Behavioral Economics
ECO 61 Microeconomic Analysis
Udayan Roy
December 2008
Main Topics
• Objectives and methods of behavioral
economics
• Departures from perfect rationality
• Choices involving time
• Choices involving risk
• Choices involving strategy
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Motivations and Objectives
• The two main motivations for behavioral economics concern
apparent weaknesses in standard economic theory:
– People sometimes make choices that are difficult to explain with
standard economic theory
– Standard economic theory can lead to seemingly unreasonable
conclusions about consumer welfare
• Behavioral economics grew out of research in psychology
• The objective is to modify, supplement, and enrich
economic theory by adding insights from psychology
– Suggesting that people care about things standard theory typically
ignores, like fairness or status
– Allowing for the possibility of mistakes
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Methods
• Behavioral economics uses many of the same tools and
frameworks as standard economics
– Assumes individuals have well-defined objectives, that objectives and
actions are connected, and actions affect well-being
– Relies on mathematical models
– Subjects theories to careful empirical testing
• Important difference is use of experiments using human
subjects
• Behavioral economists tend to use experimental data to test
their theories rather than drawing data from the real world
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Advantages of Experiments
• Easier to determine whether people’s choices are
consistent with standard economic theory by ruling
out alternative explanations
• Often easier to establish causality
• Researchers can double-check their assumptions and
conclusions by testing and debriefing subjects
• Often possible to obtain information that isn’t
available in the real world
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Disadvantages of Experiments
• Decisions made in the lab differ from decisions made
in the real world
• Introduce influences on decision-making that are
hard to measure or control
– Strong evidence that subjects often try to conform to what
they think are the experimenter’s expectations
• Most subjects are students, thus not representative
of the general population
– Also inexperienced at making economic decisions
• Scale of any given experiment is limited by the
available resources
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Evaluating Behavioral Evidence
• Critical questions about behavioral research that
appears inconsistent with standard economic theory:
– Is the evidence convincing? Was the experiment welldesigned?
– Is the observed behavioral pattern robust?
– What are the possible explanations? Can we reconcile this
with standard theory?
– If theory appears to fail in a significant situation, how
should we modify the theory?
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Are we predictably irrational?
• It is not surprising that we are not always
perfectly rational
• But are our departures from perfect
rationality completely random?
• Or are these departures predictable?
• If we can find predictable patterns of
irrationality in human behavior, then we can
improve economic theory
Incoherent Choices:
Choice Reversals
• Laboratory subjects sometimes display incoherent
choice behavior
• Circular choices indicate preferences that violate the
Ranking Principle
• Example: a participant in an experiment
– Values a low stakes bet at $3.40 and a high stakes bet at
$3.60
– Chooses the low stakes bet
• Include $3.50 as a third choice; no way to rank these
three options from best to worst
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Figure 13.1: Inconsistent Choices
• Laboratory subjects sometimes display
incoherent choice behavior
• Circular choices indicate preferences that
violate the Ranking Principle
• Experiments suggest that these
inconsistencies arise often
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Table 13.1: Inconsistent Choices
• In 276 comparisons of high stakes and low stakes bets,
people preferred the low stakes bet 99 times and the
high stakes bet 174 times
• But in 69 of the 99 cases in which the low stakes bet
was preferred, the value of the high stakes bet was
considered higher!
Figure 13.2: A Choice Reversal
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Incoherent Choices:
Anchoring
• Anchoring occurs when someone’s choices are linked to
prominent but irrelevant information
• Suggests that some choices are arbitrary and can’t reflect
meaningful preferences
• Example: experiment showing subjects’ willingness to pay
for various goods was closely related to the last two digits of
their social security number, by suggestion
– Skeptics note that subjects had little experience purchasing the
goods in the experiment
– Might have been less sensitive to suggestion if used familiar
products
• Significance of anchoring effects for many economic choices
remains unclear
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Anchoring
• 55 subjects were shown a series of six common
products with average retail price of $70
• For each product, the experiment had three
steps: Each participant was asked
– his/her SSN
– whether he/she would buy the product at a price
equal to the last 2 digits of SSN
– The maximum he/she would be willing to pay
Bias Toward the Status Quo:
Endowment Effect
• The endowment effect is people’s tendency to value
something more highly when they own it than when they
don’t
• Example: experiment in which median owner value for mugs
was roughly twice the median non-owner valuation
• Some economists think this reflects something fundamental
about the nature of preferences
• Incorporating the endowment effect into standard theory
implies an indifference curve kinked at the consumer’s initial
consumption bundle
– Smooth changes in price yield abrupt changes in consumption
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Endowment Effect
• Half the participants were given mugs available at the campus bookstore
for $6
• The other half were allowed to examine the mugs
• Each student who had a mug was asked to name the lowest sale price
• Each student who did not have a mug was asked to name the highest
purchase price
• Supply and demand curves were constructed and the equilibrium price
was obtained
• Trade followed
• There were four rounds of this
Figure 13.3: Endowment Effect
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Bias Toward the Status Quo:
Default Effect
• When confronted with many alternatives, people sometimes
avoid making a choice and end up with the option that is
assigned as a default
• Example: Experiment showing that more subjects kept $1.50
participation fee rather than trading it for a more valuable
prize when the list of prizes to choose from was lengthened
• Possible explanation is that psychological costs of decisionmaking rise as number of alternatives rises, increasing
number of people who accept the default
• Retirement saving example illustrates the default effect when
the stakes are high
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Default effect: retirement
• Prior to April 1, 1998, the default option was
nonparticipation in the retirement plan
• After April 1, 1998, all employees were by default enrolled
in a plan that invested 3% of salary in money market
mutual funds
• Only the default option changed
Narrow Framing
• Narrow framing is the tendency to group items into categories
and, when making choices, to consider only other items in the
same category
• Can lead to behavior that is hard to justify objectively
• Examples:
– Far more people are willing to pay $10 to see a play after losing $10
entering a theater vs. losing the ticket on the way in
– Calculator and jacket example, decisions about whether to drive 20
minutes to save $5
• These choices may be mistakes or may reflect the consumers’
true preferences
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Narrow Framing
• Q1: Imagine you have decided to see a play
where admission is $10. As you enter the theatre
you discover that you have lost a $10 bill. Would
you still buy a ticket to see the play?
• Q2: Imagine you have bought a $10 ticket to see a
play. As you enter the theatre you discover that
you have lost the ticket. Would you buy a new
ticket to see the play?
• 88% say yes to Q1 and 56% to Q2
Narrow Framing
• Q1: Imagine you are about to buy a jacket for
$125 and a calculator for $15. The calculator
salesman informs you that a store 20 minutes
away offers the same calculator for $10. Would
you make the trip to the other store?
• Q2: Imagine you are about to buy a jacket for $15
and a calculator for $125. The calculator
salesman informs you that a store 20 minutes
away offers the same calculator for $120. Would
you make the trip to the other store?
