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Chapter 31
Behavioral Economics
This is a new chapter on one of the hottest fields in economics, behavioral
economics. I’ve tried to provide a survey of some of the most interesting results,
but there is lots of new and interesting material available on the web, so be sure
to look there as well.
I’ve found that everybody can identify with this material, as we are all subject
to periods of non-rational behavior.
Most of this material can be introduced right after the chapters on consumer
theory, but I put it after game theory since some of the material at the end of
the chapter is based on strategic issues.
Behavioral Economics
A. Consumer choice theory is elegant but not always accurate
1. Behavioral economics combines insights of economics and psychology
2. Often based on psychology experiments
B. Framing effects
1. Choices may depend on how they are presented or framed
2. A serious disease threatens 600 people. You are offered a choice between
two treatments, A and B, which will yield the following outcomes.
saving no one.
3. Which would you choose? Now consider:
no one dying.
4. Which would you choose?
5. Many people choose A over B, but D over C.
6.Buttheyarethesame!
76 Chapter Highlights
C. Anchoring effects
1. Spurious information can influence choices
2. Spin a wheel of fortune
3. Is the number of African countries in the UN greater or less than the
number shown?
4. Then asked: how many countries in Africa?
5. The number shown on wheel of fortune had an influence on answer.
6. Wine experiment
7. Pension plans
D. Bracketing
1. Hard to predict your own behavior
2. Snack choice
E. Too much choice
1. Jam experiment
2. Constructed preferences
a) According to psychologies we discover our preferences
F. Uncertainty
1. Law of small numbers: people unduly influenced by small samples
2. Large hospital: 45 babies born each day
3. Small hospital: 15 babies born each day
4. During 1 year, each hospital recorded the days during which more than 60
percent of the babies born were boys
5. Which one had more such days?
6. Survey results
days
7. People find it very difficult to recognize randomness
a) Write down 150 random coin tosses
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G. Asset integration and loss aversion
1. Should care in principle about total wealth
2. But many people care about the gamble level itself
a) Suppose you make $100,000 per year
b) Offered $14 if heads comes up, lose $10 if tails comes up
H. Coffee mug experiment
1. Give half the class coffee mugs
2. Asked those with mugs: what is lowest price at which you would sell?
3. Asked those without mugs: what is highest price at which you would buy?
4. Answer should be about the same, but were quite different
5. The subjects with mugs were more reluctant to part with them
6. Similar to sunk cost fallacy
I. Time discounting
1. Exponential discounting v hyperbolic discounting
2. Time consistency and self control
3. Time inconsistency: plans differ from outcomes
4. How can I commit myself to future choices?
J. Overconfidence in stock trading
1. Infrequent traders: 18% return
2. Frequent traders: 11.3% return
3. An important factor: gender
4. Trading can be hazardous to your wealth!
K. Social norms
1. Ultimatum game
2. What affects behavior?
a) Gender
b) Culture
3. Punishment games
L. Assessment
1. No theory is 100 percent correct (at least in social sciences)
2. How big a violation do we need to reject theory?
3. People don’t even get simple physics problems right, even though we live
in a physical world
4. Apparently intuitive physics is good enough for everyday life
5. Markets may help correct serious biases (such as sunk cost)
6. Some behavioral anomalies appear to be similar to optical illusions
7. Others are more profound
8. Best advice: be critical, objective so far as possible