Chapter 1 Review Questions
1.1 Why is the standard economic model a good thing, and why is it a bad thing, in trying to
understand economic behavior?
A good economic model is simple and yet gives useful insight on economic behavior. The standard
economic model makes two main assumptions: people are rational and people are selfish. At heart,
these are simplifying assumptions. They give economists something objective to work with – there
is often only one way to be rational and selfish, but lots of ways to be irrational and kind. And the
model undoubtedly gives useful insight – it tells us about the law of supply, the law of demand, the
remarkable efficiency of markets, and so on.
The standard economic model did not, therefore, happen by accident. It is a remarkable
powerful tool for looking at behavior. It is the natural benchmark against which to compare
observed behavior. It is the natural starting point in developing models that allow for irrational and
unselfish behavior. Some would also point towards the more positive message that the standard
economic model tells us how we should behave. I am less convinced by this argument given the
assumption of selfishness built in to the model – economists have rightly got a bad press in the past
for teaching people how to be egoists!
The problem with the standard economic model is that people are neither rational nor
selfish. Naturally, therefore, we need to develop alternative models that can account for this. This
logic may seem common sense. It is, however, highly controversial. Some economists are convinced
that people are rational and selfish, or can be modeled as such. And they object to the ad‐hoc
nature of behavioral economics. This argument, however, has lost force over the last few decades.
To explain why let me first recall that the main selling point of the standard economic model is its
objectivity – there is only one way to be rational and selfish, but lots of ways to be irrational and
kind. Current usage of the standard economic model, however, does away with objectivity – the
model it seems can be contorted so that just about any behavior is rational and selfish. And the way
that behavioral models are being developed is more and more objective – we can draw on
evolutionary theory and neuroscience to tie down what assumptions are reasonable.
Time is up, therefore, on the standard economic model. It remains a fantastic tool for
understanding economic behavior. But, to progress further we need to make the natural step away
from it and drop the assumptions of rationality and selfishness.
1.2 Why do we need to run economic experiments?
A good model makes novel testable predictions. Testing those predictions in the ‘real world’ is often
impossible. Experiments are a fantastic way to test predictions in a controlled environment. To
illustrate, suppose you have a model of asset market bubbles. You can, and should, look at data
from stock market trading to test the model’s predictions. But, such data will be incredibly noisy.
That makes it difficult to accept or reject your predictions – maybe the prediction is correct but
failed to show up in the data because of some unobservable shock. It is also difficult to compare
one model against another – maybe both models make the same prediction in the type of market
there is in the world. In the lab you can do away with unobservable shocks and design the
experiment in a way that two comparable models give different predictions. Experiments are
natural in physics, chemistry, biology and economics.
1.3 Why does a heuristic usually come hand in hand with a cognitive bias? Should we emphasize how
clever people are for having good heuristics, or how dumb they are for being biased?
A heuristic is a simple rule of thumb for making a decision. A good heuristic makes a ‘good enough’
choice ‘most of the time’. Both the ‘good enough’ and ‘most of the time’ leave room for bias. For
example, consider the heuristic when out shopping ‘buy the same as last time’. This is a simple rule
of thumb. Buying the same as last time should be good enough most of the time, but it is unlikely to
be the ‘optimal thing’ to do. Systematic deviations from the optimum give us cognitive bias. For
example, we might end up with the cognitive bias ‘reluctant to try new products’.
Whether or not we should emphasize the cleverness or dumbness of people is related to the
issue of ecological rationality. Heuristics are adapted well to do the job they were designed to do.
They fit the environment. Experimentalists are adept at making people use the wrong heuristic for
the wrong environment. This can make people look unfairly dumb. To illustrate, consider the visual
illusion below. We can think the person is dumb because he sees perspective on a 2D piece of
paper. Or we can marvel at his ability to see perspective which is so useful in the world that he lives.
Do not, therefore, jump to the conclusion people are dumb just because clever experimenters can
get them to do dumb things.
Ecological rationality, however, works both ways. Consider, for example, our desire for
sugar. The heuristic ‘eat any sugary food you can get’ was a good heuristic in our evolutionary past.
Unfortunately, rising levels of obesity suggest it is not such a good heuristic now. Similarly, lack of
saving for retirement does not seem ecologically rational in a world where people can expect to live
for a long while.
1.4 Why does is make sense to mix up experimental treatments and sessions, i.e. to have multiple
treatments in each session and multiple sessions for each treatment?
In most experimental studies we are interested in comparing behavior across treatments. We do
not want some artificial effect inducing a difference. For example, suppose an experiment has an A
treatment and a B treatment. If we only perform the A treatment in sessions on a Saturday
afternoon and only perform the B treatment in sessions on a Monday morning we might get a
difference that has nothing to do with the change in treatment. Different people might show up to
take part in an experiment on Monday mornings, and people might feel and behave differently on a
Monday morning. Mixing up treatments with sessions avoids this kind of bias.
A good experiment is also single and double blind. Single blind means that subjects do not
know the purpose of the experiment – for example those in the A treatment are ignorant of the B
treatment. Double blind means the experimenter also does not know what is going on – he does
not know if a particular subject is in the A or B treatment. Mixing up treatments with sessions is a
simple way to avoid this kind of bias. In terms of double blindness it is worth noting that we are not
just talking about experimenters deliberately biasing results. We know that experimenters can
subconsciously bias things. For example, if the prediction is that people will be more generous in
treatment A the experimenter may subconsciously be more bubbly and happy when greeting
subjects who show up for treatment A.
1.5 Is it good that experiments usually involve students as subjects?
Students are used purely for convenience. So, the simple answer would appear to be that it is not
good experiments usually involve student subjects. Students are unlikely to be representative of the
population and so we need to be careful in generalizing the conclusions from an experimental
study.
That said, the problem may not be as big as it seems. First, of all students are a quite diverse
group and so we should get lots of heterogeneity of behavior. Second, the externality validity of
experiments appears good. Meaning that results from the lab seem to match behavior in the field,
in those instances where we have checked. A further advantage of using students is that they are
not ‘intimidated’ by the lab environment. When working with a more general population there is far
more chance for bias because of confusion over the instructions, behavior being influenced by the
setting, etc.
1.6 What are the objectives of behavioral economics?
I would encourage you to focus on the big objectives of understanding and predicting economic
behavior. How do we behave? And why do we behave that way? Why are you reading this? Why are
you studying behavioral economics? Why are you not saving for retirement? What profession do
you want? How much money would you spend on a new car? Why are stock prices so high? Why
are wages so low? These are the kinds of questions we need insight on. Economics is a fantastic
subject to study because it is all around us, everywhere we look. So, open your eyes and start
analyzing behavior.
Do not get trapped into thinking the objectives of behavioral economics are things like
showing the standard economic model is wrong. If the standard economic model is right then a
behavioral economist would be happy to say so.
1.7 What are the objectives of studying the standard economic model?
Generally speaking, the objectives of studying the standard economic model are pretty much
exactly the same as the objectives of behavioral economics. The only slight difference I would note
is that the standard economic model also has appeal as a ‘mathematical puzzle’. It is sometimes
interesting to question what the rational outcome would be to a particular problem. As a behavioral
economist the main objective of studying the standard economic model is as a benchmark from
which to start. This should be clear from the way all the chapters in part II of the book are set out. If
the standard economic model worked all the time there would be no need for behavioral
economics. Unfortunately, it does not and so we need to build upon it.