CHAPTER 1: Introduction
1.A psychological perspective on economics:
Standard economics: “the agent of economic theory is rational and selfish, and his tastes do not
change
pilar economic theory
as a trained psychologist not, a single word is true:
Bounded self-interest
Bounded rationality
Bounded willpower (time-inconsistent preferences)
Rational Utility Principle, Efficient Market Hypothesis and, the Capital Asset Pricing in the mid 20th
century
1.1 SELFISHNESS
Ultimatum games show that:
People want to be treated fairly ( <-> selfishness)
BUT not when interaction with a PC
there is a social component
Both good and bad behaviors reciprocated
good =>good vs. bad => bad
Standard example: You have two players p1 and p2. P1 gets all the money while p2 gets nothing. P1
needs to decide how he wants to split the money (and thus has all freedom to do as he pleases).
both players show inconsistency from selfishness theory
for instance
in most of the cases there is a fair split
Bounded selfishness = there is a limit to someone’s self-interest
1.2 RATIONALITY
Standard theory: utility maximization
observed preferences violate this standard theory: Allais and Ellsberg paradox: framing effects in
preference elicitation
,Allais paradox:
choose between a: (1M, 1) and b: (5M, .1; 1M, .89; 0, .01)
choose between a’: (1M, .11; 0, .89) and b’: (5M, .1; 0, .9)
last column is redundant (same in all cases)
Ellsberg paradox: Suppose you have an urn containing 30 red balls and 60 other balls that are either
black or yellow. You don't know how many black or yellow balls there are, but that the total number of
black balls plus the total number of yellow balls equals 60. The balls are well mixed so that each
individual ball is as likely to be drawn as any other. You are now given a choice between two gambles
a: you receive $100 if you draw a red ball
b: you receive $100 if you draw a black ball
c: you receive $100 if you draw a red or a yellow ball
d: you receive $100 is you draw a black or yellow ball
now the yellow ball is again redundant information
1.3 UNCHANGING TASTES
Standard theory: current positions on indifference curves (treats taste as unchanging) irrelevant
reference independence: position on the curves will be absolute (never relative to what you have
already)
Now: relevance of short-term emotions associated with gains and losses
prospect theory: descriptive model of risky choice: “ideal of loss aversion extended to riskless
choice to explain endowment effect (= people feel more attached to things they own)”
Taste change = adaptation and shift in reference point
bounded will-power
Example: Two persons get their monthly report from a broker: A is told that her wealth went from 4Mto
3M; B is told that her wealth went from 1Mto 1.1M
who has more reason to be satisfied with her financial situation: A (she has more money)
who is happier today: B
reference dependency !!!
2.What is behavioral economics?
Behavioral economics = application of psychological research and theory to economic analysis to
form a behavioral decision theory
slight modification towards more realism
human limit on rationality, willpower and self-interest
,2.1 HISTORY
People think of it as a modern concept, however:
18th century
Smith (‘the theory of moral sentiments’), Bentham (‘psych. Underpinnings utility’) and
Edgeworth (‘social utility’)
Late 19th century
Neoclassical revolution: expunge psych.
20th century
criticism of positivism in eco. and psych.
Katona, Simon, Leibenstein, Scitovsky: importance of psych. measures and bounds on
rationality
works both ways:
o Eco: anomalous implications of (subjective) expected utility
o Psych: use of eco models as benchmark against which to contrast their psych models
2.2 RESEARCH RECIPE
STEP1: identify normative economic models/assumptions
STEP2: identify anomalies (not as prediction)
STEP3: create alternative theories that generalize existing models (using behavioral assumptions)
STEP4: derive fresh implications and test them
Research methods:
often all types available used with a switch depending on situation to situation
Experiments
Field data / field study
Computer simulation
Brain scans (being in a scanner while making a decision)
2.3 RESEARCH TOPICS: JUDGEMENT
= process that people use to estimate probabilities
anomalies examples: Availability heuristic, hindsight bias, representativeness heuristic, law of
small numbers, …
Example: the Linda Problem: Linda is 31 years old, single, outspoken, and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and
also participated in anti-nuclear demonstrations
which is more probable:
A. Linda is a bank teller
B. Linda is a bank teller and is active in the feminist movement
more rational: first option is most likely to happen (statistically speaking): it is a way larger
population than bank tellers who are also active in those movements
anomaly: Linda seems representative as someone who would be active in such a movement
, 2.4 RESEARCH TOPICS: CHOICE
= process that people use to select among actions
anomalies: framing effects, anchoring effects, preference reversals, context effects, …
Example: Asian disease problem 1.0 : Imagine that the U.S. is preparing for the outbreak of an unusual
Asian disease, which is expected to kill 600 people. There are two alternative programs. If Program A is
adopted, 200 people will be saved. If Program B is adopted, there is a one-third probability that all 600
people will be saved and a two-thirds probability that no people will be saved
which program do you prefer? A or B?
