many of them having to
do with information – we will get to these assumptions.
Changes in Equilibrium
The market for pizza when the price of tomatoes increases
The market for pizza when the price of beer increases
Health reform that succeeds in covering many of the uninsured. How would this affect the
markets for health care in the short run?
Hospitals can hire only baccalaureate RNs. How would this affect the market for hospital care?
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Government lowers reimbursement rates paid to physicians for Medicare patients. How would
this affect the market for non-Medicare patients?
What about when Medicare lowers DRG rate to hospitals? How does this impact prices to nonMedicare patients?
Market Failure
We just described how the free market results in the outcome that is the best outcome from
society’s standpoint. This is often the case but there are some assumptions we make to get there.
We will get into those in more detail later, but there are a few situations where the market does
not produce an efficient level of output.
I.
Public Goods, Common Resources, and Natural Monopolies
Any good or service can be characterized by two attributes:
Rivalry -- if one person consumes the good, does it go away?
Excludability – is it possible to exclude non-paying customers?
By this there are 4 types of good:
1. PRIVATE GOODS – rival and excludable. The market does a good job of producing
these types of goods. To steal an example from Dr. Shay:
Sandwich
it is rival – if I eat it, it is not there for anyone else to eat.
It is excludable – if you don’t pay for it you can’t have it.
2. PUBLIC GOODS – nonrival and nonexcludable. The market doesn’t do so well here.
Firework show, national defense, music, aerobics class (group project?)
Problem is freeriders – I have an incentive to wait until someone else buys it then use
theirs (think group project with a single grade). But we all have this incentive so the
market tends to either not produce the good at all, or it will produce too little from
society’s perspective.
3. COMMON RESOURCES – rival and nonexcludable. The market doesn’t do too well
here either. Creates a “Tragedy of the Commons” situation
Fisheries, wildlife, clean air and water, congested roads, etc. healthcare???
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4. NATURAL MONOPOLY – nonrival and excludable. We will see this from a different
angle next week. But think about cable tv, power companies, a noncongested toll road.
Some argue Health Insurance is a natural monopoly and we should, therefore, have a
single payer.
Bottom line: Markets do best when goods are rival and excludable – they struggle (or fail
completely) when nonrival and (especially) nonexcludable.
II.
Externalities
One of the assumptions we made when we talked about the supply and demand graphs
was that all of the costs of producing the good were incurred by the firms producing it,
and all of the benefits of consuming it were enjoyed by those actually consuming it. This
is normally how it is, but not always – and when this is not the case the market tends to
not do too well.
1.
Negative Externalities in production
Think about producing electricity by burning coal – much of the costs are
transportation, running the factory, etc. These are “internal” costs that are completely
borne by the firms producing electricity. However, there are other costs – when coal
is burned it puts pollution into the air. This imposes “external” costs on individuals
who are not involved with the decision to produce electricity.
100
Total
Cost
(social
costs)
C
B
75
50
Internal Cost
(supply)
A
Demand
75
100
In this case note that since there are both internal and external costs, there are two
cost curves. The firm only cares about the internal costs so when it is considering
how much of the good they are willing to sell at any given price, they ignore the
external costs and only pay attention to the internal costs. In this case the market
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equilibrium is at point A: Price = 50, quantity =100. But note this is NOT
allocatively efficient. The market is producing 100 units – the value of the 100th unit
is $50 to the consumer BUT the (total) cost of producing it was 100. So we took
resources valued at 100 and converted it into a good that is worth 50 – not so good.
The market over-values the good. The loss to society because of this is the area ABC
The efficient level of output would be point B – this is where the total cost crosses the
demand curve. So 75 is the allocatively efficient level of output, and the price would
be 75.
When there are negative externalities the market tends to produce too much of the
good and it is priced too low from what would be best for society.
Usually the solution here is to tax the production of this good – to internalize the
external costs.
