Behavioral
Economics
FOR
DUMmIES
‰
Behavioral
Economics
FOR
DUMmIES
‰
by Morris Altman, PhD
Behavioral Economics For Dummies®
Published by
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Library and Archives Canada Cataloguing in Publication Data
Altman, Morris
Behavioral economics for dummies / Morris Altman.
Includes index.
Issued also in electronic formats.
ISBN 978-1-118-08503-5
1. Economics—Psychological aspects. 2. Finance, Personal—Decision making. I. Title.
HB74.P8A58 2012
330.01’9
C2011-907846-5
ISBN 978-1-118-08969-9 (ebk); 978-1-118-08970-5 (ebk); 978-1-118-08971-2 (ebk)
Printed in the United States
1 2 3 4 5 RRD 15 14 13 12 11
About the Author
A former visiting scholar at Cornell, Duke, Hebrew, and Stanford universities,
Morris Altman is currently professor of behavioral and institutional economics and head of the School of Economics and Finance at Victoria University of
Wellington. He is also professor of economics at the University of Saskatchewan,
where he was head of the Department of Economics from 1994 to 2009.
Recently, Morris was elected Visiting Fellow at St. Edmund’s College, Cambridge
University, and was a Visiting Scholar at Stirling University in Scotland and an
Erskine Fellow at the University of Canterbury, Christchurch, New Zealand.
Morris was elected and served as president of the Society for the Advancement
of Behavioral Economics (SABE) from 2003 to 2006. In 2009, he was elected
president of the Association for Social Economics. He is editor of the Journal of
Socio-Economics (Elsevier Science) and former Associate Editor of the Journal
of Economic Psychology, where he remains on the editorial board.
Morris has published over 80 refereed papers on behavioral economics, economic history, methodology, and empirical macroeconomics and four books
in economic theory and public policy and has made over 150 international
presentations on these subjects. He is currently completing three books on
related subjects and is researching endogenous technical change, the linkages between economic justice (human rights), power, and economic growth
and development, as well as the importance of altruism, ethics, and reciprocity in economic theory.
Morris is also leading major projects in experimental economics. One examines the role of prices, incomes, and social variables in determining consumer demand. Another investigates the conditions under which improved
working conditions affect effort inputs and how this might impact unit costs
and profitability.
He currently lives in Wellington, New Zealand, with his wife, Louise, and their
daughter, Hannah.
Dedication
To my wife, Louise Lamontagne, and our daughter, Hannah Altman, for their
love, inspiration, and patience.
Author’s Acknowledgments
I am very grateful to Robert Hickey of John Wiley & Sons, who got me
involved in this exciting project. He carefully helped me work through a
detailed template for this book, which has become its backbone. I would
also like to thank Elizabeth Kuball, my project editor, for keeping me on my
toes throughout my tight schedule and making very helpful suggestions that
have contributed to improving the rhetoric, style, and content of this book.
I’m sure that without Elizabeth’s interventions, there would be no book. I’d
like to thank my technical editor Nathan Berg of the University of Texas at
Dallas for his many helpful comments and suggestions. Louise Lamontagne,
my colleague and collaborator of over 30 years, read through the manuscript,
making critical comments and suggestions that added much to this book’s
value. Hannah Altman played a critical role, always encouraging me to tackle
this difficult but exciting project and adding a few hot tips of her own.
Teaching behavioral economics over the past decade has contributed
immensely to the quality of this book. It gave me the opportunity to read
deeply into the literature. Difficult and sometimes seemingly simple questions from my students forced me to think through concepts in behavioral
economics in much more nuanced fashion than I might otherwise have done.
Also, many of students’ research papers in behavioral and experimental economics helped enrich my understanding of the field.
I’ve been thinking about and researching behavioral economics since the
early 1980s, when I was working through, deconstructing, and reconstructing x-efficiency theory in my doctoral work in economic history. I’ll always
be appreciative to the late Harvey Leibenstein of Harvard University, the
pioneer in this line of theoretical reasoning, for his mentoring and encouragement even though I was clearly heading for a road that he was not a great
fan of. I also owe thanks to Professor Harold (H. R. C.) Wright, my McGill
University teacher and mentor, who gave me the freedom to think and
develop my own thoughts. Also of foundational importance from my McGill
days are Paul Davenport, Chris Green, Jack Weldon, and Athanasios (Tom)
Asimakopulos. It was Tom who enticed me out of political philosophy into
economics where, he insisted, you really can make a difference. I must also
thank John Tomer, a close colleague and friend on the behavioral economics
bandwagon for 20 years, whose pioneering research pushed me into thinking
about behavioral economics from different and interesting perspectives.
Publisher’s Acknowledgments
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Some of the people who helped bring this book to market include the following:
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Composition Services
Project Editor: Elizabeth Kuball
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Layout and Graphics: Jennifer Mayberry,
Corrie Socolovitch, Laura Westhuis
Copy Editor: Elizabeth Kuball
Technical Editor: Nathan Berg, PhD
Project Coordinator, Canada:
Pauline Ricablanca
Proofreaders: Debbye Butler, Dwight Ramsey
Indexer: Estalita Slivoskey
Editorial Assistant: Katie Wolsley
Cover Photos: © iStock / Marcello Bortolino
Cartoons: Rich Tennant
(www.the5thwave.com)
John Wiley & Sons Canada, Ltd.
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Contents at a Glance
Introduction................................................................. 1
Part I: Introducing Behavioral Economics: The Science
of Making Real-World Choices................................................. 7
Chapter 1: Decoding Behavioral Economics................................................................... 9
Chapter 2: Getting Real about Assumptions................................................................. 19
Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis................ 41
Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything......... 65
Part II: Understanding Choice..................................... 89
Chapter 5: Exploring the Limits to Free Choice............................................................ 91
Chapter 6: Quick and Simple Heuristics and Real-World Decision Making............. 107
Chapter 7: How the Framing of Choices Affects Decision Making........................... 131
Chapter 8: How Norms, Peers, History, and Culture Influence Choice.................... 153
Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis............ 167
Part III: Growing the Economic Pie: The Economic
Importance of Ethics, Well-Being, and Culture............ 181
Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law....... 183
Chapter 11: Labor Supply in the Real World............................................................... 197
Chapter 12: The Black Box of the Firm: Human Relationships
and Productivity........................................................................................................... 215
Chapter 13: The Good Economy: How Ethical Behavior
Can Grow the Economy............................................................................................... 229
Chapter 14: Why Institutions Matter............................................................................ 243
Part IV: When Bubbles and Busts and Inefficiencies Are
Possible: Some Behavioral Insights into the Strange
World of Economic Reality........................................ 257
Chapter 15: Deciphering Behavioral Finance.............................................................. 259
Chapter 16: Looking into Recessions and Depressions............................................. 275
Chapter 17: The Art and Science of Happiness: Can You Be Happy
without More Money?.................................................................................................. 291
Part V: The Part of Tens............................................ 309
Chapter 18: Ten (Or So) Key Public Policy Implications
of Behavioral Economics............................................................................................. 311
Chapter 19: Ten (Or So) Experiments in Behavioral Economics.............................. 321
Chapter 20: Ten Decision-Making Lessons from Behavioral Economics................. 333
Index....................................................................... 341
Table of Contents
Introduction.................................................................. 1
About This Book............................................................................................... 1
Conventions Used in This Book...................................................................... 2
What You’re Not to Read................................................................................. 2
Foolish Assumptions........................................................................................ 3
How This Book Is Organized........................................................................... 3
Part I: Introducing Behavioral Economics: The Science
of Making Real-World Choices........................................................... 4
Part II: Understanding Choice............................................................... 4
Part III: Growing the Economic Pie: The Economic Importance
of Ethics, Well-Being, and Culture..................................................... 4
Part IV: When Bubbles and Busts and Inefficiencies Are
Possible: Some Behavioral Insights into the Strange World
of Economic Reality............................................................................ 5
Part V: The Part of Tens......................................................................... 5
Icons Used in This Book.................................................................................. 6
Where to Go from Here.................................................................................... 6
Part I: Introducing Behavioral Economics: The Science
of Making Real-World Choices.................................................. 7
Chapter 1: Decoding Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . 9
Making Wise Assumptions.............................................................................. 9
Why reality matters.............................................................................. 10
Why incentives matter — even in behavioral economics............... 10
Making Sense of Choice................................................................................. 11
Maximizing versus satisficing............................................................. 11
The effect of emotions......................................................................... 12
The avoidance of loss........................................................................... 12
How options are framed...................................................................... 12
Paternalism versus free choice........................................................... 13
The role of social context in decision making.................................. 14
Relative positioning.............................................................................. 14
Growing the Economic Pie............................................................................ 15
Deciphering Bubbles and Busts.................................................................... 15
Inefficient markets and investment behavior................................... 16
Emotions, intuition, animal spirits, and business cycles................ 16
Understanding Happiness: Money Isn’t Everything................................... 17
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Behavioral Economics For Dummies
