BEHAVIORAL ECONOMICS
Professor Ebo Botchway
KU LEUVEN
Rik Teugels
,1 TABLE OF CONTENTS
2 What is Behavioral Economics ....................................................................................................... 2
3 Experimental Design .................................................................................................................... 11
4 Bounded Rationality and Prospect Theory................................................................................... 16
5 Bounded Self-Interest .................................................................................................................. 20
6 Self-Control and Intertemporal Choices....................................................................................... 24
7 Heuristics, Biases, and Preference Construction ......................................................................... 26
8 Papers class 8 ............................................................................................................................... 29
9 Consumer Behavior and Energy Consumption ............................................................................ 33
10 Concepts ....................................................................................................................................... 35
11 Sample Exam ................................................................................................................................ 39
1
,2 WHAT IS BEHAVIORAL ECONOMICS
2.1 PAPER 1 – A PSYCHOLOGICAL PERSPECTIVE ON ECONOMICS (KAHNEMAN, 2003)
Classical theory (Frey, 1970): “The agent of economic theory is rational and selfish, and his tastes do
not change
Kahneman thought this was not true, that agents are not completely rational, selfish and that their
tastes can change
Behavioral approach to economics: 3 pillars of Behavioral Economics (BE)
- Bounded Self-Interest: people are not completely selfish
o Classical theory: people are selfish
o Ultimatum games: decision-makers act differently when people are involved than
when a computer is involved, this means that they are not completely rational
o Bounded self-interest
- Bounded Rationality: people are not completely rational
o Classical theory: people are rational, utility maximizers (choose decision that gives
best option)
o Subjective expected utility maximization?
▪ Subjective expected utility: attractiveness of an economic opportunity as
perceived by a decision-maker in the presence of risk
o Observed preferences violate the standard theory (so people are not completely
rational):
▪ Allais paradox (2 alternatieven met kans op geld)
▪ Ellsberg paradox (vat met 90 ballen)
▪ Framing effects in preference elicitation (Kahneman & Tversky)
o Bounded rationality (Simon) and satisficing as realistic normative standard for
organisms with finite minds:
▪ People are rational but within limits, we cannot calculate everything as a
computer, we can not use all the info
- Bounded Will-power (= time-inconsistent preferences): people are not completely consistent
o Classical theory: unchanging tastes
▪ Current position on indifference curves are irrelevant (het maakt niet uit wat
we al hebben, we gaan altijd hetzelfde verkiezen)
▪ So people are reference independent? Their reference point does not matter?
o Relevance of short-term emotions associated with gains and losses:
▪ Prospect Theory (Kahneman & Tversky): descriptive model of risky choice
▪ Idea of loss aversion extended to riskless choice to explain endowment effect
o Taste does change:
▪ Adaptation and shift in reference point: hedonic and affective forecasts
▪ We have a reference point = relative (so not absolute)
o Bounded will-power (= time-inconsistent preferences)
Ultimatum game:
- 2 players where player 1 gets money and has to divide between the 2 players
o Has the freedom of the division decisions
- Player 2 can accept or reject the offer. When he reject, both players get nothing
2
, - Decision of player 1:
o Split fairly:
▪ Decision of player 2:
• Accept: 5, 5
• Reject: 0, 0
o Split unfairly:
▪ Decision of player 2:
• Accept: 8, 2
• Reject: 0, 0
- Observation: most of the time, player 1 will divide fairly (bounded self-interest) even though
out of selfishness, the best split is unfairly because player 1 and player 2 want to maximize
- Player 1 can decide first, and player 2 can decide (independent of the decision of player 1)
between money or no money
Allais paradox:
- Experiment 1:
o A: 1M, prob = 1
o B: 5M, 0.1; 1M, 0.89; 0, 0.01
o DM is risk averse and chooses A
- Experiment 2:
o A’: 1M, 0.11; 0, 0.89
o B’: 5M, 0.1; 0, 0.9
o B’ is preferred
Probability
Option: 0.1 0.01 0.89
A 1M 1M 1M
B 5M 0 1M
A’ 1M 1M 0
B’ 5M 0 0
- 3e kolom geeft redundant informatie tussen de 2 alternatieven (voor beide situaties). Bij het
weghalen van deze kolom, valt het ook op dat A = A’ en B = B’. Toch worden A en B’ verkozen
door DM. Dus ze veranderen van alternatief
- Thus: people are not rational because they change
Ellsberg paradox:
- Context: 90 ballen waarvan 30 rode en 60 zwart/gele
- Experiment 1: de meeste mensen kiezen A want ze weten dat er 30 rode ballen er zijn
o A: je krijgt 100 euro als je een rode bal trekt
o B: je krijgt 100 euro als je een zwarte bal trekt
- Experiment 2: kiezen B’ want ze weten dat er 60 zwarte of gele ballen zijn
o A’: je krijgt 100 euro als je een rode of gele bal trekt
o B’: je krijgt 100 euro als je een zwarte of gele bal trekt
- Redundante informatie: zowel in A’ als B’ krijg je 100 euro als je een gele of zwarte bal trekt.
