Summary Behavioral Economics
Lecture 1
What is behavioral economics?
(Why and how make people decisions?)
3 definitions:
(1) It is about understanding economic behavior and it’s consequences (for example why someone buys
something, goes to work, saves for retirement, …)
> it’s about understanding whether people make good or bad choices
(2) Testing the standard economic model on humans seeing when it works and when it does not
(3) Applying insights from laboratory experiments, psychology and other social sciences in economics
Behavioral economics is about working constructively with the standard economic model to get a
better understanding of economic behavior. The objective is definitely not to criticize the standard
economic model, or to accentuate the negatives
It can tell us when the standard economic model does a good job and when not, and it can tell us how to
change the model to get a better fit with reality.
BE is not new, going back to Adam Smith: “The theory of moral sentiment 1759”
Some economic principals were based on the Psychological theory at the time
At the end of the 20th century Vilfredo Pareto argued that economics should break from
psychology and the focus should be on choice rather than desire “if people are rational then
they will reveal their desires through their choices, and so we need to focus only on choice.”
Economics was then dominated by models of rational choice
In the second half of the 21st century behavioral economics made a comeback
Herbert Simon questioned the purpose of rational models and proposed the concept of
bounded rationality: Rationality is bounded because there are limits to our thinking capacity,
available information, and time.
Kahneman and Tversky provided evidence that the assumptions of the standard economic model are
limited (cognitive bias, framing effects, reference point)
Nobel prize 2017
Richard H. Thaler “for his contributions to behavioral economics”
Nobel prize 2002
Vernon L. Smith “for having established laboratory experiments as a tool in empirical
economic analysis, especially in the study of alternative market mechanisms”
Daniel Kahneman “for having integrated insights from psychological research into
economic science, especially concerning human judgment and decision-making under
uncertainty”
Nobel prize 1978
Herbert A. Simon “for his pioneering research into the decision-making process within
economic organizations”
,Standard Economic Model
a model to try to understand economic behavior
The no-classical economic model is the way most economists think about consumer welfare
and consumer choice. This unified vision of the economy is based on some common
rationality assumptions.
> this sets economics apart from other social sciences such as psychology, where ‘theories’
describe empirical regularities
A potential problem with this model is that it assumes people to be approximated by a Homo
economicus who is rational and selfish. And it also assumes market institutions work and so prices
should come together.
So agents are assumed to:
maximise their utility.
to have complete information, and to be able to process such information.
be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option available=> Rational choices
Behavioural Economics versus Standard Economic Model:
People often tend to satisfice rather than to maximise.
Information is not generally available (information about the existence of information
may also not be available.
Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.
Ultimately: Perceptions count for much more than facts. `
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions
if they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain
goal (usually utility maximasation)
Descriptive theories: How people do really behave, and may or may not be the
same as the normative theory
,Expected Value
The first theory used to model decision making under risk was expected value theory (EVT).
Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble (=gok) is the value of each possible outcome times
(=maal) the probability of that outcome.
Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
ST Petersburg Paradox
limits of expected value paradox
, Expected Utility
A probability is a number between 0 and 1 that indicates a likelihood that a particular
outcome will occur.
- 0 means the event is impossible
- 1 means it is certain
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
Pr (Rain) + Pr (Cloudy) + Pr (Sunny) = 0.30 + 0.10 + 0.60 = 1
We focus mostly on binary prospects with 2 outcomes x > y and probability p, we can write
this as (x,p ;y). Choices can be represented using decision trees.
∼ indicates indifference and ≻ strict preference (do not confuse this with inequalities >)
The expected utility theory was proposed as a solution to the St. Petersburg paradox by
Daniel Bernouilli. The paradox is the discrepancy between wat people seem to be willing to
pay to enter the game and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes.
The determination of the value of an item must not be based on the price but rather on
the utility it yields.
❖ Utility refers to the satisfaction or pleasure a person derives from consuming a good, service,
level of wealth.
We can use it to order a person’s preferences over a set of options numerically by assigning
larger numerical values to more preferred options.
(If you prefer eating apples (A) to eating chocolate (C ), we can assign U(A)=2 and U(C )=1)
❖ under the standard economic model choice is assumed to be revealed preference. Given the
alternatives, X and Y, if you choose X then this “reveals” that you prefer X to Y (X>Y)
We use utility to explain how individuals make choices to maximize their overall
happiness or satisfaction based on their preferences
Lecture 1
What is behavioral economics?
