Behaviour, Decisions and Markets
Table of Contents
Week 1 – Ra onality ..........................................................................................................5
Economic Theory – Norma ve or Posi ve? .................................................................................5
Axioms...........................................................................................................................................................5
Norma ve vs. posi ve economics.................................................................................................................5
Milton Friedman (1953) ................................................................................................................................5
The ‘Golden Age’ of Economic Theory ..........................................................................................................5
Contemporary Economics .............................................................................................................................5
Irra onality ...................................................................................................................................................5
Ra onal Choice...........................................................................................................................6
Choice Theory ...............................................................................................................................................6
Axioms of Ra onality ....................................................................................................................................6
Indi erence Curves .......................................................................................................................................6
Examples of Preferences ...............................................................................................................................6
Lexicographic Preferences.............................................................................................................................6
Majority Rule Preferences.............................................................................................................................7
Counter-points ..............................................................................................................................................7
Summary .......................................................................................................................................................7
U lity Func ons .........................................................................................................................7
The U lity Func on.......................................................................................................................................7
St Petersburgh Paradox: Diminishing Marginal U lity ..................................................................................7
Risk ............................................................................................................................................8
Risk Aversion .................................................................................................................................................8
Risk Aversion and the Risk Premium .............................................................................................................9
Declining Absolute Risk Aversion (DARA)....................................................................................................11
The Wealth-Elas city of Marginal U lity ....................................................................................................11
Ra onal Choice.........................................................................................................................13
Completeness..............................................................................................................................................13
Transi vity...................................................................................................................................................13
Independence .............................................................................................................................................13
Alterna ve Views on Ra onality...............................................................................................15
Julia Galef....................................................................................................................................................15
Professor Ramneta......................................................................................................................................16
Gerd Gigerenzer ..........................................................................................................................................16
Readings...................................................................................................................................16
Preferences and U lity................................................................................................................................16
Preferences Under Uncertainty...................................................................................................................16
Exercises...................................................................................................................................16
Week 2 – Prospect Theory and Mental Accoun ng ...........................................................17
Prospect Theory........................................................................................................................17
Kahneman and Tversky ...............................................................................................................................17
Prospect Theory ..........................................................................................................................................17
The Value Func on......................................................................................................................................17
, The Weigh ng Func on ..............................................................................................................................18
The Allais Paradox Explained by a Probability Weigh ng Func on.............................................................19
Fehr-Duda and Epper (2012).......................................................................................................................19
Summary .....................................................................................................................................................20
Mental Accoun ng ...................................................................................................................20
What is Mental Accoun ng? .......................................................................................................................20
Kahneman and Tversky (1984)’s Three Types of Mental Accounts .............................................................20
Hedonic Framing .........................................................................................................................................21
Principles of Hedonic Framing ....................................................................................................................21
Mental Accoun ng and Transac on U lity .................................................................................................23
Opening and Closing Accounts....................................................................................................................24
Advance Purchases, Sunk Costs and Payment Deprecia on.......................................................................24
Budgets .......................................................................................................................................................24
Narrow Bracke ng and Dynamic Mental Accoun ng .................................................................................25
Myopic Loss Aversion and Narrow Framing ................................................................................................25
Readings...................................................................................................................................25
Mental Accoun ng Ma ers by Richard Thaler (1999) ................................................................................25
Prospects and Regrets.................................................................................................................................25
Week 3 – Bayesian Upda ng............................................................................................26
Probabili es .............................................................................................................................26
The Frequen st Approach...........................................................................................................................26
The Bayesian Approach...............................................................................................................................26
Bayesian Probabili es...............................................................................................................26
Setup ...........................................................................................................................................................26
Example.......................................................................................................................................................26
Bayesian Upda ng ......................................................................................................................................27
Applica ons of Belief Upda ng: Herding in Financial Markets ...................................................................27
Informa on Cascades..................................................................................................................................28
Readings...................................................................................................................................30