• 68% say yes to Q1 and 29% to Q2
Why you can’t get a cab in NYC when
you really need one
• On any given day, the length of a cab driver’s
shift was negatively related to hourly earnings
• Total daily income remained the same
Salience
• Imagine a disease is expected to kill 600 people
– Under program A, 200 people will be saved
– Under program B, there is a 1/3 probability that 600
people will be saved and a 2/3 probability that no
people will be saved
– Under program C, 400 people will die
– Under program D, there is a 1/3 probability that no
one will die and a 2/3 probability that 600 people will
die
• 72% prefer A to B and 78% prefer D to C
Rules of Thumb
• Thinking through every alternative for complex economic
decisions is difficult
• May rely on simple rules of thumb that have served well in
the past
• Example: saving
– In economic models finding the best rate of savings involves complex
calculations
– In practice people seem to follow rules of thumb such as 10% of
income
– These rules appear to ignore factors that theory says should be
important, such as expected future income
• Popular rules may be choices that are nearly optimal, using
one is not necessarily a mistake
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Choices Involving Time
• Many behavioral economists see standard theory of decisions
involving time as too restrictive, it rules out patterns of
behavior that are observed in practice
• For example, theory rules out these three observed behaviors
– Preferences over a set of alternatives available at a future date are
dynamically inconsistent if the preferences change as the date
approaches
– The sunk cost fallacy is the belief that, if you paid more for something,
it must be more valuable to you
– Projection bias is the tendency to evaluate future consequences based
on current tastes and needs
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The Problem of Dynamic Inconsistency
• Thought to reflect a bias toward immediate gratification,
know as present bias
– A person with present bias often suffers from lapses of self-control
• Laboratory experiments have documented the existence of
present bias
• Precommitment is useful in situations in which people don’t
trust themselves to follow through on their intentions
• Precommitment is a choice that removes future options
– Example: A student who wants to avoid driving while intoxicated
hands his car keys to a friend before joining a party
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The Problem of Dynamic Inconsistency
• Save More Tomorrow (SMART) plans
• The earlier option is chosen more frequently
the shorter the delay
The Problem of Dynamic Inconsistency
• People often waste expensive gym
memberships
– The LIU gym plan for faculty
Figure 13.4: Dynamic Inconsistency in
Saving
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We should ignore sunk costs but often
do not
• Uncomfortable shoes
• Bad movie rentals
• Season ticket discounts lead to lower initial
attendance
Projection bias in forecasting future
tastes and needs
• Hungry shoppers tend to buy more than sated
shoppers when shopping for the week ahead
• People tend to underestimate their
adaptability to change
Trouble Assessing Probabilities
• People tend to make specific errors in assessing probabilities
• Hot-hand fallacy is the belief that once an event has occurred several
times in a row it is more likely to repeat
– Arises when people can easily invent explanations for streaks, e.g., basketball
• Gambler’s fallacy is the belief that once an event has occurred it is less
likely to repeat
– Arises when people can’t easily invent explanations for streaks, e.g., state
lotteries
• Both fallacies have important implications for economic behavior, e.g.,
clearly relevant in context of investing
• Overconfidence causes people to:
– Overstate the likelihood of favorable events
– Understate the uncertainty involved
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Hot-hand fallacy
• Philadelphia 76ers, 48 home games, 1980-81
season
Gambler’s fallacy
• A study of nearly 1800 daily drawings between
1988 and 1992 in a New Jersey lottery showed
that after a number came up a winner, bettors
tended to avoid it
Overconfidence
• In one study of US students with an average
age of 22, 82% ranked their driving ability
among the top 30% of their age group
• In the manufacturing sector, more than 60%
of new entrants exit within five years; nearly
80% exit within ten years
Preferences Toward Risk
• Two puzzles involving observed behavior and risk preferences
• Low probability events:
– Experimental subjects exhibit aversion to risk in gambles with
moderate odds
– However, some subjects appear risk loving in gambles with very high
payoffs with very low probabilities
• Aversion to very small risks:
– Many people also appear reluctant to take even very tiny shares of
certain gambles that have positive expected payoffs
– Implies a level of risk aversion so high it is impossible to explain the
typical person’s willingness to take larger financial risks
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Low probability events grab all the
attention
• Option A: Win $2,500
• Option B: Win $5,000 with 1/2 probability
• Most choose Option A over B, suggesting riskaverse preferences
• Option C: Win $5
• Option D: Win $5,000 with 1/1000 probability
• A sizable majority picks Option D over C, which is
puzzling because the choice suggests risk-loving
preferences
Extreme risk aversion
• Option A: Win $1,010 with 50% probability
and lose $1,000 with 50% probability
• Most people refuse this gamble
• Option B: Win $10.10 with 50% probability
and lose $10.00 with 50% probability
• Most people refuse this gamble too,
suggesting extreme risk aversion
Prospect Theory:
A Potential Solution
• Proposed in late 1970s by two psychologists, Daniel
Kahneman (later won Nobel Memorial Prize in
economics) and Amos Tversky
• An alternative to expected utility theory
• May resolve a number of puzzles related to risky
decisions, including the two on previous slide
• Remains controversial among economists
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Prospect Theory
• Expected utility theory:
– Evaluates an outcome based on total resources
– Multiplies each valuation by its probability
• Prospect theory:
– Evaluates an outcome based on the change in total
resources, judges alternatives according to the gains and
losses they generate relative to the status quo
– Uses a weighting function exhibiting loss aversion and
diminishing sensitivity
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Prospect Theory
• Consumer starts out with $R
• A gamble pays $X1 with probability P and $X2
with probability 1 - P
• Will the consumer take this gamble?