research: program A (because of a certainty of saving)
Asian disease problem 2.0: Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. There are two alternative programs. If Program A is
adopted, 400 people will die. If Program B is adopted, there Is a one-third probability that nobody will
die and a two-thirds probability that 600 people will die
which program do you prefer? A or B?
research: program B (because of a noncertainty of dying)
different result than 1.0 although the two problems are basically equivalent
3.Anomalies: utility maximization and experienced utility:
Decision (“wantability”): used to explain choices and was main focus in practice
Experienced utility: hedonic experience = pleasure we think we will derive utility experienced
with outcome
we need to take both into account + importance of hedonic forecasting
biases likely if circumstances at T=0 and T=1 differ (intuitive thinking context effects)
why?: hedonic forecasting will not be perfect: we think efficient not perfect (we will not think
everything completely through and are heavily affected by decision context)
3.1 ERRORS OF HEDONIC FORECASTING
differences between T = 0 and T = 1:
1. Emotional / motivational state of agent
we decide at T = 0 under a certain emotional state, however our emotional state could be
different at T = 1 and thus our decision made will not be the best for us at T = 1
a. projection bias = project your current emotional state into the future (example: way
too much food shipping when you are hungry)
focusses more on beliefs, cognition, etc
our tendency to overestimate how much our future self will share the same tastes
and preferences as our current self
hot-cold empathy gap = focusses on the role of emotion (e.g. I am sad now, I am not
going to enjoy going to a restaurant tonight)
both biases implicate that current mental state influences future decisions
b. lack of empathy for future self
2. Attentional focus in both situations (choice context)
1.A psychological perspective on economics:
Standard economics: “the agent of economic theory is rational and selfish, and his tastes do not
change
pilar economic theory
as a trained psychologist not, a single word is true:
Bounded self-interest
Bounded rationality
Bounded willpower (time-inconsistent preferences)
Rational Utility Principle, Efficient Market Hypothesis and, the Capital Asset Pricing in the mid 20th
century
1.1 SELFISHNESS
Ultimatum games show that:
People want to be treated fairly ( <-> selfishness)
BUT not when interaction with a PC
there is a social component
Both good and bad behaviors reciprocated
good =>good vs. bad => bad
Standard example: You have two players p1 and p2. P1 gets all the money while p2 gets nothing. P1
needs to decide how he wants to split the money (and thus has all freedom to do as he pleases).
both players show inconsistency from selfishness theory
for instance
in most of the cases there is a fair split
Bounded selfishness = there is a limit to someone’s self-interest
1.2 RATIONALITY
Standard theory: utility maximization
observed preferences violate this standard theory: Allais and Ellsberg paradox: framing effects in
preference elicitation
,Allais paradox:
choose between a: (1M, 1) and b: (5M, .1; 1M, .89; 0, .01)
choose between a’: (1M, .11; 0, .89) and b’: (5M, .1; 0, .9)
last column is redundant (same in all cases)
Ellsberg paradox: Suppose you have an urn containing 30 red balls and 60 other balls that are either
black or yellow. You don't know how many black or yellow balls there are, but that the total number of
black balls plus the total number of yellow balls equals 60. The balls are well mixed so that each
individual ball is as likely to be drawn as any other. You are now given a choice between two gambles
a: you receive $100 if you draw a red ball
b: you receive $100 if you draw a black ball
c: you receive $100 if you draw a red or a yellow ball
d: you receive $100 is you draw a black or yellow ball
now the yellow ball is again redundant information
1.3 UNCHANGING TASTES
Standard theory: current positions on indifference curves (treats taste as unchanging) irrelevant
reference independence: position on the curves will be absolute (never relative to what you have
already)
Now: relevance of short-term emotions associated with gains and losses
prospect theory: descriptive model of risky choice: “ideal of loss aversion extended to riskless
choice to explain endowment effect (= people feel more attached to things they own)”
Taste change = adaptation and shift in reference point
bounded will-power
Example: Two persons get their monthly report from a broker: A is told that her wealth went from 4Mto
3M; B is told that her wealth went from 1Mto 1.1M
who has more reason to be satisfied with her financial situation: A (she has more money)
who is happier today: B
reference dependency !!!
