IA 350, Intermediate Microeconomics
Part IV – Behavioral Economics
A Methodological Approach …
Individual
Choices
Observed
Aggregate
Outcomes
Are the individuals “humans” or are they “econs”?*
* This distinction between the way psychologists and economists model the agents in their models was
originally suggested by Richard Thaler (see Kahneman, 2011, p269).
Strategic Interaction and Social Norms
Simple Ultimatum Games
Mean offer: ~.37x
Modal offer: .50x
Offers < .20x often rejected
Ultimatum Games and Rationality
Consider a two-stage ultimatum game in which player 1 allocates $100 in
round 1. If player 2 accepts player 1’s offer, the game ends with the players
keeping the respective amounts. If player 2 refuses player 1’s offer in round
1, the game moves to round 2 with the player’s switching roles, and player 2
allocates $25. The same rules apply as in round 1. What is player 1’s optimal
offer in round 1?
($75, $25)
x = $25
($1, $24)
($76, $24)
x = $24
($1, $24)
x = $23
($77, $23)
($1, $24)
Uncertainty and Loss Aversion
“Most respondents in a sample of undergraduates refused to stake $10 on
the toss of a coin if they stood to win less than $30.”
Value = V($)
+v
- $10
+ (Loss)
+ $30
-v
+ (Gain)
Uncertainty and Loss Aversion
You respondents
are offered in
thea sample
following
bet: A fair coin
will to
bestake
tossed.
If
“Most
of undergraduates
refused
$10 on
is heads,
youif will
x,towhile
if itthan
is tails
theit toss
of a coin
theywin
stood
win less
$30.”you will lose y.
If y is $1, what value
of x =
would
Value
V($)you require to accept the
$1.63
bet? ______________
If y is $100, what value of x would you require to accept the
+v
$931
bet? ______________
If y is $1,000, what- value
$10 of x would you require to accept
$3,212
bet? ______________
+ the
(Loss)
+ (Gain)
+ $30
If y is $10,000, what value of x would you require to accept
$100,647
the bet? ______________
-v
If y is $100,000, what value of x would you require to
$463,824
accept the bet? ______________
A Mean Reverting Walk Down Wall Street
What implications do the concepts of “endowment effects” and “loss aversion” have for
our understanding of investor behavior and stock market performance?
Loss aversion also explains one of the most common investing
mistakes: investors evaluating their stock portfolio are most likely to
sell stocks that have increased in value or, during a week like this
(September 2008), have gone down the least amount. Why? Because it
hurts to take a loss. Unfortunately, this means that people end up
holding on to their depreciating stocks. Over the long term, this
strategy is exceedingly foolish, since it ultimately leads to a portfolio
composed entirely of shares that are losing money. (A study by
Terrance Odean, an economist at UC-Berkeley, found that the stocks
investors sold outperformed the stocks they didn't sell by 3.4 percent).
Even professional money managers are vulnerable to this bias, and
tend to hold losing stocks twice as long as winning stocks. Because
selling shares that have decreased in value makes the loss tangible and losing sucks - we try to postpone the pain for as long as possible.
Jonah Lehrer, author of How We Decide
http://scienceblogs.com/cortex/2008/09/loss_aversion_and_the_stock_ma.php
Time Inconsistency
Discounting as a Function of Time Delay and Money Amount
Three strong patterns:
1. Discount rates decline with the length of time to be waited.
2. Discount rates decline with the size of reward.
3. Discount rates for gains are higher than for losses.
0.50
Implied Discount Rate
0.45
$40
0.40
0.35
$200
0.30
.025
.020
0.15
$1,000
$5,000
0.10
0.05
0
0
1
2
3
4
Delay in Years
Adapted from Thaler, The Winner’s Curse (1992), Figure 8 – 1. Original source given as
Benzion et al. (1989), “Discount Rates Inferred from Decisions: An Experimental Study,”
Management Science 35: 270 – 284.
Time Inconsistency
6.
You are working at a job and are currently earning $10,000 a month. You receive a memo that says
a new payment plan is under consideration for next year. Instead of receiving monthly paychecks,
you can start the new year by receiving your annual salary in a lump sum. (If you quit during the
year, you will have to pay back an amount equal to the percentage of the year that you will not be
working there, plus interest.) There is a catch, however: if you choose this new plan, your salary
