GE CBD Lecture 1 - Introduction to Behavioral Economics.pptx

Lecture 1 – Decoding Behavioral Economics GE Elective Choices, Behavior, and Decision-Making Christian C. Pasion Economics Department Ateneo de Davao University Learning outcomes Understand the importance of assumptions for economic analys...

Lecture 1 – Decoding Behavioral Economics GE Elective Choices, Behavior, and Decision-Making Christian C. Pasion Economics Department Ateneo de Davao University Learning outcomes Understand the importance of assumptions for economic analysis Look at how real people make choices in the real world Identify the non-monetary variables that grow the economic pie Blow bubbles and weathering bumps See what makes people happy What is behavioral economics? Behavioral economics is all about developing economic analyses for real people in the real world. It’s about making economic models more robust, more accurate, and more practical. Like conventional economic, it is very much concerned with incentives, costs and benefits, cause and effect, and economic efficiency. Neoclassical assumptions of economics (i.e. utility maximization, profit maximization, efficiency) What is behavioral economics? Behavioral economics enriches the conventional economics toolbox by incorporating insights from psychology, neuroscience, sociology, politics, and the law. We end up with more vibrant and revealing economic analyses based on more realistic assumptions about how individuals behave in the real world and the real-world circumstances that influence the decisions they make. In behavioral economics, people are decision makers driven by both passion and reason. Nature vs. nurture, emotions vs. reason Are good writers born or made? Making Wise Assumptions Making Wise Assumptions All economists — conventional or not — make assumptions about people in order to do their economic analyses. But in conventional economics, the realism of assumptions doesn’t count for much. Assumptions are supposed to be all about prediction, and building models requires economists to simplify reality. Making Wise Assumptions The problem of oversimplification Conventional economists figure they just need to get the basics down pat — they don’t need to describe in detail the apple market to build a model of the apple market. For example, in economics, people are self-interested. Why is it that some people are satisfied when they donate to a community (altruism)? Why is it that some people like to buy very expensive things? When price is high, customers do not want to purchase. Subjective measures (feelings, beliefs) vs. objective measures (income, price) Making Wise Assumptions Behavioral economists, on the other hand, believe that too many of the assumptions in conventional economics are not only simplifications of reality, but also simple-minded and often downright wrong. In statistics, we call it “omitted variable bias”. Behavioral economics says that these unrealistic assumptions often lead to weak and sometimes inaccurate economic analyses and are misleading guides for public policy and private practice. Why reality matters One of the originators of behavioral economics, Nobel Laureate Herbert Simon, argued that economic models require realistic simplifying assumptions. Realistic assumptions are necessary in order for economists to build models that help explain not only the causes of actual human behavior but also the institutional framework in which real people make decisions. Trust, crime, and economic growth, for example Fairness perceptions Why reality matters For example, if we start with the assumption that all economic outcomes are efficient (which conventional economics assumes), we’ll never notice any inefficiencies, and we’ll assume that people’s choices are producing efficient outcomes. Productive efficiency versus socially optimal allocation Externalities – uncompensated impact of one person’s actions on the well-being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Why reality matters Price of Social Aluminum cost Pollution as a Cost of negative externality pollution Supply (private cost) Private production vs social optimum Optimum Equilibrium Demand (private value) 0 QOPTIMUM QMARKET Quantity of Aluminum Why reality matters Our assumptions can blind us from engaging in rigorous economic analysis. To construct rigorous and meaningful scientific models, our simplifying assumptions have to capture important, realistic elements of how people behave and the decision-making environment they’re in. Why incentives matter — even in behavioral economics Conventional economics focuses on the effect of economic incentives like prices and income on people’s decisions. It’s true that behavioral economics is fixated on the psychological, sociological, and institutional underpinnings of modeling assumptions, but behavioral economics doesn’t dismiss the importance of economic incentives. Incentives do affect people’s decisions. It’s just that, often, incentives aren’t enough to tell a good story about economic phenomena. Why incentives matter — even in behavioral economics Why incentives matter — even in behavioral economics The Easterlin Paradox states that at a point in time happiness varies directly with income, both among and within