2.What is behavioral economics?
Behavioral economics = application of psychological research and theory to economic analysis to
form a behavioral decision theory
slight modification towards more realism
human limit on rationality, willpower and self-interest
,2.1 HISTORY
People think of it as a modern concept, however:
18th century
Smith (‘the theory of moral sentiments’), Bentham (‘psych. Underpinnings utility’) and
Edgeworth (‘social utility’)
Late 19th century
Neoclassical revolution: expunge psych.
20th century
criticism of positivism in eco. and psych.
Katona, Simon, Leibenstein, Scitovsky: importance of psych. measures and bounds on
rationality
works both ways:
o Eco: anomalous implications of (subjective) expected utility
o Psych: use of eco models as benchmark against which to contrast their psych models
2.2 RESEARCH RECIPE
STEP1: identify normative economic models/assumptions
STEP2: identify anomalies (not as prediction)
STEP3: create alternative theories that generalize existing models (using behavioral assumptions)
STEP4: derive fresh implications and test them
Research methods:
often all types available used with a switch depending on situation to situation
Experiments
Field data / field study
Computer simulation
Brain scans (being in a scanner while making a decision)
2.3 RESEARCH TOPICS: JUDGEMENT
= process that people use to estimate probabilities
anomalies examples: Availability heuristic, hindsight bias, representativeness heuristic, law of
small numbers, …
Example: the Linda Problem: Linda is 31 years old, single, outspoken, and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and
also participated in anti-nuclear demonstrations
which is more probable:
A. Linda is a bank teller
B. Linda is a bank teller and is active in the feminist movement
more rational: first option is most likely to happen (statistically speaking): it is a way larger
population than bank tellers who are also active in those movements
anomaly: Linda seems representative as someone who would be active in such a movement
, 2.4 RESEARCH TOPICS: CHOICE
= process that people use to select among actions
anomalies: framing effects, anchoring effects, preference reversals, context effects, …
Example: Asian disease problem 1.0 : Imagine that the U.S. is preparing for the outbreak of an unusual
Asian disease, which is expected to kill 600 people. There are two alternative programs. If Program A is
adopted, 200 people will be saved. If Program B is adopted, there is a one-third probability that all 600
people will be saved and a two-thirds probability that no people will be saved
which program do you prefer? A or B?
research: program A (because of a certainty of saving)
Asian disease problem 2.0: Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. There are two alternative programs. If Program A is
adopted, 400 people will die. If Program B is adopted, there Is a one-third probability that nobody will
die and a two-thirds probability that 600 people will die
which program do you prefer? A or B?
research: program B (because of a noncertainty of dying)
different result than 1.0 although the two problems are basically equivalent
3.Anomalies: utility maximization and experienced utility:
Decision (“wantability”): used to explain choices and was main focus in practice
Experienced utility: hedonic experience = pleasure we think we will derive utility experienced
with outcome
we need to take both into account + importance of hedonic forecasting
biases likely if circumstances at T=0 and T=1 differ (intuitive thinking context effects)
why?: hedonic forecasting will not be perfect: we think efficient not perfect (we will not think
everything completely through and are heavily affected by decision context)
3.1 ERRORS OF HEDONIC FORECASTING
differences between T = 0 and T = 1:
1. Emotional / motivational state of agent
we decide at T = 0 under a certain emotional state, however our emotional state could be
different at T = 1 and thus our decision made will not be the best for us at T = 1
a. projection bias = project your current emotional state into the future (example: way
too much food shipping when you are hungry)
focusses more on beliefs, cognition, etc
our tendency to overestimate how much our future self will share the same tastes
and preferences as our current self
hot-cold empathy gap = focusses on the role of emotion (e.g. I am sad now, I am not
going to enjoy going to a restaurant tonight)
both biases implicate that current mental state influences future decisions
b. lack of empathy for future self
2. Attentional focus in both situations (choice context)