We kunnen deze ‘of’ weglaten en bekomen opnieuw A = A’ en B = B’. Toch verkiezen mensen
A en B’
- Thus: people are not rational because they change from A = A’ to B’ = B
3
Professor Ebo Botchway
KU LEUVEN
Rik Teugels
,1 TABLE OF CONTENTS
2 What is Behavioral Economics ....................................................................................................... 2
3 Experimental Design .................................................................................................................... 11
4 Bounded Rationality and Prospect Theory................................................................................... 16
5 Bounded Self-Interest .................................................................................................................. 20
6 Self-Control and Intertemporal Choices....................................................................................... 24
7 Heuristics, Biases, and Preference Construction ......................................................................... 26
8 Papers class 8 ............................................................................................................................... 29
9 Consumer Behavior and Energy Consumption ............................................................................ 33
10 Concepts ....................................................................................................................................... 35
11 Sample Exam ................................................................................................................................ 39
1
,2 WHAT IS BEHAVIORAL ECONOMICS
2.1 PAPER 1 – A PSYCHOLOGICAL PERSPECTIVE ON ECONOMICS (KAHNEMAN, 2003)
Classical theory (Frey, 1970): “The agent of economic theory is rational and selfish, and his tastes do
not change
Kahneman thought this was not true, that agents are not completely rational, selfish and that their
tastes can change
Behavioral approach to economics: 3 pillars of Behavioral Economics (BE)
- Bounded Self-Interest: people are not completely selfish
o Classical theory: people are selfish
o Ultimatum games: decision-makers act differently when people are involved than
when a computer is involved, this means that they are not completely rational
o Bounded self-interest
- Bounded Rationality: people are not completely rational
o Classical theory: people are rational, utility maximizers (choose decision that gives
best option)
o Subjective expected utility maximization?
▪ Subjective expected utility: attractiveness of an economic opportunity as
perceived by a decision-maker in the presence of risk
o Observed preferences violate the standard theory (so people are not completely
rational):
▪ Allais paradox (2 alternatieven met kans op geld)
▪ Ellsberg paradox (vat met 90 ballen)
▪ Framing effects in preference elicitation (Kahneman & Tversky)
o Bounded rationality (Simon) and satisficing as realistic normative standard for
organisms with finite minds:
▪ People are rational but within limits, we cannot calculate everything as a
computer, we can not use all the info
- Bounded Will-power (= time-inconsistent preferences): people are not completely consistent
o Classical theory: unchanging tastes
▪ Current position on indifference curves are irrelevant (het maakt niet uit wat
we al hebben, we gaan altijd hetzelfde verkiezen)
▪ So people are reference independent? Their reference point does not matter?
o Relevance of short-term emotions associated with gains and losses:
▪ Prospect Theory (Kahneman & Tversky): descriptive model of risky choice
▪ Idea of loss aversion extended to riskless choice to explain endowment effect
o Taste does change:
▪ Adaptation and shift in reference point: hedonic and affective forecasts
▪ We have a reference point = relative (so not absolute)
o Bounded will-power (= time-inconsistent preferences)
Ultimatum game:
- 2 players where player 1 gets money and has to divide between the 2 players
o Has the freedom of the division decisions
- Player 2 can accept or reject the offer. When he reject, both players get nothing
2
, - Decision of player 1:
o Split fairly:
▪ Decision of player 2:
• Accept: 5, 5
• Reject: 0, 0
o Split unfairly:
▪ Decision of player 2:
• Accept: 8, 2
• Reject: 0, 0
- Observation: most of the time, player 1 will divide fairly (bounded self-interest) even though
out of selfishness, the best split is unfairly because player 1 and player 2 want to maximize
- Player 1 can decide first, and player 2 can decide (independent of the decision of player 1)
between money or no money
Allais paradox:
- Experiment 1:
o A: 1M, prob = 1
o B: 5M, 0.1; 1M, 0.89; 0, 0.01
o DM is risk averse and chooses A
- Experiment 2:
o A’: 1M, 0.11; 0, 0.89
o B’: 5M, 0.1; 0, 0.9
o B’ is preferred
Probability
Option: 0.1 0.01 0.89
A 1M 1M 1M
B 5M 0 1M
A’ 1M 1M 0
B’ 5M 0 0
- 3e kolom geeft redundant informatie tussen de 2 alternatieven (voor beide situaties). Bij het
weghalen van deze kolom, valt het ook op dat A = A’ en B = B’. Toch worden A en B’ verkozen
door DM. Dus ze veranderen van alternatief
- Thus: people are not rational because they change
Ellsberg paradox:
- Context: 90 ballen waarvan 30 rode en 60 zwart/gele
- Experiment 1: de meeste mensen kiezen A want ze weten dat er 30 rode ballen er zijn
o A: je krijgt 100 euro als je een rode bal trekt
o B: je krijgt 100 euro als je een zwarte bal trekt
- Experiment 2: kiezen B’ want ze weten dat er 60 zwarte of gele ballen zijn
o A’: je krijgt 100 euro als je een rode of gele bal trekt
o B’: je krijgt 100 euro als je een zwarte of gele bal trekt
- Redundante informatie: zowel in A’ als B’ krijg je 100 euro als je een gele of zwarte bal trekt.
We kunnen deze ‘of’ weglaten en bekomen opnieuw A = A’ en B = B’. Toch verkiezen mensen
A en B’
- Thus: people are not rational because they change from A = A’ to B’ = B
3