Informa on Cascades in the Laboratory by Anderson and Holt .................................................................30
Week 4 – Heuris cs ..........................................................................................................30
Heuris cs..................................................................................................................................30
Introduc on ................................................................................................................................................30
The Default Heuris c...................................................................................................................................30
Heuris cs Around Probability Judgements ................................................................................30
Conjunc on Fallacy – Tversky & Kahneman (1983) ....................................................................................30
The Availability Heuris c.............................................................................................................................30
The A ect Heuris c.....................................................................................................................................31
The Representa veness Heuris c ...............................................................................................................31
Sta c Choice .............................................................................................................................31
Anchoring....................................................................................................................................................31
Neoclassical or Behavioural Economics? ...................................................................................31
Pros and Cons of Expected U lity Theory ...................................................................................................31
Pros and Cons of Heuris cs.........................................................................................................................32
The Psychology Behind Irra onal Decisions...............................................................................32
Loss Aversion...............................................................................................................................................32
Gerd Gigerenzer – Bounded Ra onality ....................................................................................32
, Readings...................................................................................................................................32
Behavioural Economics and Finance by Baddeley ......................................................................................32
Week 5 – Intertemporal Decision-Making.........................................................................32
Discounted U lity .....................................................................................................................32
Theory .........................................................................................................................................................32
Model..........................................................................................................................................................33
Exponen al Discoun ng..............................................................................................................................34
Quasi-Hyperbolic Discoun ng.....................................................................................................................36
Worked Examples........................................................................................................................................38
Worked Example – Delayed Bene ts ..........................................................................................................38
Worked Example – Upfront Bene ts...........................................................................................................40
Recap...........................................................................................................................................................43
Week 7 – Fairness ............................................................................................................43
Evidence ...................................................................................................................................43
The Ul matum Game..................................................................................................................................43
The Voluntary Contribu ons Mechanism (VCM) ........................................................................................44
The Dictator Game ......................................................................................................................................46
Theories ...................................................................................................................................48
Inequality Aversion .....................................................................................................................................48
Inequality Aversion and Reciprocity............................................................................................................49
Applying Social Preferences to Mini-Dictator Games..................................................................................51
Readings...................................................................................................................................51
Understanding Social Preferences with Simple Tests by Charness and Rabin.............................................51
Week 8 – Incen ves..........................................................................................................52
Moral Hazard............................................................................................................................52
How Asymmetric Informa on Can Lead To Moral Hazard ..........................................................................52
Principal/Agent.........................................................................................................................52
Assump ons................................................................................................................................................52
Background .................................................................................................................................................52
Moral Hazard............................................................................................................................52
Nota on ......................................................................................................................................................52
Benchmark ..................................................................................................................................................54
Unobservable E ort & Risk-Neutral Agent..................................................................................................56
Unobservable E ort & Risk-Averse Agent ...................................................................................................57
Solu ons to Moral Hazard ........................................................................................................58
User Ra ngs ................................................................................................................................................58
House Inspec ons/Second Opinions ..........................................................................................................58
Reading ....................................................................................................................................58
Moral Hazard and Performance Incen ves by Edward P Lazear .................................................................58
Week 9 – Incen ves (con nued) .......................................................................................59
Unobservable E ort..................................................................................................................59
With Risk-Averse Agent...............................................................................................................................59
The Incen ve-Intensity Principle...............................................................................................59
Analysis 1 ....................................................................................................................................................61
Analysis 2 ....................................................................................................................................................61
Analysis 3 ....................................................................................................................................................62
, Analysis 4 ....................................................................................................................................................62
The Monitoring-Intensity Principle............................................................................................62
Premise .......................................................................................................................................................62
Mul tasking .............................................................................................................................63
Premise .......................................................................................................................................................63
The Equal Compensa on Principle .............................................................................................................64
The Principal’s Problem...............................................................................................................................64
Week 10 – Behaviour Change...........................................................................................66