2. Positive Externalities in consumption.
Another situation is when the benefits of the good are not solely enjoyed by the
consumers of the good. A classic example is education. Getting an education not
only benefits those getting the education but others – (you are more interesting to talk
with, you contribute to society, etc.). So if left to its own devices the market will
produce too little of the good.
100
C
Supply
75
B
50
Social
Benefits
A
Internal
benefits
(demand)
75
100
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Here note that there are benefits that go to those “external” to the market so the
demand curve does not reflect the full social benefits of the good. The market
equilibrium (point A) is where the supply curve crosses the demand (internal benefits)
resulting in 75 units at a price of 50. Note from society’s standpoint this is too little.
Note that the 75th unit of the cod costs of 50 to make but is worth 100 – we would
benefit with more of this good than what the market produces. The market
undervalues that good. The area CBA represents how much better off we would be as
a society if we produced the efficient level of output
When there are positive externalities the market tends to produce too little of the good
and it is priced too low from what would be best for society.
Usually the solution here is to subsidize the consumption of this good – to internalize
the external benefits. Hence we have public schools, generous student loan programs,
etc.
3. Negative Externalities in consumption.
Another situation is when there are costs imposed on other consumers when the good
is consumed. A classic example is smoking. If I choose to smoke a cigarette, I enjoy
all the benefits of smoking – but note I potentially also impose some costs on you if
you are near me. So if left to its own devices the market will produce too much of the
good.
Supply
75
B
50
Internal
Benefits
(demand)
A
C
25
75
100
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Social
benefits
Here note that there are costs that go to those “external” to the market so the demand
curve does not reflect the full social benefits of the good. The market equilibrium
(point B) is where the supply curve crosses the demand (internal benefits) resulting in
75 units at a price of 100. From society’s standpoint this is too much. Note that the
100th unit of the cod costs of 75 to make but is worth only 25 – we would benefit with
less of this good than what the market produces. The market overvalues that good.
The area BCA represents how much better off we would be as a society if we
produced the efficient level of output
When there are negative externalities in consumption the market tends to produce too
much of the good and it is priced too high from what would be best for society.
Usually the solution here is to tax the consumption of this good – to internalize the
external costs. Also, social norms are really important here – smoking, drunk driving,
gun use?
If this all seems irrelevant, hold on – we will see this has a direct application to
healthcare.
III.
Market power
We will talk more about this next week – but one of the assumptions we make when we
draw the supply and demand curve above is that there are many firms producing the
good. If there is only one firm (or just a few) then things don’t work as smoothly – the
market will tend to produce too little of the good and charge too much
IV.
Information Asymmetry
Again, we will spend a lot of time on this later since it is a huge deal in health care
markets, but when one side of the market has more information than the other (the buyers
of insurance often have a much better idea of their risk than the sellers, or the seller of a
used car might know much more about the quality of the car than a potential buyer) the
market can struggle – even can fail completely resulting in a “death spiral”
What if we don’t like the market price?
Even though the market equilibrium is, in general, an efficient allocation of resources, we may
not like it – or think it isn’t “fair”. What can be done?
Suppose we consider the market for housing. Keep it simple and assume there is one quality
level so a single product:
10
C
Supply
B
1000
750
F
D
A
E
Demand
The
market
equilibrium is a price of 1,000/month with a quantity of 100 units. We want to make housing
more affordable since 1,000 is a lot. If we had a lower price then more people could afford to
live on their own and the world would be a better place. So let’s set a price ceiling at
$750/month as the maximum price that can be charged. What will happen?
75
100
125
At a price of $750, more people want to buy an apartment – quantity demanded goes from 100 to
125 (so 25 new people can now afford a place). But note that quantity supplied shrinks. Only 75
apartments are available to rent. So this creates a shortage of 50 apartments – 25 new entrants
can’t find one, but note also that there were 25 people who used to have an apartment who can
no longer find one. The consumers who are able to get an apartment are potentially made better
off but note there is a net loss in welfare.
Total welfare goes from CFE prior to the price control to CBAE after the price controls are
imposed. A net loss of BFA is incurred.