will be deduced. What annual salary would you be willing to accept to receive the your entire year's
salary in a lump sum at the beginning of the year?
Average
Minimum
Maximum
7.
$120,000
$68,136
$200,000
Implied d
~ 0%
120%
- 85%
You are working at a job and are currently earning $10,000 a month. You receive a memo that says
a new payment plan is under consideration for next year. Instead of receiving monthly paychecks,
you can receive your annual salary in a lump sum at the end of the year. (If you quit during the
year, you will be paid a lump sum equivalent to an amount equal to the percentage of the year that
you worked there.) To induce you to sign up for this plan, your salary will be increased. What
annual salary would you require to sign up for this end-of-year lump sum payment plan?
Average
Minimum
Maximum
$143,000
$100,000
$200,000
Implied d
32%
- 34%
92%
Time Inconsistency – One Implication
The psychology of intertemporal choice complicates the already
complicated question of selecting the proper social rate of discount
(the rate at which the government should discount future costs and
benefits). The standard view is that the market rate of interest,
corrected for tax distortions, represents an aggregation of individual
time preferences, and is the appropriate social rate of time
discounting … But, if individuals do not discount everything at a
single rate, then which rate is the one that is appropriate for social
discounting?
Rhichard Thaler, The Winner’s Curse,1992, pp. 105 – 106.
Some observations about the “correctness” of risk assessments:
Risk analysis and the assumption of normality
S&P 500 – Frequency Distribution of Daily Returns
7%
Properties of Distribution
Median
Mean
Standard Deviation
Skewness
Kurtosis
6%
5%
0.05%
0.03%
0.96%
-0.6778
23.0759
4%
October 21, 1987
Daily Change: 9.10%
Probability: 1.716 X 1021
3%
October 19, 1987
Daily Change: -20.47%
Probability: 2.038 X 10101
2%
October 13, 2008
Daily Change: 11.58%
Probability: 1.195 X 1033
1%
0.25
0.20
0.15
0.10
0.05
0.00
-0.05
-0.10
-0.15
-0.20
-0.25
0%
Risk Analysis and the Assumption of Normality
Mean:
Std. Dev.:
0.0323%
0.9653%
Range
October 19, 1987
+/- s
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Low
-0.9329%
-1.8982%
-2.8634%
-3.8287%
-4.7939%
-5.7592%
-6.7244%
-7.6897%
-8.6550%
-9.6202%
-10.5855%
-11.5507%
-12.5160%
-13.4812%
-14.4465%
-15.4117%
-16.3770%
-17.3423%
-18.3075%
-19.2728%
-20.2380%
-21.2033%
-22.1685%
-23.1338%
-24.0990%
High
0.9976%
1.9629%
2.9281%
3.8934%
4.8586%
5.8239%
6.7891%
7.7544%
8.7196%
9.6849%
10.6501%
11.6154%
12.5807%
13.5459%
14.5112%
15.4764%
16.4417%
17.4069%
18.3722%
19.3374%
20.3027%
21.2680%
22.2332%
23.1985%
24.1637%
Probailbity
68.2689492%
95.4499736%
99.9487524%
99.9936658%
99.9999427%
99.9999998%
1-Probability
31.7310508%
4.5500264%
0.0512476%
0.0063342%
0.0000573%
0.0000002%
October 21, 1987
October 13, 2008
IA 350, Intermediate Microeconomics
Part IV – Externalities
Externalities
Market prices reflect only private valuations
and private costs of production.
S’
P
[= Private + Social Cost]
The “Dead Weight Loss” associated
With a negative externality.
S
[= Private Cost]
D
[= Private Value]
P’
P*
MSC
Q’ Q*
Optimal Output
-- Society’s View
[Social Cost]
Q
Optimal Output
-- Private Market’s View
Externalities
The Problem of Social Cost (1960)
“It is strange that a doctrine as faulty as that developed by Pigou
should have been so influential …”
Ronald Coase
1910 -
“The traditional approach [to the externality problem, the
‘Pigovian’ approach] has tended to obscure the nature of the choice
that has to be made. The question is commonly thought of as one
in which A inflicts harm on B. But this is wrong. We are dealing
with a problem of a reciprocal nature. To avoid the harm to B
would be to inflict harm on A … The problem is to avoid the more
serious harm.”
The Coase Theorem: In the absence of transaction costs, all government allocations of
property rights are equally efficient, because interested parties will bargain privately to correct
any externality.
Implication: Any market plagued by externalities can be made efficient if property rights are
clearly defined and assigned (the “missing market” interpretation), and if transaction
(bargaining) costs are negligible.
Pure Exchange and Externalities