nations, but over time happiness does not trend upward in correspondence with income growth. Why incentives matter — even in behavioral economics (reality matters!) Why incentives matter — even in behavioral economics For example, people sometimes do buy more when the price is high or do less work when new monetary payoffs are introduced. Economists need to enrich the traditional economics toolbox — but we can’t ignore the importance of economic incentives to the decisions people make. Examples: Communal ownership of land, recycling Making Sense of Choice Conventional economics assumes that people are calculating, omniscient, self-interested, and focused on maximizing their wealth or income. Behavioral economics is unapologetic about expanding on this conventional decision-making toolkit. Conventional economics offers us a model that prescribes how people should behave to get ideal results. The conventional model also tells us (or so it’s assumed) how people behave, on average. Maximizing versus satisficing Almost no one maximizes, carefully calculates cost versus benefit, operates with perfect information, or carefully forecast into the future the implications of current decisions, especially with any degree of certainty. There is no 100% accurate prediction. People engage in what behavioral economists refer to as satisficing — they do the best they can to get the best possible results they can, given the psychological, physiological, and environmental constraints they face. If conventional behavior is considered to be rational, then behavioral economists refer to the way in which people actually do behave as boundedly rational. Maximizing versus satisficing Being boundedly rational often involves decision-making shortcuts, or heuristics. Bounded rationality Heuristics - mental shortcuts that allow people make judgments quickly and efficiently (at least from their viewpoint) Some behavioral economists argue that using heuristics typically results in errors and biases in decision making. Others argue that heuristics often generate superior results, given that people are human, not machinelike decision makers. The effect of emotions Emotions play an important role in people’s decision making, and behavioral economics incorporates this important fact of life into its decision theory. Not important in traditional economic model. But other behavioral economists believe that emotions and intuition can play an important positive role in the decisions people make, with emotions and intuition building on memories of past experience and understandings. The effect of emotions Source: Antunes and Coelho (1999) The effect of emotions The avoidance of loss In conventional economics, people are particularly concerned with maximizing income and wealth. But behavioral economics recognizes that people aren’t only willing to trade off some income to reduce the risk of making money. On average, people tend to really despise losses and even despise giving up on lost causes. People are afraid of failure. And people often are willing to sacrifice some income and wealth to avoid losses, to stick with what appears to be a lost cause, to gain some certainty, and to avoid ambiguous outcomes. The avoidance of loss This all is referred to as loss aversion. People do what it takes to make themselves more satisfied — but however important money is to them, maximizing money and wealth given the risk involved doesn’t appear to be the only thing that matters. Most people will also gladly sacrifice some income and wealth to help others or to punish people they consider to be cheats and free riders. They get a happiness spike by being nice to good people and by punishing the “bad guys.” This isn’t to say that people are willing to sacrifice everything — but when you go with the conventional assumption that people are focused solely on maximizing their income and wealth, you’re overlooking a key part of human behavior. How options are framed Conventional economics says that people aren’t influenced by trivial changes in the manner in which options are framed. For example, conventional economics says that if people want to donate their organs after they die, they’ll arrange for that to happen no matter what — and if they don’t become organ donors, it’s because they didn’t really want to. But the fact of the matter is that people are affected by how options are framed. For example, if the default option for organ donation is to not donate at death (in other words, if you have to make some kind of effort to become an organ donor), most people won’t. If the default option is to donate (for example, if organ donation is the rule, and you have to make an effort to indicate that you don’t want to donate), most people will donate. How options are framed Very often, opting for the default is just one less obstacle to cross when making decisions. In a world of uncertainty, defaults also signal what is the right thing to do. However you look at the issue, framing is important. And because of its importance, how options are framed becomes very important to the choices people make and to economic outcomes that can have considerable implications for society at large, such as retirement savings. Paternalism versus free choice In conventional