Secondary effects – quality, discrimination, etc.
The elasticity of the supply curve will be important here.
Economist in general will argue that price controls are always per se bad – any time we impose
them we will always decrease social welfare – but think about Medicare and their prospective
payment system which is a form of price control… good or bad?
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What happens when we tax a market? (skip if short on time)
Suppose we consider the market for gasoline. In order to raise money to pay for street repair the
state decides to impose a $.50 per gallon on the sales of gasoline. Gasoline sellers are required to
send $.50 per gallon of gasoline they sell to the state at the end of each month. How does this
affect the market for gasoline?
Supply
w/ tax
2.50
Supply
D
2.25
E
2.00
F
1.75
G
B
A
C
H
Demand
100
150
Before the tax the market is in equilibrium at point A – price is $2.00 and 150 gallons are sold.
When the tax is imposed, note this can be thought of as a cost to the firm. So for any given
quantity, it costs an extra $.50 to produce the good – supply shifts up by $.50. But note price
cannot go to 2.50 – since if it did demand would drop to close to zero. Instead the new
equilibrium is at point B. The new quantity is 100 – so they make 100*.50=$50 in tax revenue
(not $150*.50=$75 which some would expect). The price that consumers pay goes to $2.25, and
the price that firms get to keep (after paying the tax is 2.25-.5=1.75. So consumers are paying
an extra .25 and firms get .25 less because of the tax. In this case the burden of the tax is split
evenly between firms and consumers.
In general the burden of the tax is a function of demand and supply elasticity (draw some of
these).
What are the net effects of this tax on society’s well being?
Prior to the tax:
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Consumer surplus = DAF
Producer surplus = FAH
Note this is maximizing social welfare: DAH
After the tax:
Consumer surplus = DBE
Producer surplus = GCH
Tax revenue = EBCG
Total welfare = DBCH
So note the area BAC is lost because of the tax
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Consumer Choice and Challenges to the Classical Model
Consumer Choice
We just looked at Demand and argued that the demand curve is downward sloping – the higher
the price the less of the good I would like to buy. I want to explore this in a bit more detail to get
at some of the main assumptions we make to get there and their implications. Then we will talk
about what if those assumptions are not true – this later part gets into behavioral economics
which is the interception of economics with psychology.
Consumer Choice
People differ widely in terms of their preferences – what I like might be very different from what
you like. We use the term preferences
Preferences – the rankings consumers give to the alternative opportunities available to
them
Preferences are not the same as choices or demand. We make choices based on our preferences
and the prices of goods and that gives rise to our demand – demand incorporates prices.
I would prefer to drive a much nicer car but I choose to drive a 20 year old car.
Assumptions about preferences
1. People can rank alternatives: that is preferences are “complete”. We are able to rank any
given basket of goods – “I don’t know” is not allowed. Note this is different from “I
don’t care” or “I am Indifferent”
2. Preferences are transitive: If a>b, and b>c, then transitivity implies that a>c. If I like
Pizza more than hamburgers, and hamburgers more than barbeque, then I have to like
pizza more than barbeque.
3. More is preferred to less. Consumers have insatiable desire for goods and services (or
there is free disposal)
These may all seem pretty reasonable and in most cases they are, but as we will see later, not
always – especially when we are making choices over time. But for now, let’s assume these are
good assumptions.
Given we are in a world of scarcity – unlimited wants with limited resources – as individuals we
have to make choices.
Another assumption we make is that people make choices to maximize a stable “utility
function”. A utility function can be thought of as some equation of the following form:
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U = f(x1,x2,x3,….xn) where x1, x2, etc are the quantity of goods and services of the various
goods the consumer chooses. The “stable” assumption is important – that means your
preferences are fixed and consistent.
Independence of Irrelevant Alternatives Suppose you want to have a bowl of cereal for
breakfast. You open the cupboard and find: Lucky Charms, Cocoa Pebbles, Cap’n Crunch, and
Wheaties. Of course you choose Cocoa Pebbles.
