Behavioral Decision Making (BDM)
Week 1: introduction
A. The Traditional Economic Model
Traditional economics relies on the Expected Utility Theory (EUT), which is a
normative theory defining how decisions should be made.
• Assumptions of the "Economic Man" (Econ): People are rational agents who aim to
maximize their utility. They are driven exclusively by monetary incentives, and optimal
decisions are made at the margin (benefits must exceed costs). Utility is dependent on
final wealth.
• The Psychological Challenge: Psychologists, notably Daniel Kahneman and Amos
Tversky, observed that EUT made faulty predictions about human decision-making in
real life. Their research, summarized in works like Thinking, Fast and Slow, revealed that
irrationality is built into the structure of human thinking itself, not just an emotional
interference.
B. Prospect Theory
Prospect Theory (PT) is a descriptive theory that models how people actually behave in
the face of risk.
1. Reference Dependence: People evaluate outcomes as a deviation from a reference
point (usually the status quo or current wealth). The outcomes themselves do not
determine the choice; the framing relative to the reference point does. For example,
moving from $900 to $500 results in sadness, even if the final amount is substantial.
2. Loss Aversion: People react more strongly to potential losses than to equivalent
gains; "losses loom larger than gains". Examples include golfers being more accurate
when putting for par (avoiding a bogey/loss) than for a birdie (gain).
3. Diminished Sensitivity: People experience reduced sensitivity to changes as the
magnitude of gains or losses increases.
4. Framing and Risk Propensity: Risk behavior is determined by how options are
framed.
◦ In a Gain Frame, people become risk-averse (choosing the safe option).
◦ In a Loss Frame, people become risk-seekers (choosing the risk of losing).
Example: labeling a product as "20% fat" versus "80% fat-free".
, C. Real-World Applications (Barberis)
PT has been successfully integrated into mainstream economics, explaining previously
anomalous behavior:
• Finance: PT explains the disposition effect (hesitancy to sell losing investments),
stock return momentum, and the equity premium puzzle (why investors demand high
returns for stocks).
• Labor Economics: Taxi drivers often stop working once they meet a daily income
reference point, a behavior inconsistent with standard theory that predicts working
more when wages are higher.
• Insurance: People frequently pay high premiums to avoid small losses, which is
consistent with loss aversion and the tendency to overweight small probabilities.
• Consumer Behavior: PT explains the endowment effect (people value items they
own more highly than items they do not yet own). It also addresses the status quo bias,
where people prefer the default option (e.g., opt-in vs. opt-out).
• Tax Compliance: How tax payments are framed—as a loss relative to what one thinks
they deserve—can influence the likelihood of tax avoidance.
Week 2 – cognitive biases
A. The Dual Process System
Humans are dual-process thinkers utilizing two cognitive systems:
Feature System 1 (Automatic) System 2 (Reflective)
Fast, intuitive, unconscious, Slow, deliberate, conscious,
Speed/Effort
emotional. effortful, logical.
Everyday decisions, routine tasks, Complex/first-time decisions,
Function comfortable with the familiar, crisis weighing pros and cons, reductive
response. thinking.
Error-prone, jumps to conclusions,
Slow to decide, requires energy,
Vulnerability susceptible to unhelpful emotional
prone to decision fatigue.
responses.
System 1 is the default system. When people are tired, stressed, or low on cognitive
resources (e.g., at the end of the day), they rely heavily on heuristics (mental shortcuts).
Examples of System 1 errors include Israeli parole boards granting more paroles after
lunch, showing that physical needs like hunger affect decisions.
Week 1: introduction
A. The Traditional Economic Model
Traditional economics relies on the Expected Utility Theory (EUT), which is a
normative theory defining how decisions should be made.
• Assumptions of the "Economic Man" (Econ): People are rational agents who aim to
maximize their utility. They are driven exclusively by monetary incentives, and optimal
decisions are made at the margin (benefits must exceed costs). Utility is dependent on
final wealth.
• The Psychological Challenge: Psychologists, notably Daniel Kahneman and Amos
Tversky, observed that EUT made faulty predictions about human decision-making in
real life. Their research, summarized in works like Thinking, Fast and Slow, revealed that
irrationality is built into the structure of human thinking itself, not just an emotional
interference.
B. Prospect Theory
Prospect Theory (PT) is a descriptive theory that models how people actually behave in
the face of risk.
1. Reference Dependence: People evaluate outcomes as a deviation from a reference
point (usually the status quo or current wealth). The outcomes themselves do not
determine the choice; the framing relative to the reference point does. For example,
moving from $900 to $500 results in sadness, even if the final amount is substantial.
2. Loss Aversion: People react more strongly to potential losses than to equivalent
gains; "losses loom larger than gains". Examples include golfers being more accurate
when putting for par (avoiding a bogey/loss) than for a birdie (gain).
3. Diminished Sensitivity: People experience reduced sensitivity to changes as the
magnitude of gains or losses increases.
4. Framing and Risk Propensity: Risk behavior is determined by how options are
framed.
◦ In a Gain Frame, people become risk-averse (choosing the safe option).
◦ In a Loss Frame, people become risk-seekers (choosing the risk of losing).
Example: labeling a product as "20% fat" versus "80% fat-free".
, C. Real-World Applications (Barberis)
PT has been successfully integrated into mainstream economics, explaining previously
anomalous behavior:
• Finance: PT explains the disposition effect (hesitancy to sell losing investments),
stock return momentum, and the equity premium puzzle (why investors demand high
returns for stocks).
• Labor Economics: Taxi drivers often stop working once they meet a daily income
reference point, a behavior inconsistent with standard theory that predicts working
more when wages are higher.
• Insurance: People frequently pay high premiums to avoid small losses, which is
consistent with loss aversion and the tendency to overweight small probabilities.
• Consumer Behavior: PT explains the endowment effect (people value items they
own more highly than items they do not yet own). It also addresses the status quo bias,
where people prefer the default option (e.g., opt-in vs. opt-out).
• Tax Compliance: How tax payments are framed—as a loss relative to what one thinks
they deserve—can influence the likelihood of tax avoidance.
Week 2 – cognitive biases
A. The Dual Process System
Humans are dual-process thinkers utilizing two cognitive systems:
Feature System 1 (Automatic) System 2 (Reflective)
Fast, intuitive, unconscious, Slow, deliberate, conscious,
Speed/Effort
emotional. effortful, logical.
Everyday decisions, routine tasks, Complex/first-time decisions,
Function comfortable with the familiar, crisis weighing pros and cons, reductive
response. thinking.
Error-prone, jumps to conclusions,
Slow to decide, requires energy,
Vulnerability susceptible to unhelpful emotional
prone to decision fatigue.
responses.
System 1 is the default system. When people are tired, stressed, or low on cognitive
resources (e.g., at the end of the day), they rely heavily on heuristics (mental shortcuts).
Examples of System 1 errors include Israeli parole boards granting more paroles after
lunch, showing that physical needs like hunger affect decisions.