Chapter 2: Getting Real about Assumptions . . . . . . . . . . . . . . . . . . . . . . 19
Defining an Economic Model......................................................................... 20
Explaining economic phenomena....................................................... 21
Making simplifying assumptions........................................................ 21
Discovering the irrelevance of facts................................................... 22
Understanding the role of math in model building.......................... 23
Considering cause and effect.............................................................. 26
Watching out for spurious correlations............................................. 26
Contemplating Conventional Economic Assumptions and
Real-World Alternatives............................................................................. 27
Conventional assumption #1: People’s preferences
are stable and consistent................................................................. 27
Conventional assumption #2: People are solitary
decision makers................................................................................ 28
Conventional assumption #3: How people
form preferences doesn’t matter.................................................... 28
Conventional assumption #4: People have
the same preferences....................................................................... 29
Conventional assumption #5: People are all maximizers................ 30
Conventional assumption #6: People have perfect knowledge............32
Conventional assumption #7: People have unbounded
computational capabilities.............................................................. 33
Conventional assumption #8: People have willpower..................... 34
Conventional assumption #9: People are capable
of acting upon their preferences..................................................... 35
Understanding Rational Economic Behavior.............................................. 36
You can do no wrong: Errors and biases in decision making......... 37
Selfishness and the smart society...................................................... 38
Getting to Know the Behavioral Economics Actor..................................... 39
Chapter 3: Neuroeconomics: Exploring the Brain
for Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Where Neuroeconomics Fits in the Behavioral Economics
Perspective.................................................................................................. 43
The Brain and Economics.............................................................................. 45
The evolution of the human brain...................................................... 45
The division of labor in the human brain.......................................... 48
The Emotional Brain...................................................................................... 49
Descartes’ error: The somatic marker hypothesis........................... 49
Phineas Gage and the social and emotional side
of rational decision making.............................................................. 50
How Emotions Affect Decision Making........................................................ 53
Fear and decision making.................................................................... 53
Happiness and decision making......................................................... 54
The Limits of the Human Brain and Homo Economicus........................... 54
The brain is not a calculating machine.............................................. 55
The brain is a scarce resource............................................................ 55
Table of Contents
What Brain Sciences Confirm for the Behavioral Economist.................... 57
People prefer the present to the future............................................. 57
People’s aversion to loss affects their decision making.................. 58
What people feel isn’t always what they experience....................... 58
People care about keeping up with — and beating —
the Joneses......................................................................................... 60
People’s brains evolve over their lifetimes....................................... 61
People value fairness............................................................................ 62
People like to trust and be trusted..................................................... 63
Chapter 4: Why Incentives and Markets Matter,
but Money Isn’t Everything . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
The Role of Economic Incentives for Economic Behavior........................ 66
Why money is all that matters in conventional economics............ 67
Opportunity costs for Homo economicus......................................... 69
Decision Making and Opportunity Costs..................................................... 71
Using up your mind: Bounded rationality......................................... 71
Considering costs other than money: Psychological costs............ 72
Reducing opportunity costs in the real world:
Satisficing behavior........................................................................... 73
Weighing the opportunity cost of altruism....................................... 75
Supply and Demand and Behavioral Economics........................................ 75
Introducing the bandwagon effect...................................................... 76
Investigating the snob effect............................................................... 77
Interjecting morals and ethics............................................................ 78
Introducing sociology to supply and demand.................................. 79
Economic Psychology: How Thoughts and Feelings
Impact Decisions......................................................................................... 84
Loss aversion: How framing, ownership, and control
affect economic behavior................................................................. 85
How the fear of uncertainty influences decisions............................ 85
The warm glow: Why people sacrifice money
for fairness or justice........................................................................ 87
Forfeiting money for status................................................................. 88
Part II: Understanding Choice...................................... 89
Chapter 5: Exploring the Limits to Free Choice . . . . . . . . . . . . . . . . . . . 91
Free Choice in Economic Decision Making................................................. 92
What conventional economics says................................................... 92
What behavioral economics says....................................................... 93
Revealed Preferences: When Choices Reveal Your Inner Self.................. 94
The narrative about preferences........................................................ 95
False preferences versus true preferences....................................... 96
The limits of revealed preferences and free choice......................... 98
xiii