Social Norms.............................................................................................................................66
Descrip ve Norms.......................................................................................................................................67
Injunc ve Norms.........................................................................................................................................67
Modelling Descrip ve vs Injunc ve Social Norms ......................................................................................67
Social Image and Reputa on E ects..........................................................................................69
Thoughts .....................................................................................................................................................69
A Simple Model of Social Image and Reputa on E ects.............................................................................69
Observability ...............................................................................................................................................70
Habits.......................................................................................................................................71
Recurring Behaviours ..................................................................................................................................71
Changing Habits ..........................................................................................................................................71
Groups.........................................................................................................................................................72
Readings...................................................................................................................................72
Social Norms and Pro-environmental Behaviour: A Review of Evidence by Farrow, Grolleau and Ibanez..72
When and Why Incen ves (Don’t) Work to Modify Behaviour by Gneezy, Meier and Rey-Biel .................73
Using Social Norms to Change Behaviour and Increase Sustainability in the Real World: a Systema c
Review of the Literature by Yamin, Fei, Lahlou and Levy ............................................................................74
Impure Altruism and Dona ons to Public Goods: A Theory of Warm-Glow Giving by Adreoni..................74
When a Nudge Back res: Combining (Im)Plausible Deniability with Social and Economic Incen ves to
Promote Behavioural Change by Bolton, Dimant and Schmidt...................................................................74
Projec on Bias in Predic ng Future U lity by Loewenstein, O’Donoghue and Rabin ................................74
Week 11 – Dishonesty ......................................................................................................74
Decep on .................................................................................................................................74
Background .................................................................................................................................................74
Empirical Evidence....................................................................................................................74
Lying Experiment.........................................................................................................................................74
Experimental Evidence................................................................................................................................75
Stylised Facts on Lying Experimental Data ..................................................................................................75
Behavioural Models of Lying .......................................................................................................................75
Economics of Crime (& What Punishment)................................................................................75
Policies to Incen vise Good Behaviour .......................................................................................................75
A Model of Tax Evasion ...............................................................................................................................76
Ambiguity Aversion ..................................................................................................................78
Ellsberg Paradox ..........................................................................................................................................78
Chateauneuf et al (2007) ............................................................................................................................79
Readings...................................................................................................................................81
Preferences for Truth-Telling by Abeler, Nosenzo and Raymond ................................................................81
Tax Compliance by Adreoni, Erard and Feinstein ........................................................................................81
Table of Contents
Week 1 – Ra onality ..........................................................................................................5
Economic Theory – Norma ve or Posi ve? .................................................................................5
Axioms...........................................................................................................................................................5
Norma ve vs. posi ve economics.................................................................................................................5
Milton Friedman (1953) ................................................................................................................................5
The ‘Golden Age’ of Economic Theory ..........................................................................................................5
Contemporary Economics .............................................................................................................................5
Irra onality ...................................................................................................................................................5
Ra onal Choice...........................................................................................................................6
Choice Theory ...............................................................................................................................................6
Axioms of Ra onality ....................................................................................................................................6
Indi erence Curves .......................................................................................................................................6
Examples of Preferences ...............................................................................................................................6
Lexicographic Preferences.............................................................................................................................6
Majority Rule Preferences.............................................................................................................................7
Counter-points ..............................................................................................................................................7
Summary .......................................................................................................................................................7
U lity Func ons .........................................................................................................................7
The U lity Func on.......................................................................................................................................7
St Petersburgh Paradox: Diminishing Marginal U lity ..................................................................................7
Risk ............................................................................................................................................8
Risk Aversion .................................................................................................................................................8
Risk Aversion and the Risk Premium .............................................................................................................9
Declining Absolute Risk Aversion (DARA)....................................................................................................11
The Wealth-Elas city of Marginal U lity ....................................................................................................11
Ra onal Choice.........................................................................................................................13
Completeness..............................................................................................................................................13
Transi vity...................................................................................................................................................13
Independence .............................................................................................................................................13
Alterna ve Views on Ra onality...............................................................................................15
Julia Galef....................................................................................................................................................15
Professor Ramneta......................................................................................................................................16
Gerd Gigerenzer ..........................................................................................................................................16
Readings...................................................................................................................................16
Preferences and U lity................................................................................................................................16
