Defining Behavioral Economics

Defining Behavioural Economics

• Behavioral economics is defined as drawing extensively on psychological theory to explain economic decision-making.
• The field integrates psychology, including its subfields of social and cognitive psychology
• It integrates the importance of market price, consumer behavior, and preferences.
• Behavioral economics is used to extend current standard economic theory to better reflect human behavior.

How Behavioral Economics Researches Get Their Ideas

• Identify assumptions in standard economic theory serves as Step 1.
• Step 2 requires the identification of anomalies and clear violations of the assumptions.
• The anomalies in the model are inspiration to creating alternative theories as Step 3
• Economic models are constructed based on behavioral theories from step three as Step 4.

Defining Behavioural Economics Further

• The study of economics does not rely on the assumption of a rational, selfish economic man.
• Theories and results are derived from psychology, sociology, anthropology, neurology, and other fields.
• Inconsistencies in human decision-making are demonstrated through empirical studies and experiments.
• This is to gain a deeper understanding of human behavior and interactions, individually and in groups.

Assumptions in Traditional Economics

• Well-defined and stable preferences are present.
• Individuals are Bayesian information processors, processing information optimally.
• People maximize expected utility.
• Exponential discounting is applied, weighting current and future well-being.
• Individuals are self-interested, though narrowly defined.
• Preferences are based on final outcomes, not changes.
• There is no taste for beliefs or information.

Everyday Examples of Behavioural Economics

• Framing deals in an appealing manner to increase sales; this is known as framing effects.
• Vintage items are more expensive, although modern counterparts may be more efficient; this is known as the endowment effect.
• People tend to prefer restaurants with fewer menu options; this is choice overload.
• At restaurants with many options, most sales will come from a few items

Importance of Behavioural Economics

• Humans are not purely rational like many assume.
• It looks at actual behavior instead of just rational behavior.
• It includes the application of psychological insights.
• It has an interdisciplinary application, that includes unique academic fields.
• It is a frontier of economic research.

History of Behavioural Economics

• It arrived in a roundabout fashion.
• The roots of the field can be traced back to classical economic theory, despite being young.
• Even when psychology did not exist as a distinct field, there were elements of psychology relevant to human emotions and decision-making in economics theories.
• The notion of loss aversion existed in the 18th century.
• Adam Smith wrote, "We suffer more when we fall from a better situation to a worse one, than we ever enjoy when we rise from a worse situation to a better one."

Previous Attitudes Towards Behavioural Economics

• In the 1952 RAND Conference participants were told to "do your best to make a correct prediction."
• The field has seen fear, loathing, distrust and suspicion towards it.
• It has been the subject of fact searches.
• Economic theorizing is using psychology.

Post-Kahneman-Tversky (1981-88)

• Many anomalies in individual decision-making were revealed.
• Loss aversion was one.
• Reference-dependent preferences was another.
• Additionally, endowment effects.
• Daniel Kahneman (with Vernon L. Smith) received the Nobel Prize in 2002
• Richard Thaler received the Nobel Prize in 2017.

Role in the Financial Crisis

• The failure of traditional economic models to predict behavior became more prominent.
• George Akerlof and Robert Shiller (2009) cite ‘Animal spirits’ (Keynes) caused the crisis.
• These consist of confidence, trust, emotions, fairness, etc.
• ‘Stories' lead to the household boom and subsequent bust post-dot-com bubble (2000).

Behavioural Economics Models

• They are a simplification and abstract representation of how things should work.
• Most models are based on assumptions, that are exactly false.
• The properties of a good model in economics include: parsimony, tractability, conceptual insightfulness, generalizability, falsifiability, and empirical consistency.
• The assumptions of standard econ models are not true for most people.
• Key questions of the models is understanding if some assumptions of economic models can be more realistic in a tractable way.
• Another is questions of how well they can explain important phenomena.

Key concepts in Behaviourial Economics

• Prospect Theory
• Loss Aversion & Endowment Effects
• Hyperbolic Discounting
• Choice Architecture
• Decision Points
• Empathy Gaps
• Bounded Rationality
• Framing Effects, Heuristics & Biases

Prospect Theory: Scenario 1 and 2

• Scenario 1: If given $1,000, you must pick between a 50% chance of gaining $1,000, and a 50% chance of gaining $0, or a 100% chance of gaining $500.
• Scenario 2: If given $2,000, you must pick between a 50% chance of losing $1,000, and 50% of losing $0, or 100% chance of losing $500.

Prospect Theory: Results

• In Scenario 1, you are given $1,000. A 50% chance of gaining $1,000, and a 50% chance of gaining $0, or 100% chance of gaining $500.
• Scenario 2, you are given $2,000. A 50% chance of losing $1,000, and 50% chance of losing $0, or 100% chance of losing $500
• In both scenarios a choice of A gives a 50% chance of ending up with $2,000, and 50% chance of ending up with $1000, against a 100% chance of ending up with $1500.

Prospect Theory Key Points

• Kahneman & Tversky developed Prospect Theory in 1979.
• Decisions are not always optimal & rational in this theory.
• Willingness to take risks is influenced by the way the choices (prospects) are framed.
• Individuals are more sensitive to losses than to an equivalent amount of gains.
• People like more certainty and can sometimes sacrifice a higher reward for certainty.

Changes Matter + Diminishing Sensitivity

• Utility is better described by changes in consumption rather than by levels of consumption.
• In diminishing sensitivity, people are risk-averse in the gain region, but risk-loving in the loss region.
• A person’s sensitivity to further changes in consumption is smaller for consumption levels further away from the reference point.

Features of Value Function in Prospect Theory

• The carrier of utility consists of changes relative to reference point, rather than levels.
• Loss aversion is kink at zero relative to reference point.
• Diminishing sensitivity involves diminishing returns on both sides of the reference point.
• Gains come with concavity.
• Losses come with convexity.
• The reference point helps define the value function.