economics, people’s choices are always the best choices, and we should leave well enough alone, unless people’s choices are causing harm to others or where individuals don’t bear the entire costs or benefits of their choices. So, crime should be regulated and so should pollution. But the fact that people don’t behave as conventional economics recommends raises the issue of whether most people can make choices that are in their own best interest. Some behavioral economists recommend that governments intervene to nudge people into making choices that the experts perceive to be in people’s best interest. (Policy Nudging) They argue that these choices are the choices people would make if they knew better— in other words, the experts’ choice is people’s preferred choice. Paternalism versus free choice But many behavioral economists argue that even if governments trust the individual to do the right thing, they need to arm decision makers with appropriate tools so that they’ll make the best possible decisions. This means making sure that people have accurate information, the means to locate and understand the information, and the power to make decisions. If a woman has no power to decide how many kids she’ll have and no information on contraception, she can’t make choices that are in her best interest. Nudging is not required here. Governments only need to provide citizens with the capability to make good decisions. The role of social context in decision making People don’t make decisions in isolation from society or, at a more micro level, in isolation from family and friends. They don’t behave as if they’re operating in a hermetically sealed room. They’re influenced by what their friends and family think and do and by what those outside their group do. People are affected by social norms, by culture, by religion. Their decisions also can be significantly influenced by those they identify with — their level of happiness is impacted by their desire to fit in. Current decisions also often are influenced by past decisions — by friends or enemies people have made, by whether they smoked or did drugs, by whether they fell in love with learning or sports. The role of social context in decision making The fact that people are influenced by the world around them doesn’t mean that economic incentives aren’t of any consequence. Nor does it mean that social context precludes choice. Instead, traditional economic factors must be placed in a broader context. People’s decisions are enriched by the ebb and flow of noneconomic variables. These noneconomic variables affect how and the extent to which people respond to economic variables. They make our economic models more rigorous. Relative positioning According to conventional economics, people’s relative position (for example, how one person’s income or status compares to another’s) is not supposed to influence their choices or level of well-being, but it does. Increasing income or wealth makes most people happier. But very often, how people are doing relative to other people also has a major impact on their level of happiness. And very often, how income is growing relative to what it was before is just as important as, if not more important than, the growth of income in absolute terms. Sometimes people are even willing to sacrifice some income or wealth to improve their relative positioning.  Relative positioning Beyond averages - Fairness in an economy that works for people June 2020 DOI:10.2760/261169 Publisher: Publications Office of the European Union ISBN: 978-92-76- 11243-3 Relative positioning Income Inequality and Happiness Shigehiro Oishi [email protected] , Selin Kesebir, and Ed DienerView all authors and affiliations Volume 22, Issue 9 https://doi.org/10.1177/095679761 14172 Relative positioning Also, if people’s incomes are not growing but their relative position is deteriorating because others are experiencing a boost to their income, many people would prefer to block income improvements to others, just to maintain their superior relative standing. Better to be rich in a society of beggars than in a society where most people are pretty well off. Growing the Economic Pie The size of the economic pie is affected by nonmonetary factors, often by factors that are assumed to be bad for the economy by conventional economics (such as being fair and ethical). Some behavioral economists argue that sometimes the striving for fairness introduces rigidities into the market for good, rational reasons, which can have good or bad effects, depending on circumstance. The bottom line is that we can’t properly model macro economy without introducing a constellation of nonmonetary variables into the mix. Growing the Economic Pie People tend to retaliate against unfair behavior and reward fair behavior when and where possible, and this can have tremendous consequences on how productivity is determined and how different levels of productivity are sustained over time. Fairness has no such effect in conventional economics. But the advent of what are referred to as x-efficiency theory and efficiency wage theory opened the door wide open to the reality that how hard and smart people work very much depends on how fairly they’re treated. Growing the Economic Pie Unlike