B
·
X’
Good 2 (Externality)
·
X
·
A
·
Good 1 (Income)
Pure Exchange and Externalities : The Coase Theorem

B
·
X’
X
Good 2
·
A
·
·
Good 1
IA 350, Intermediate Microeconomics
Part IV – Asymmetric Information
Markets with asymmetric information
Varian’s “market for plums and lemons”
P
S plums : P  44Q ps
Slemons : P  1100  44Qls

2200  Pplums
1925  P̂plums
D plums : P  4400  44 Q pd
1375  P̂lemons
Duncertainquality

1100  Plemons


 pr plums* D plums   prlemons* Dlemons 
Dlemons : P  3300  44Qld
Qˆ plums
Q plums Qˆ lemons
||
43.75

Qlemons
||
||
56.25
Duncertainquality

Q

 pr plums* D plums   prlemons* Dlemons 
||
50
Adapted from Varian, Intermediate Microeconomics, 8th ed., 719 – 720. His example is itself an adaptation from a famous paper by George
Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 (1970): 485 – 500.
Markets with asymmetric information
Signaling in a Labor Market
w
cl(e)
ch(e)
wh
b(e)
wl
e*
e
Adapted from Varian, Intermediate Microeconomics, 8th ed., 726 – 730. His example is itself an adaptation from a famous paper by Michael
Spense, “Job Market Signaling.” Quarterly Journal of Economics 87 (1973): 355 – 374.
Markets with asymmetric information
General categories of problems of asymmetric information:

Adverse Selection: A situation in which individuals possess hidden information, leading
to a market selection process that results in a pool of individuals with economically
undesirable characteristics.

Moral Hazard: A situation in which one party to a contact takes a hidden action that
creates benefits at the expense of another party to the contract.
Social institutions that help solve these market inefficiencies:
Private agent responses to problems of asymmetric information:

Signaling – the party possessing private information takes action to generate a credible
signal, such as warranties or guarantees.

Screening – the party with imperfect information takes action to induce a
advantageous sorting of the market, such as an incentive-driven menu of options.
Public / Private sector responses to problems of asymmetric information:

Compulsory purchase plans (insurance markets)

Licensing and certification (note that this may also be done by private agents).

Market regulation, including “truth” laws and “insider trading” laws.
Agency costs
What is the “agency problem” and what are agency costs?
 Efficiency costs which arise when there is a divergence of
interests between parties to a transaction.
 When one party to a transaction cannot observe the effort of
another party, upon whose effort the value of the transaction
depends, we say there is a principal-agent problem. Examples:
• Shareholders (principal) cannot perfectly monitor the efforts
of a CEO (agent)
• CEO (principal) cannot perfectly monitor the efforts of
managers (agent)
 In such cases, the principal cannot determine whether a bad
outcome was the result of the agent’s low effort or due to bad
luck.
Basic Principal-Agent Model
Principal’s Share
Uncertainty
Observable Outcome
Payoffs
Agent’s Share
Agent’s Actions
Contract
The Agency Challenge. To structure a contract that specifies division of payoffs in
such a way that the agent’s actions will maximize those payoffs, given two
complicating factors:
 Uncertainty
 Unobservability of effort
Implications of Agency Theory
Summary
 There is an implicit tradeoff between efficient risk bearing
and creation of incentive effects.
 The difference in utility outcomes may be interpreted as the
cost of inducing a risk-averse agent to accept some risk
 Inability to observe effort entails efficiency costs (in terms
of lower utility or surplus generated from the transaction.