Now, in a parallel universe, you look in the cupboard and find Lucky Charms, Cocoa Pebbles,
and Cap’n Crunch. IIA says you have to still choose Cocoa Pebbles. That is having Wheaties
out of the mix should not affect your choice.
For simplicity, let’s assume there are only two goods in the world: Beer and pizza
Quantity
of Beer
D
C
B
A
Quantity
of Pizza
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Note that a point like A (a lot of pizza, some beer) is going to bring a certain level of utility.
Likewise a point like D (a lot of beer, some pizza) is going to also bring some level of utility.
Completeness means we can rank points A and D.
[Build an indifference curve]
An Indifference Curve connects the points on a graph that correspond to market baskets of equal
utility to the consumer.
Indifference curves must be negatively sloped (more is better)
Combinations on indifference curves farther from the origin are preferred to those closer to the
origin. (more is better)
Indifference curves cannot cross (transitivity)
Diminishing marginal rate of substitution. The MRS is the amount of good y that a consumer
would give up to obtain one more unity of good x. We generally assume this is diminishing and
this is what gives indifference curves their convex shape.
Take away some of my beer.
At this point all we know is something about my preferences. In order to make a choice we need
to know what is possible. This is where the budget comes in.
Budget line – Income = Pb*BEER +PP*Pizza. We assume we spend all of our income (later we
can make savings a good – or more accurately future consumption).
So my budget line is a function of the prices of the two goods and my income.
The y-intercept tells me how much beer I could buy if I spent all my income on beer. The xintercept tells me how much pizza I could buy if I spent it all on pizza. The slope of the line tells
me the relative prices of the two – or the ability to trade one for the other
Maximizing Utility:
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Quantity
of Beer
U3
D
U2
U1
B
10
8
A
5
C
1
4 6
Quantity
of Pizza
Point A would be great – the highest utility, but that is not affordable (outside of the
budget constraint). We could afford a point like B, but note that if we had 10 beers
and 1 pizza we would be willing to trade beer for pizza at the going price and be happier.
Note point C is just right. We have achieved the highest rate of utility attainable. – so at 5 beers
and 4 pizzas, our willingness to trade beer for pizza is just equal to our ability to trade them.
That is the slopes are the same (MRS = relative price). The last penny spent on pizza gave us
the same Marginal Utility as the last penny spent on beer.
Show different tastes: If you LOVE beer then (in this example) you will have very flat
indifference curves. If you HATE beer, then you will have very steep indifference curves.
(Corner solution)
Income-Consumption Curves
Normal Goods
Inferior Goods
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What happens when he price of the good changes?
U3
Quantity
of Beer
U2
U1
C
A
B
3
5
8
Price of
Pizza
3
5
Quantity
of Pizza
8
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Start at point A -- suppose the price of pizza increase. That will result in an inward pivot in the
budget constraint. Point A is no longer affordable. We need to find a new equilibrium. This is
noted as point B – a lower level of utility. Our consumption of pizza went from 5 to 3. Now
suppose that, starting at Point A, the price of pizza falls. Now the budget line pivots outward,
and we can afford more than point A. The new equilibrium would be at Point C, consumption
goes to 8. We could do this over and over and would map out the price-consumption curve
which is below the utility curve graph.
Note I just made a demand curve!! It is downward sloping. The slope of the demand curve is a
function of my willingness to substitute pizza for beer (or the MRS). If I have different shaped
indifference curves, my demand curve will have a different slop.
Elasticity of demand is a function of my willingness to trade one good for the other.
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Challenges to the rational model of behavior
Classical economics, which we have just discussed, assumes that individuals are rational – that
is, they do the best they can to achieve their objectives, given the opportunities they have.
People make mistakes, but they learn from them. Individuals will use all the information
available to them to make a decision.
This has come under fire recently from behavioral economics. I want to cover some of this since
it often applies to health care.
Of course the model above is wrong – it is overly simplistic. But note that is the point – it is a
simplified view of the world that allows us to better understand human behavior. It is not
enough for us to just say it is wrong or find examples where people make mistakes, etc. In order
to truly criticize classical model we must show there is
1) Systematic deviation from the rational paradigm
2) this deviation must be important for some economic phenomena
Violations of Basic Rationality
We assume that the demand curves are based on people making choices in order to maximize
utility based on a stable utility function. That is was assume the independence of irrelevant
alternatives. Note the economist.com example was a violation of this
Note that most of these problems occur when the consumer does not have full information and is
trying to fill in the gaps.
1. Framing Effects
Often our choices can be greatly affected by framing effects: seemingly inconsequential
changes in the way an option is presented can lead to big changes in the choices that people
make.
Suppose we are preparing for an unusual disease which is expected to kill 600 people. There are two
alternative programs we have to choose from to combat the disease:
If program A is adopted, 200 people will be saved
If program B is adopted, there is a one-third probability that 600 people will be saved, and a twothirds probability that no people will be saved.
What would you pick?
Alternatively:
If program C’ is adopted, 400 people will die
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If program D’ is adopted, there is a one-third probability that nobody will die and a two-thirds
probability a two-thirds probability that 600 people will die.
Now what do you pick?
In experiments people overwhelmingly choose A from the first group and D from the second group.
What does this tell you?
How is framing at work here?
The first choice set sets the ‘reference point’ to be that everyone will die and so the language is
about people being saved – so any amount of lives saved seems like a gain. The opposite is true for the
second choice set.
People tend to be loss averse -- people really hate losing something for sure. Such that when faced with a
loss they tend to be risk loving in choices between losses – the idea of losing 400 lives for sure is so
horrible that people are prepared to take a gamble to avoid it. In contrast when it comes to gains, people
tend to be risk averse.
More framing effect examples:
Our personal finance and budgeting.
Would you accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5?
Would you pay $5 to participate in a lottery that offers a 10% chance to win $100 and a 90%
chance to win nothing?
Employee wellness programs can either offer $550 discount on premiums, or send a check for
$550 in the mail. To a rational economist these are the same, but they may have very different
effects on employee’s compliance.
Consider the two statements: “The Giants won” vs. “The Cowboys lost”. Do they mean the
same thing?
When gas stations first started installing credit card purchasing – cash discount vs. credit
surcharge.
A physician could be given two different descriptions of the short-term outcomes of a surgery:
1) The one-month survival rate is 90%
2) There is a 10% mortality in the first month.
Surgery is more popular in the first frame (84% chose it) than the second (50% chose it) even
though it is exactly the same information.
NEJM Paper: People perceive a far larger difference between $0 and $100 then between $1000
and $1100. Used this to increase colonoscopy rates – by separating the reward from routine
payment (If I get a check for 100 that is different than if I get an extra 100 tacked onto my
paycheck)
Anchors are a type of frame
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The anchoring effect occurs when people consider a particular value for an unknown quantity
before estimating that quantity – the estimates stay close to the number that people considered.
Consider two sets of questions:
Was Gandhi more than 114 years old when he died?
How old was Gandhi when he died?
vs
Was Gandhi more than 35 years old when he died?
How old was Gandhi when he died?
People who are asked the first set of questions will give a higher answer to the second question,
on average, than those who are asked the second set of questions.
Similarly, in another experiment, individuals were shown a wireless keyboard then asked if they
would be willing to pay an amount equal to the last two digits of their social security number
(so basically a random number). Then they were asked what was the maximum price they
would pay for the keyboard. What do you think happened?
Top 20 3x
Think about the listing price of a house, or a car and your willingness to pay.
How do you respond to the price of gasoline when prices are falling vs. when they are rising?
Arbitrary rationing: “Limit x per person”
In negotiations (say over the price of a home) the first move is often an advantage
Caps on damages due to personal injury or mal practice.