in the conventional wisdom, effort is not fixed. The economic pie often grows with some good doses of fairness and ethical behavior inside the firm. Nasty societies tend to be poorer. But being fair costs money. So, both fair and unfair societies can subsist side by side. Either way, being fair or ethical can be sustainable, even in highly competitive market economies. Growing the Economic Pie Consumers often get a happiness jolt from being fair, buying ethical products, and shopping in ethical stores. Many people are even willing to pay a higher price to get what they want, creating a market for higher-priced ethical products. But more often than not, competition makes ethical output cost competitive. Ethical firms are induced into becoming more productive, allowing them to cut costs and reduce prices. Deciphering Bubbles and Busts Markets can be seriously inefficient, causing opportunities for gain for some and opening the floodgates to humongous economic losses on both individual and social scales. Ex. Market failures: externalities, uneven market power Conventional economics insists that markets are efficient. But simply assuming away market inefficiencies results in weak and misleading analyses and dangerous public policy recommendations. Inefficient markets and investment behavior Financial markets are said to be efficient if asset prices reflect the fundamental or intrinsic values of the real assets that they represent. In conventional economics, this is what asset prices are supposed to do. But they don’t in the real world, where history is overflowing with examples of asset price and commodity price bubbles, in which these prices deviate enormously from their fundamental levels. Inefficient markets and investment behavior Behavioral economics has documented and analyzed these realities. Sometimes bubbles are a product of rumor, escalated by investors following the crowd. Then there is the inevitable crash. And, yes in the long run, asset prices and commodity prices converge to their fundamental values. But behavioral economics, by recognizing the reality of inefficient markets, is building the capacity to understand them and to discern whether limiting the extent of bubbles and crashes is possible. And these crashes can potentially drive otherwise healthy economies into serious economic crisis, unless saved by the visible hand of government. Emotions, intuition, animal spirits, and business cycles Cycles in the real economy are part and parcel of healthy capitalist production. But the extent of deep and severe economic recessions or depressions or the great heights of economic prosperity can’t be explained by economic variables alone. Behavioral economists have introduced animal spirits (people’s expectations of what may happen in the future) to help explain business cycles. In this way, emotions, intuition, and social context are introduced into the modeling of business cycles. Emotions, intuition, animal spirits, and business cycles Traditional emphasis on consumer, firm, and government spending, saving, and investment behavior; interest rates; and exchange rates remain important. But the states of mind of the consumer, investor, and politician also are critically important to explain movements in total output and unemployment. If most people believe that the economy is going to hell in a handbasket, then dropping interest rates to zero won’t have much effect. And if workers are depressed, both current and future productivity can drop significantly. Understanding Happiness: Money Isn’t Everything The more money people have, the happier they should be. Money buys happiness, according to the conventional wisdom. But this easy linkage between money and happiness, which still serves to inform economic theory and public policy, is not unequivocally supported by the facts. To the contrary, a multitude of research has examined in great detail the relationship between income and happiness, as well as the noneconomic determinants of happiness or life satisfaction. Understanding Happiness: Money Isn’t Everything What’s clear is that increasing income is of some importance to happiness, especially in low-income economies and especially among the poor in all countries. But there are also some very real diminishing returns — more income per person produces smaller and smaller gains in happiness. Also, what people do with their money, how government spends their money, and the extent of people’s political freedom all have great effects on people’s level of happiness. Easterlin Paradox Understanding Happiness: Money Isn’t Everything With different systems of education, healthcare, levels of trust, security, and governance, will end up with different levels of happiness. For example, people in the United States are, on average, less happy than people in less wealthy economies, such as Canada. This doesn’t mean that reducing per-capita income in the United States won’t dramatically reduce the level of happiness of Americans. But the evidence suggests that if the Americans spent their money differently, especially in the public sector, they might very well be happier than they are today, especially the American middle class and the American poor. Understanding Happiness: Money Isn’t Everything