• Expected utility theory: yes if
– U(R) < [P  U(R + X1)] + [(1 – P)  U(R + X2)]
• Prospect theory: yes if
– V(0) < [W(P)  V(X1)] + [W(1 – P)  V(X2)]
Prospect Theory
• W(P) is the weight (or, importance) a consumer assigns to the probability
P. It is called the weighting function
– Note that people tend to assign disproportionate weight to low-probability
outcomes
• V(X) is the value of $X to the consumer. It is called the valuation function.
– This is the same as the befit function in expected utility theory, except that it is
asymmetric. Loss aversion and diminishing sensitivity are built in.
Choices Involving Strategy
• Some of game theory’s apparent failures may be
attributable to faulty assumptions about people’s
preferences
– May not be due to fundamental problems with the theory
itself
• Many applications assume that people are motivated
only by self-interest
• Players sometimes make decisions that seem
contrary to their own interests
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Voluntary Contribution Games
• In a voluntary contribution game:
– Each member of a group makes a contribution to a common pool
– Each player’s contribution benefits everyone
• Creates a conflict between individual interests and collective
interests
• Like a multi-player version of the Prisoners’ Dilemma
• Game theory predicts the behavior of experienced subjects
reasonably well
• For two-stage voluntary contribution game, predictions
based on standard game theory are far off
• Assumptions about players’ preferences may be incorrect
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Importance of Social Motives:
The Dictator Game
• In the dictator game:
– The dictator divides a fixed prize between himself and the
recipient
– The recipient is a passive participant
– Usually no direct contact during the game
– Strictly speaking, not really a game!
• Most studies find significant generosity, a sizable
fraction of subjects divides the prize equally
• Illustrates the importance of social motives: altruism,
fairness, status
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Importance of Social Motives:
The Ultimatum Game
• In the ultimatum game:
– The proposer offers to give the recipient some share of a fixed prize
– The recipient then decides whether to accept or reject the proposal
– If she accepts, the pie is divided as specified; if she rejects, both
players receive nothing
• Theory says the proposer will offer a tiny fraction of the prize;
the recipient will accept
• Studies show that many subjects reject very low offers; the
threat of rejection produces larger offers
• In social situations, emotions such as anger and indignation
influence economic decisions
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Importance of Social Motives:
The Trust Game
• In the trust game:
– The trustor decides how much money to invest
– The trustee divides up the principal and earnings
• If players have no motives other than monetary gain, theory says that
trustees will be untrustworthy and trustors will forgo potentially profitable
investments
• Studies show that
– Trustors invested about half of their funds
– Trustees varied widely in their choices
– Overall, trustors received about $0.95 in return for every dollar invested
• Many (but not all) people do feel obligated to justify the trust shown in
them by others, thus many are willing to extend trust
• This game helps us understand why business conducted on handshakes
and verbal agreements works
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