The availability heuristic – we often create our own frames.
How often do people over 60 get married? To answer this question, people typically think about
any examples from their past. The easier time we have coming up with examples, the larger our
estimate will be.
When we don’t know the answer to a question we often substitute a question that we do know
the answer to. Sometimes this works well, sometimes it can lead to bias.
Spouses were asked: “How large was your personal contribution to keeping the house clean, in
percentages?” Or “what is your contribution to causing quarrels?”
The self-assessed contributions added up to more than 100%
Why do people fear flying more than they do driving?
Our emotions play a key role here. Some events stick in our heads easier due to the emotions
attached to them. Thus they are more “available” even if not more likely.
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2. Status Quo Bias
Status Quo Bias is the propensity for people to choose a particular alternative just because it is
the status quo – or default option.
 People demanding a higher price to sell an object that they own than they are
prepared to pay for the same object (think housing)
 Higher Enrollment rates in companies that have opt out 401k investment plans
than those that have opt in plans
 Organ donors opt in vs opt out
This is a concern in the insurance marketplaces
Reasons for status quo bias:
i.
Transaction costs – this would be a rational explanation for status quo “bias”. I say
“bias” since in this case it isn’t really bias.
ii.
The endowment effect
According to standard economic theory the just-acceptable selling price for a good and the just-acceptable
buying price should be equal. Suppose you think it would be worth $200 to go to the BCS championship
game. Then theory would suggest that if you do not own a ticket, any offer price less than 200 would
cause you to buy, and if you do own a ticket an offer price greater than 200 would cause you to sell. In
many cases this is true. But not always. Experiment of Duke University basketball games: Willingness
to pay of $170, and a willingness to accept of $2400. Suggests that those who owned the tickets valued
them 14 times more than those who did not.
NEJM Paper – using defaults in CPOE – could save $9billion in prescription drug treatment (and does
not restrict choice – just makes it harder to choose the expensive option)
Because of an affect known as “loss aversion” which says the pain of giving something up is larger than
the joy of getting something. There often becomes a gap between our maximum buying price and our
minimum selling price. Once we own the ticket, selling it involves the pain of giving it up. If we don’t
own it, we consider the pleasure of getting it.
Best example of loss aversion – putting for par vs. putting for birdie on the PGA tour.
NEJM Paper – Mass General used up-front incentive payments to improve hand hygiene, increase eprescribing, and reduce ed use. Fear of losing the payment has a stronger effect than the hope of earning
it.
iii.
Procrastination and Decision Avoidance
Often people desire to avoid difficult or complicated decisions. Sticking with the status quo
then tends to happen more often.
Think about end-of-life care here.
iv.
Perceived Recommendation.
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Often people will perceive the default as the perceived recommendation of an “expert”. For
401k investment plans people may perceive the default as the recommended investment level
v.
Fallacy of choice
Usually we assume more choices are better and will always make the consumer better off.
But note that there can be such a thing as too much choice which will tend to stick with the
status quo.
3. Social Preferences
Consider the following Game: Player A has $10 to divide between themselves and player B.
They make a single take it or leave it offer (eg, I get 5, you get 5). Player B can either accept or
reject. If he/she rejects then nobody gets anything.
What would classical utility theory suggest would happen?
What do you think would really happen?
Typically Player A offers between 20 and 50% of the pie – player B usually rejects offers of less
than 20%
What is going on?
There are 3 basic classes of explanation;
i.
Fairness: people have a preference for ‘fair’ outcomes over unfair ones
ii.
Altruism: people get utility from other people’s happiness
iii.
Reciprocity: People like to punish people who have not treated them well – even if it
means also punishing his or herself.
Dictator Game – similar to above but Player B has no voice. Not if Reciprocity then now
player A would keep all 10. Yet Player A still tends to share.
If the game is played anonymously, however, it tends to be closer to the rational prediction.
Think about how rude you are willing to be as a driver vs. in, say, the classroom.