(Why and how make people decisions?)
3 definitions:
(1) It is about understanding economic behavior and it’s consequences (for example why someone buys
something, goes to work, saves for retirement, …)
> it’s about understanding whether people make good or bad choices
(2) Testing the standard economic model on humans seeing when it works and when it does not
(3) Applying insights from laboratory experiments, psychology and other social sciences in economics
Behavioral economics is about working constructively with the standard economic model to get a
better understanding of economic behavior. The objective is definitely not to criticize the standard
economic model, or to accentuate the negatives
It can tell us when the standard economic model does a good job and when not, and it can tell us how to
change the model to get a better fit with reality.
BE is not new, going back to Adam Smith: “The theory of moral sentiment 1759”
Some economic principals were based on the Psychological theory at the time
At the end of the 20th century Vilfredo Pareto argued that economics should break from
psychology and the focus should be on choice rather than desire “if people are rational then
they will reveal their desires through their choices, and so we need to focus only on choice.”
Economics was then dominated by models of rational choice
In the second half of the 21st century behavioral economics made a comeback
Herbert Simon questioned the purpose of rational models and proposed the concept of
bounded rationality: Rationality is bounded because there are limits to our thinking capacity,
available information, and time.
Kahneman and Tversky provided evidence that the assumptions of the standard economic model are
limited (cognitive bias, framing effects, reference point)
Nobel prize 2017
Richard H. Thaler “for his contributions to behavioral economics”
Nobel prize 2002
Vernon L. Smith “for having established laboratory experiments as a tool in empirical
economic analysis, especially in the study of alternative market mechanisms”
Daniel Kahneman “for having integrated insights from psychological research into
economic science, especially concerning human judgment and decision-making under
uncertainty”
Nobel prize 1978
Herbert A. Simon “for his pioneering research into the decision-making process within
economic organizations”
,Standard Economic Model
a model to try to understand economic behavior
The no-classical economic model is the way most economists think about consumer welfare
and consumer choice. This unified vision of the economy is based on some common
rationality assumptions.
> this sets economics apart from other social sciences such as psychology, where ‘theories’
describe empirical regularities
A potential problem with this model is that it assumes people to be approximated by a Homo
economicus who is rational and selfish. And it also assumes market institutions work and so prices
should come together.
So agents are assumed to:
maximise their utility.
to have complete information, and to be able to process such information.
be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option available=> Rational choices
Behavioural Economics versus Standard Economic Model:
People often tend to satisfice rather than to maximise.
Information is not generally available (information about the existence of information
may also not be available.
Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.
Ultimately: Perceptions count for much more than facts. `
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions
if they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain
goal (usually utility maximasation)
Descriptive theories: How people do really behave, and may or may not be the
same as the normative theory
,Expected Value
The first theory used to model decision making under risk was expected value theory (EVT).
Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble (=gok) is the value of each possible outcome times
(=maal) the probability of that outcome.
Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
ST Petersburg Paradox
limits of expected value paradox
, Expected Utility
A probability is a number between 0 and 1 that indicates a likelihood that a particular
outcome will occur.
- 0 means the event is impossible
- 1 means it is certain
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
Pr (Rain) + Pr (Cloudy) + Pr (Sunny) = 0.30 + 0.10 + 0.60 = 1
We focus mostly on binary prospects with 2 outcomes x > y and probability p, we can write
this as (x,p ;y). Choices can be represented using decision trees.
∼ indicates indifference and ≻ strict preference (do not confuse this with inequalities >)
The expected utility theory was proposed as a solution to the St. Petersburg paradox by
Daniel Bernouilli. The paradox is the discrepancy between wat people seem to be willing to
pay to enter the game and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes.
The determination of the value of an item must not be based on the price but rather on
the utility it yields.
❖ Utility refers to the satisfaction or pleasure a person derives from consuming a good, service,
level of wealth.
We can use it to order a person’s preferences over a set of options numerically by assigning
larger numerical values to more preferred options.
(If you prefer eating apples (A) to eating chocolate (C ), we can assign U(A)=2 and U(C )=1)
❖ under the standard economic model choice is assumed to be revealed preference. Given the
alternatives, X and Y, if you choose X then this “reveals” that you prefer X to Y (X>Y)
We use utility to explain how individuals make choices to maximize their overall
happiness or satisfaction based on their preferences
