Module 19 krugman 1
Module 18
Behavioral Economics
What’s New in the Fourth Edition?
• Updated Teaching Tips
• Updated Business Cases
• Handouts for use in class
Module Objectives
• What do economists consider to be rational and irrational behavior?
• Why do people behave in irrational yet predictable ways sometimes?
Teaching Tips
How People Make Economic Choices
Creating Student Interest
• Ask students if they think of themselves as rational decision makers. Remind them that a rational
decision maker chooses the outcome that leads to the most preferred outcome. When they decide
not to study until one day before the exam, is this rational? Are they making the decision that gives
them the most preferred outcome? They should argue yes here. Now point out that they could have
earned a higher grade if they had chosen to begin studying earlier. Was the decision to wait
rational even though they ended up with a B or C instead of an A? They could still argue yes
because the action you prefer is not always the same as the action that gives you the highest
payoff. Other examples to introduce at this time are charitable contributions and the decision to
take a lower-paying job over a higher-paying job.
Now ask students if they think they ever make decisions that leave them worse off than if
they had chosen another option. These are the irrational decisions. Going back to the example of
when to start studying for the exam, waiting until the last day could also have been an irrational
decision. Suppose for example the students were overconfident about what they thought they
knew, and then once they started studying they realized they would never have enough time to
master what they needed to know. Being overconfident can lead people to make irrational
decisions.
Presenting the Material
• This is a topic that you can really have fun with. Use a variety of examples to explain the
difference between a rational and an irrational decision. Discuss reasons why a decision may be
rational but still result in a lower economic payoff. Next, discuss the common reasons why people
Module Outline
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Opening Example: The opening story discusses a choice faced by many people every year, namely the
I. Behavioral Economics
A. Behavioral economics studies why it is rational for people to sometimes make less-than-
perfect choices.
B. Rational, but human, too
1. People sometimes make less-than-optimal choices because they are concerned about
fairness.
2. A decision maker operating with bounded rationality makes a choice that is close to
but not exactly the one that leads to the best possible economic outcome. A person
makes a less-than-perfect choice because the effort of finding the best payoff is too
costly.
3. People are sometimes risk averse and will sacrifice some economic payoff in order to
avoid a potential loss.
C. Irrationality: an economist’s view
1. An irrational decision maker chooses an option that leaves him worse off than if he
had chosen another available option.
2. People’s irrational behavior stems from six mistakes:
a. Misperceptions of opportunity cost—for example, including a sunk cost or
ignoring an implicit cost.
b. Overconfidence—for example, assuming your finances are better than they
actually are.
c. Unrealistic expectations about future behavior—for example, assuming you will
study twice as hard tomorrow.
d. Mental accounting, or the habit of making some dollars worth more than other
dollars. For example, people often spend more if they use a credit card.
e. An oversensitivity to loss (or loss aversion), leading to unwillingness to recognize
a loss and move on; for example, refusing to sell a stock that is not performing
well.
f. Status quo bias, or the tendency to avoid making a decision and to stick with the
status quo.
D. Rational models for irrational people?
1. Models based on rational behavior still provide good predictions for most markets.
2. People sometimes behave more rationally over time, justifying the use of models
based on rational behavior.
3. Models based on rational behavior are much simpler to work with.
Case Studies in the Text
Economics in Action
In Praise of Hard Deadlines—This EIA describes the results of an experiment wherein three classes
were given assignment schedules with different deadlines. The grades were then compared in order to
learn more about the decisions the students made under each assignment schedule.
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Ask students the following questions:
Web Resources
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Handout 18-1
Date_________ Name____________________________ Class________ Professor________________
Rational or Irrational?
Explain why a person might make each of the following rational choices:
1. Fred needs to buy a new computer, compares the prices at the two stores close to his house, and picks the
store with the lower price. Fred does not check the price at any other store that sells the same computer.
2. Jane gives $1,000 to the local food bank each year.
3. Bob thinks that if he quit his current job and moved to New York City, there is a good chance he would be
able to find a job that pays twice his current salary. Bob decides to stay with his current job.
Explain why a person might make each of the following irrational choices:
1. Ben lost his job as a construction worker, and although he has been offered jobs as a maintenance worker,
he is still looking for a new construction job.
2. George owns 10 houses that he bought because he thought it was a good investment. Although he has
observed housing prices declining, he refuses to sell any of his houses.
3. Bill refuses to go back and get a second degree because he has already paid for one college degree.
4. Jack has not yet reduced his spending despite the fact that his wealth has declined and people at his place
of employment are being laid off.
5. Mary wants a new car but does not want to spend her savings. After an unexpected bonus at work, she
decides to buy the car.
6. Mark knows he could get a better job if he moves to another city, but he has not sent off any résumés.
Answers
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Rational:
Irrational: