TOPIC 1: Behavioral Economics - Why We Make Bad Decisions?
Neo-Classical Economics Assumptions
Meant to describe a perfect world, not real life
1. Rational - use information efficiently, picking choices which maximize their Expected Utility
2. Perfect information - consumers make perfect decisions, maximizing utility
a. Rarely in reality do consumers have perfect information
3. Profit-maximization - MC = MR
a. Does not consider other objectives e.g. CSR, revenue maximization
4. Self-interested - do not look to others when deciding what to do
5. Preferences are transitive - more is preferred to less
Expected Utility Theory (EUT)
Calculating Expected Values of alternatives to estimate your Expected Utilities. By picking the alternative with
the highest Expected Value, you will maximize your total utility.
Examples
1) Coin toss. You get heads you receive £10. Should you pay £4 to play the game?
Yes. Expected value is £5. Neo-Classical theory says you should play this game, but in reality not
everyone would. Humans we are risk averse, very few people are risk neutral
2) Choose between
a) £1000 with certainty → reality
b) 90% odds of £2000 and 10% odds of -£1000 → neoclassical theory
3) Choose between
a) £0 with certainty → reality
b) 50% odds of £150 and 50% odds of -£100 → neoclassical theory
4) Choose between
a) -£100 with certainty → reality
b) 50% odds of £50 and 50% odds of -£200 → neoclassical theory
1
,COUNTER-ARGUMENTS TO EUT
We don’t follow EUT in practice despite it being mathematically optimal to do so. This is outlined by (A)
Prospect Theory and (B) Heuristics/Cognitive Biases which challenge the Expected Utility Theory,
explaining the reality of how individuals actually make decisions
A: Tversky’s and Kahneman’s Prospect Theory (1979)
Outlines:
1. Certainty effect (a phenomenon): individuals are risk averse in the domain of gains, and risk seeking in
the domain of losses, overweighting outcomes which are considered certain relative to those that are
considered merely probable
To support this theory, Tversky and Kahneman described a series of choice problems in which
individuals’ decisions systematically violated the ideas outlined by EUT. The most widely known
counter-example was introduced in 1953 by economist Maurice Allais from France
Problem 1: Choose between
A: 2,500 with 0.33 probability, B: 2,400 with 1 probability (certainty).
2,400 with 0.66 probability,
0 with 0.01 probability;
Percentage of respondents: 18 Percentage of respondents: 82
Problem 2: Choose between
C: 2,500 with probability 0.33, D: 2,400 with probability 0.34,
0 with probability 0.67; 0 with probability 0.67.
Percentage of respondents: 83 Percentage of respondents: 14
This shows how when individuals are faced with a risky choice leading to gains, individuals will be
risk averse, preferring an outcome with lower expected utility but with a higher certainty. with choice
B prevailing in problem 1. However, as shown by problem 2, when faced with a risky choice leading
to losses, individuals are risk-seeking, preferring an outcome with a lower expected utility, as long
as it has the potential to avoid losses
2
, 2. Using this empirical evidence among others, Tversky and Kahneman were able to derive the Value
Function
The diagram shows how individuals value
losses
and gains of different sizes. Because the loss
side of the curve is steeper than the gain side,
the value of a loss is proportionately greater
than the value of a gain of the same size
3. Cornell Mug Experiment
In 1990 Thaler, Kahneman and Knetsch, conducted a series of experiments to demonstrate humans’
loss averse nature as shown by Prospect Theory. Their first experiment was with undergraduate
economics students at Cornell University. Some students roleplayed as buyers and the rest as
sellers, with the good in question being the Cornell coffee mugs which typically retailed for $6.00. 22 of
the mugs were randomly distributed amongst students, half of whom were classified as ‘mug lovers’
and the other half as ‘mug haters.’ Although economic theory predicts that when the market clears all
the mugs should be owned by individuals who value them the most, mug lovers, this was not the case.