Preferences Under Uncertainty...................................................................................................................16
Exercises...................................................................................................................................16
Week 2 – Prospect Theory and Mental Accoun ng ...........................................................17
Prospect Theory........................................................................................................................17
Kahneman and Tversky ...............................................................................................................................17
Prospect Theory ..........................................................................................................................................17
The Value Func on......................................................................................................................................17
, The Weigh ng Func on ..............................................................................................................................18
The Allais Paradox Explained by a Probability Weigh ng Func on.............................................................19
Fehr-Duda and Epper (2012).......................................................................................................................19
Summary .....................................................................................................................................................20
Mental Accoun ng ...................................................................................................................20
What is Mental Accoun ng? .......................................................................................................................20
Kahneman and Tversky (1984)’s Three Types of Mental Accounts .............................................................20
Hedonic Framing .........................................................................................................................................21
Principles of Hedonic Framing ....................................................................................................................21
Mental Accoun ng and Transac on U lity .................................................................................................23
Opening and Closing Accounts....................................................................................................................24
Advance Purchases, Sunk Costs and Payment Deprecia on.......................................................................24
Budgets .......................................................................................................................................................24
Narrow Bracke ng and Dynamic Mental Accoun ng .................................................................................25
Myopic Loss Aversion and Narrow Framing ................................................................................................25
Readings...................................................................................................................................25
Mental Accoun ng Ma ers by Richard Thaler (1999) ................................................................................25
Prospects and Regrets.................................................................................................................................25
Week 3 – Bayesian Upda ng............................................................................................26
Probabili es .............................................................................................................................26
The Frequen st Approach...........................................................................................................................26
The Bayesian Approach...............................................................................................................................26
Bayesian Probabili es...............................................................................................................26
Setup ...........................................................................................................................................................26
Example.......................................................................................................................................................26
Bayesian Upda ng ......................................................................................................................................27
Applica ons of Belief Upda ng: Herding in Financial Markets ...................................................................27
Informa on Cascades..................................................................................................................................28
Readings...................................................................................................................................30
Informa on Cascades in the Laboratory by Anderson and Holt .................................................................30
Week 4 – Heuris cs ..........................................................................................................30
Heuris cs..................................................................................................................................30
Introduc on ................................................................................................................................................30
The Default Heuris c...................................................................................................................................30
Heuris cs Around Probability Judgements ................................................................................30
Conjunc on Fallacy – Tversky & Kahneman (1983) ....................................................................................30
The Availability Heuris c.............................................................................................................................30
The A ect Heuris c.....................................................................................................................................31
The Representa veness Heuris c ...............................................................................................................31
Sta c Choice .............................................................................................................................31
Anchoring....................................................................................................................................................31
Neoclassical or Behavioural Economics? ...................................................................................31
Pros and Cons of Expected U lity Theory ...................................................................................................31
Pros and Cons of Heuris cs.........................................................................................................................32
The Psychology Behind Irra onal Decisions...............................................................................32
Loss Aversion...............................................................................................................................................32
Gerd Gigerenzer – Bounded Ra onality ....................................................................................32
, Readings...................................................................................................................................32
Behavioural Economics and Finance by Baddeley ......................................................................................32
Week 5 – Intertemporal Decision-Making.........................................................................32
Discounted U lity .....................................................................................................................32
Theory .........................................................................................................................................................32
Model..........................................................................................................................................................33
Exponen al Discoun ng..............................................................................................................................34
Quasi-Hyperbolic Discoun ng.....................................................................................................................36
Worked Examples........................................................................................................................................38
Worked Example – Delayed Bene ts ..........................................................................................................38
Worked Example – Upfront Bene ts...........................................................................................................40
Recap...........................................................................................................................................................43
Week 7 – Fairness ............................................................................................................43
Evidence ...................................................................................................................................43
The Ul matum Game..................................................................................................................................43
The Voluntary Contribu ons Mechanism (VCM) ........................................................................................44
The Dictator Game ......................................................................................................................................46
Theories ...................................................................................................................................48