Note if i or ii are important for some people more than others it will help explain why we
struggle with things like income distribution and social safety net issues.
NEJM Paper: People have a strong psychological need to maintain a positive self-image. So
pairing incentive programs with self-image/professional identity makes sense. So make
public some component of physicians’ performance.
4. Time Inconsistency
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This is a huge one – with respect to healthy choices. Note that not only do we make choices
across a set of goods and services (should I eat pizza or go to a move?) we also make choices
over time (should I buy a new computer game or put the money in the bank so that I can buy a
computer game tomorrow?). We assume time consistent preferences. We discount future utility
to put it in current period terms. So the utility of consuming c1 this period c2 next period, and c3
in the third period is:
U(c1,c2,c3) = u(ca) + βu(c2)+β2c(c3)
Where β is my discount rate
Imagine you were offered $100 today or $105 in the next period – and you prefer $100 today.
Then it must also be true that if I offer you $100 in period 3 or $105 in period 4 then you would
prefer $100 in period 3.
People don’t always do this – think about your last wicked hangover….
Suppose I offered you a choice between a greasy cheeseburger or a kale salad today. What
would you choose? How about if I asked you the same choice but you won’t eat it until next
week? Many will choose the cheeseburger today, but the kale salad next week.
Note this is huge when we think about trying to get people to change to a more healthy lifestyle –
we all want to work out, eat right, etc. but we tend to have time inconsistent preferences. Note
this is different from Gary Becker’s theory of rational addiction. This says that some people
have a high enough discount rate that it is “rational” for them to become addicted to drugs or go
on a self-destructive life-style. The policy implications between the two theories are different.
We have a tough time with self-control. It is in the bible: Romans 7:15 “I do not understand
what I do. For what I want to do I do not do, but what I hate I do.” If St. Paul was a rational
consumer, he would not have this issue.
Behavioral Economists talk about our “hot” and “cold” selves: Why you should never go to the
grocery store when you are hungry. We need ways to trick our “hot” selves into behaving.
We need to do a better job of getting people in touch with their “future selves”
5. Ambiguity
What happens when we don’t know what the outcome of a certain event will be – say who will
win a race or a game? Or if we will need surgery this year or not? The standard model says that
decision makers assign some probability to a particular runner or team winning and then
maximizes expected utility based on that probability. It turns out it doesn’t always work this
way.
Suppose I have an urn filled with 90 balls: 30 of them are red, and 60 are either black or yellow.
Consider the following pairs of choices:
a) You win $100 if you draw a red or a yellow ball
b) You win $100 if you draw a black or a yellow ball
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And
c) You win $100 if you draw a red ball
d) You win $100 if you draw a black ball
Most people will choose c) over d) and b) over a). But note there is an inconsistency here. If
you choose c) over d) that means you think there are more red than black (that is fewer than 30
black balls). But if that is true then you should prefer a) to b) since if red>black, then there
should be fewer than 30 black balls and therefore more than 30 yellow balls. Note what is
happening is that people are avoiding the ambiguity in d).
Note that these are all special case issues and do not imply that no one can ever make a “good” choice.
Also, to the extent that behavioral economists criticize the rational consumer model, does not imply they
think consumers are irrational – that is they don’t just randomly make choices. It just implies that even
when the have perfect information, consumers will not always make the choice that is predicted by
classical economics. Thus there are reasons when markets will not work perfectly even when all the
classical assumptions are met.
NEJM Paper: Emphasizes that It is important to apply behavioral economically principles when
a) Economically important issues. (ensuring guidelines are followed, correcting system
problems such as timely discharge, perceived as difficult or inconvenient)
b) The processes or outcomes are largely within the physician’s control
c) Don’t get silly/gimmicky/trivial
d) MUST PAY ATTENTION TO INTRINSIC AND EXTRINSIC MOTIVATION
Sometimes extrinsic motivation can crowd-out intrinsic motivation (paying
people to donate organs can actually reduce the total amount of donors)
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