Less than 5 trades took place in each trial, when the expected volume was 11. This was a result of
the median buyer being unwilling to pay over $3.00, and the median owner being unwilling to sell for
below $5.25. This was due to the fact that upon sellers being given the mug, forgoing it felt like a loss
due to humans’ loss-averse nature, placing a higher price on it as compensation
This is known as the endowment effect which explains how people immediately value a good more
once it is in their possession with their willingness to pay (WTP) for the good usually being lower than
the lowest amount they are willing to accept (WTA) from a buyer (one of the most firmly established
results in behavioral economics)
B: Heuristics and Cognitive Biases
Heuristics - Mental shortcuts that allow individuals to more quickly solve problems
Bounded rationality explains how individuals often find themselves in situations where they cannot engage in
entirely rational decision-making, resorting to ‘heuristics’ - mental shortcuts. Choices must be made under
3
, time-constraints using the information available at hand, which is sometimes available in abundance, other
times in limited quantities, and occasionally may not exist whatsoever
1. Endowment effect
Explains how people immediately value a good more once it is in their possession
Limitations
Despite there being considerable empirical evidence that the endowment effect is present in society,
there is also evidence suggesting that it does not apply entirely to inexperienced and experienced
sellers. American economist John List (2003) found this to be the case when looking at subjects with
sports card trading experience in the sportcard marketplace, with the common items being traded
being chocolate bars and mugs. Experienced sellers who had over time learned to make decisions
based on some underlying long-term value of an object (or lack thereof) were less subject to the
endowment effect. They ignored any emotions associated with the acquisition and sale of objects,
perceiving goods leaving their endowment as an opportunity cost instead of a loss. This exhibited
behavior is very much in line with neoclassical predictions. On the other hand, inexperienced sellers
who traded less simply did so as they wished to avoid making any embarrassing mistakes, with their
actions being in line with Prospect Theory
2. Status Quo Bias
● Explains how individuals have a tendency to prefer the current state of affairs, with the status quo
serving as a reference point for the individual's current situation and any deviation from it being
perceived as a loss
● Hartman, Doane, and Woo (1991) showed the presence of pronounced status quo bias in
decision-making using a survey of California electric power consumers. The respondents fell into
two groups, those with more and less reliable service. They were presented with six different
combinations of service reliability from which to choose as the best alternative, with the high reliability
services being 30 percent more expensive than the low reliability services. 60.2 percent of high
reliability consumers selected their status quo (current service) as their first choice, with only 5.7
percent choosing a low reliability alternative. Similarly, 58.3 percent of the low reliability consumers
selected their status quo as their first choice, with only 5.8 percent selecting a high reliability alternative.
With minor differences in the demographic characteristics1, it is evident that both groups display a
strong preference for their very different status quos. This could be explained by preferring a familiar
service over an unfamiliar one, being satisfied with the current service, and habit
3. Framing
● Refers to the idea that individuals can draw different conclusions from the same information depending
on the way it is presented
1
Differences in the two groups’ income and electricity consumption were minimal, and therefore were not seen to be
statistically significant and make the results biased
4
Neo-Classical Economics Assumptions
Meant to describe a perfect world, not real life
1. Rational - use information efficiently, picking choices which maximize their Expected Utility
2. Perfect information - consumers make perfect decisions, maximizing utility
a. Rarely in reality do consumers have perfect information
3. Profit-maximization - MC = MR
a. Does not consider other objectives e.g. CSR, revenue maximization
4. Self-interested - do not look to others when deciding what to do
5. Preferences are transitive - more is preferred to less
Expected Utility Theory (EUT)
Calculating Expected Values of alternatives to estimate your Expected Utilities. By picking the alternative with
the highest Expected Value, you will maximize your total utility.
Examples
1) Coin toss. You get heads you receive £10. Should you pay £4 to play the game?
Yes. Expected value is £5. Neo-Classical theory says you should play this game, but in reality not
everyone would. Humans we are risk averse, very few people are risk neutral
2) Choose between
a) £1000 with certainty → reality
b) 90% odds of £2000 and 10% odds of -£1000 → neoclassical theory
3) Choose between
a) £0 with certainty → reality
b) 50% odds of £150 and 50% odds of -£100 → neoclassical theory
4) Choose between
a) -£100 with certainty → reality
b) 50% odds of £50 and 50% odds of -£200 → neoclassical theory
1
,COUNTER-ARGUMENTS TO EUT
We don’t follow EUT in practice despite it being mathematically optimal to do so. This is outlined by (A)
Prospect Theory and (B) Heuristics/Cognitive Biases which challenge the Expected Utility Theory,
explaining the reality of how individuals actually make decisions
A: Tversky’s and Kahneman’s Prospect Theory (1979)
Outlines:
1. Certainty effect (a phenomenon): individuals are risk averse in the domain of gains, and risk seeking in
the domain of losses, overweighting outcomes which are considered certain relative to those that are
considered merely probable
To support this theory, Tversky and Kahneman described a series of choice problems in which
individuals’ decisions systematically violated the ideas outlined by EUT. The most widely known
counter-example was introduced in 1953 by economist Maurice Allais from France
Problem 1: Choose between
A: 2,500 with 0.33 probability, B: 2,400 with 1 probability (certainty).