Inequality Aversion .....................................................................................................................................48
Inequality Aversion and Reciprocity............................................................................................................49
Applying Social Preferences to Mini-Dictator Games..................................................................................51
Readings...................................................................................................................................51
Understanding Social Preferences with Simple Tests by Charness and Rabin.............................................51
Week 8 – Incen ves..........................................................................................................52
Moral Hazard............................................................................................................................52
How Asymmetric Informa on Can Lead To Moral Hazard ..........................................................................52
Principal/Agent.........................................................................................................................52
Assump ons................................................................................................................................................52
Background .................................................................................................................................................52
Moral Hazard............................................................................................................................52
Nota on ......................................................................................................................................................52
Benchmark ..................................................................................................................................................54
Unobservable E ort & Risk-Neutral Agent..................................................................................................56
Unobservable E ort & Risk-Averse Agent ...................................................................................................57
Solu ons to Moral Hazard ........................................................................................................58
User Ra ngs ................................................................................................................................................58
House Inspec ons/Second Opinions ..........................................................................................................58
Reading ....................................................................................................................................58
Moral Hazard and Performance Incen ves by Edward P Lazear .................................................................58
Week 9 – Incen ves (con nued) .......................................................................................59
Unobservable E ort..................................................................................................................59
With Risk-Averse Agent...............................................................................................................................59
The Incen ve-Intensity Principle...............................................................................................59
Analysis 1 ....................................................................................................................................................61
Analysis 2 ....................................................................................................................................................61
Analysis 3 ....................................................................................................................................................62
, Analysis 4 ....................................................................................................................................................62
The Monitoring-Intensity Principle............................................................................................62
Premise .......................................................................................................................................................62
Mul tasking .............................................................................................................................63
Premise .......................................................................................................................................................63
The Equal Compensa on Principle .............................................................................................................64
The Principal’s Problem...............................................................................................................................64
Week 10 – Behaviour Change...........................................................................................66
Social Norms.............................................................................................................................66
Descrip ve Norms.......................................................................................................................................67
Injunc ve Norms.........................................................................................................................................67
Modelling Descrip ve vs Injunc ve Social Norms ......................................................................................67
Social Image and Reputa on E ects..........................................................................................69
Thoughts .....................................................................................................................................................69
A Simple Model of Social Image and Reputa on E ects.............................................................................69
Observability ...............................................................................................................................................70
Habits.......................................................................................................................................71
Recurring Behaviours ..................................................................................................................................71
Changing Habits ..........................................................................................................................................71
Groups.........................................................................................................................................................72
Readings...................................................................................................................................72
Social Norms and Pro-environmental Behaviour: A Review of Evidence by Farrow, Grolleau and Ibanez..72
When and Why Incen ves (Don’t) Work to Modify Behaviour by Gneezy, Meier and Rey-Biel .................73
Using Social Norms to Change Behaviour and Increase Sustainability in the Real World: a Systema c
Review of the Literature by Yamin, Fei, Lahlou and Levy ............................................................................74
Impure Altruism and Dona ons to Public Goods: A Theory of Warm-Glow Giving by Adreoni..................74
When a Nudge Back res: Combining (Im)Plausible Deniability with Social and Economic Incen ves to
Promote Behavioural Change by Bolton, Dimant and Schmidt...................................................................74
Projec on Bias in Predic ng Future U lity by Loewenstein, O’Donoghue and Rabin ................................74
Week 11 – Dishonesty ......................................................................................................74
Decep on .................................................................................................................................74
Background .................................................................................................................................................74
Empirical Evidence....................................................................................................................74
Lying Experiment.........................................................................................................................................74
Experimental Evidence................................................................................................................................75
Stylised Facts on Lying Experimental Data ..................................................................................................75
Behavioural Models of Lying .......................................................................................................................75
Economics of Crime (& What Punishment)................................................................................75
Policies to Incen vise Good Behaviour .......................................................................................................75
A Model of Tax Evasion ...............................................................................................................................76
Ambiguity Aversion ..................................................................................................................78
Ellsberg Paradox ..........................................................................................................................................78
Chateauneuf et al (2007) ............................................................................................................................79
Readings...................................................................................................................................81
Preferences for Truth-Telling by Abeler, Nosenzo and Raymond ................................................................81
Tax Compliance by Adreoni, Erard and Feinstein ........................................................................................81