2,400 with 0.66 probability,
0 with 0.01 probability;
Percentage of respondents: 18 Percentage of respondents: 82
Problem 2: Choose between
C: 2,500 with probability 0.33, D: 2,400 with probability 0.34,
0 with probability 0.67; 0 with probability 0.67.
Percentage of respondents: 83 Percentage of respondents: 14
This shows how when individuals are faced with a risky choice leading to gains, individuals will be
risk averse, preferring an outcome with lower expected utility but with a higher certainty. with choice
B prevailing in problem 1. However, as shown by problem 2, when faced with a risky choice leading
to losses, individuals are risk-seeking, preferring an outcome with a lower expected utility, as long
as it has the potential to avoid losses
2
, 2. Using this empirical evidence among others, Tversky and Kahneman were able to derive the Value
Function
The diagram shows how individuals value
losses
and gains of different sizes. Because the loss
side of the curve is steeper than the gain side,
the value of a loss is proportionately greater
than the value of a gain of the same size
3. Cornell Mug Experiment
In 1990 Thaler, Kahneman and Knetsch, conducted a series of experiments to demonstrate humans’
loss averse nature as shown by Prospect Theory. Their first experiment was with undergraduate
economics students at Cornell University. Some students roleplayed as buyers and the rest as
sellers, with the good in question being the Cornell coffee mugs which typically retailed for $6.00. 22 of
the mugs were randomly distributed amongst students, half of whom were classified as ‘mug lovers’
and the other half as ‘mug haters.’ Although economic theory predicts that when the market clears all
the mugs should be owned by individuals who value them the most, mug lovers, this was not the case.
Less than 5 trades took place in each trial, when the expected volume was 11. This was a result of
the median buyer being unwilling to pay over $3.00, and the median owner being unwilling to sell for
below $5.25. This was due to the fact that upon sellers being given the mug, forgoing it felt like a loss
due to humans’ loss-averse nature, placing a higher price on it as compensation
This is known as the endowment effect which explains how people immediately value a good more
once it is in their possession with their willingness to pay (WTP) for the good usually being lower than
the lowest amount they are willing to accept (WTA) from a buyer (one of the most firmly established
results in behavioral economics)
B: Heuristics and Cognitive Biases
Heuristics - Mental shortcuts that allow individuals to more quickly solve problems
Bounded rationality explains how individuals often find themselves in situations where they cannot engage in
entirely rational decision-making, resorting to ‘heuristics’ - mental shortcuts. Choices must be made under
3
, time-constraints using the information available at hand, which is sometimes available in abundance, other
times in limited quantities, and occasionally may not exist whatsoever
1. Endowment effect
Explains how people immediately value a good more once it is in their possession
Limitations
Despite there being considerable empirical evidence that the endowment effect is present in society,
there is also evidence suggesting that it does not apply entirely to inexperienced and experienced
sellers. American economist John List (2003) found this to be the case when looking at subjects with
sports card trading experience in the sportcard marketplace, with the common items being traded
being chocolate bars and mugs. Experienced sellers who had over time learned to make decisions
based on some underlying long-term value of an object (or lack thereof) were less subject to the
endowment effect. They ignored any emotions associated with the acquisition and sale of objects,
perceiving goods leaving their endowment as an opportunity cost instead of a loss. This exhibited
behavior is very much in line with neoclassical predictions. On the other hand, inexperienced sellers
who traded less simply did so as they wished to avoid making any embarrassing mistakes, with their
actions being in line with Prospect Theory
2. Status Quo Bias
● Explains how individuals have a tendency to prefer the current state of affairs, with the status quo
serving as a reference point for the individual's current situation and any deviation from it being
perceived as a loss
● Hartman, Doane, and Woo (1991) showed the presence of pronounced status quo bias in
decision-making using a survey of California electric power consumers. The respondents fell into
two groups, those with more and less reliable service. They were presented with six different
combinations of service reliability from which to choose as the best alternative, with the high reliability
services being 30 percent more expensive than the low reliability services. 60.2 percent of high
reliability consumers selected their status quo (current service) as their first choice, with only 5.7
percent choosing a low reliability alternative. Similarly, 58.3 percent of the low reliability consumers
selected their status quo as their first choice, with only 5.8 percent selecting a high reliability alternative.
With minor differences in the demographic characteristics1, it is evident that both groups display a
strong preference for their very different status quos. This could be explained by preferring a familiar
service over an unfamiliar one, being satisfied with the current service, and habit
3. Framing
● Refers to the idea that individuals can draw different conclusions from the same information depending
on the way it is presented
1
Differences in the two groups’ income and electricity consumption were minimal, and therefore were not seen to be
statistically significant and make the results biased
4
