Economic Psychology PDF

Economists primarily study how individuals, businesses, and societies allocate resources to satisfy needs and wants. They analyze markets, production, distribution, and consumption of goods and services. Psychologists, on the other hand, focus on understanding human behavior and mental processes. T...

Economists primarily study how individuals, businesses, and societies allocate resources to satisfy needs and wants. They analyze markets, production, distribution, and consumption of goods and services. Psychologists, on the other hand, focus on understanding human behavior and mental processes. They study thoughts, feelings, motivations, and behaviors, often through empirical research and experimentation. While both fields may intersect in areas like behavioral economics, their core focuses and methodologies differ. Economists tend to emphasize quantitative analysis and mathematical models, while psychologists often employ qualitative research methods and clinical observation. “If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not he will not thereby avoid psychology. Rather he will force himself to make his own, and it will be bad psychology.” psychology could become science -- that was die expectation (J.M. Clark, 1918:4) economists often need to understand human behavior to build economic models effectively. If they don't draw on insights from psychology, they'll inevitably still incorporate psychological elements into their work, but without the expertise or rigor that psychologists bring. This could lead to flawed economic analysis and conclusions. So, it's better for economists to acknowledge and utilize psychological insights rather than trying to reinvent them inadequately. - 1918er noch nicht großes interesse für psychologie - physiologn waren in der zeit interessant, wie Freud für economisten war das "warum" nicht so interessant Two fields and their intersection is violated when beliefs about what is likely influence encoding of evidence, which is called ‘‘top-down’’ processing in perception and is manifested by ‘‘confirmation bias’’ in psychology (i.e., people see new evidence as more consistent with their beliefs than it really is; ref. 18). Economics: social science dealing studying production, distribution and consumption of services and goods (Krugman & Robin, 2012). Theory driven – top down. This means that economists often develop theoretical frameworks or models to explain economic phenomena. These theories are then used to make predictions or guide policy decisions. The "top-down" aspect suggests that economists often approach their analysis from a broad perspective, considering macroeconomic factors and systemic influences. Psychology: individual behavior and their underlying processes. Lacks overarching theory – bottom up. Psychology is described as lacking an overarching theory and employing a bottom-up approach. This means that psychologists often collect data and observations at the individual level, building understanding and theories based on these empirical findings. The "bottom-up" aspect suggests that psychologists often start with specific instances or cases and then generalize to broader principles or theories. there is no rational theory like in economics ex.: 2 raucher, rauchen das selbe gleich viel try to find regularties on individual level, with statistics ect economist: beide sind gleich, unterscheiden sich nicht ;würde dann steuern erheben um die menschen vom rauchen abzuhalten psychologist: der eine will unbedingt aufhören, er fühlt sich schuldig ect das er nicht aufhören kann wenn man eine norm in der gesellschaft der andere hatte nie den gedanken aufzuhören oder bedenken wegen seiner gesundheit einführt das rauchen nicht cool ist -> hier sind beide komplett unterschiedlich , das einzige was sie vereint ist das geschlecht (durch plakete), sind ppsychologisch die schauen viel mehr auf die details , bsp. beginn um zu rauchen war, weil schlimme kindheit ect , während den anderen nichts juckt erkannt wurde, kann als vorteil benutzt --> hier hätte man andere herangehensweisen werden, um menschen vom rauchen abzuhalten -economisten juckt der psychologische aspekt nicht econmoisten müssten bei gesetzesauslegen robuste gesetze finden (nudging z.b) , social image ist denen wichtiger 7 Summary: Economics and Psychology Economics Psychology as much details as possible to describe smtg Based on few fundamental assumptions: Predominantly an inductive approach, empirical Revealed choice – stable preferenceswhat you say actual truth theories at low levels Goal is maximizing utility time is tricky , how people value time money (economist doesn#t care if you give money, Explanations of individual behavior um besseres gwissen zu haben) All economic laws are derived from these assumptions Intensive effort to describe details Mathematical language and models Experimental and statistical methods, surveys Observational data, self-reports and experiments Objective data, controlled, neutral experiments often with context Assumptions on individual behavior to assist predicting Assumptions about individual behavior must be phenomena (“as if” assumptions)maximising utility (Friedmann) realistic (description and prediction) Some simple and robust psychological/behavioral Contextual, structural, and systemic variables are less concepts are narrowly defined and incorporated into relevant models komplett neutral wollen die experimente machen - beachten kaum äußere umstände social preference + fairness: defined how much you give selfish prefernce: gut feeling when giving someone money can still be selfish 8 Two interdisciplinary fields with lots of overlap: Economic Psychology (EP) vs Behavioral Economics (BE) EP: (made in Europe) psychological mechanisms, processes, cognitive theories underlying various economic behaviors. perceptions and emotions surrounding economic behavior descriptive studies, nonincentivized experiments, deception is okay (less and less so). Usually, no theoretical model – only statistical models incentinizing behaviour - dictator game. sit.1: dictator kriegt 10€ und kann verteilen sit. 2: wie viel würdest du ihm geben 9 IAREP for EP - http://www.iarep.org/ Two interdisciplinary fields with lots of overlap: Economic Psychology (EP) vs Behavioral Economics (BE) BE (made in US, now overall) Provides potential insights how and perhaps why observed behavior deviates from what econ models predict Integrating these simple and robust behavioral phenomenon into models Mostly choice models, no deception is allowed Incentivized experiments  choices/behavior have monetary consequences Theory driven – predictions are deployed from theoretical models and tested 11 12 BE and EP complement conventional economics rather than substituting E.g., world is paralyzed taking major steps in combating climate change  Conventional economics: free rider/externalities problem and financial incentivizes to deal with them. E.g. carbon tax  But! Much is left unexplained: 1) why there is too little protest, outrage (vs. terrorism?) o BE/EP adaptation external change --> we adopt o Wishful thinking o Self-servingly questioning scientific evidence climate change denial o Intangibility it is always a little bit worse - NY will be under water , but i will never go there --> doesn´t impact me 2) why greenhouse gas negotiations are so difficult all these countries have different meaning of what is fair o Self-serving beliefs about fairness: Fair burdens o Loss aversion if you lose 5€ you are way more unhappy than the happiness du gibst etwas auf (verlust) im gegensazu für x --> dann macht man es normalerweise nicht 3) Remedies through cheap and easily implementable behavioral interventions (nudge) 13 Example - The role of expectations Reference dependent choices Expectations can be reference points  You expect to get a bike for your b-day but you “only” get a nice book…  Reference point: Bike. arbeit: - wegen glassdoor erwartest du ein hohes gehalt --> realität: weniger geld  Book is seen as a loss -->loss  You are disappointed How do you form your expectations? Past experiences/Learning processes – updating process Beliefs about how things work Factoring in your knowledge All these components could be obviously self-servingly distorted – E.G., reference points can be strategically or self-servingly chosen 14 Its implication – some examples Social class issues – work by Frank – choosing one particular comparison group influences if not determines your perceived social status and well- being (psych: social comparisons by Festinger, etc) social status: vergleichst dich mit der selben gruppe die du aussuchst - du vergleichst dich nicht mit einen tennisspieler, aber mit einem akademiker o How you evaluate your income level/what you own – e.g. A very specific example of how choosing a reference group can be self- servingly exploited– e.g. Babcock, Wang & Loewenstein (1996, QJE) o Teachers/union salary negotiations with school board (market forces are less present – more like comparison) – other district salaries are by law must be taken into account. o Teachers/unions choose high salary districts vs school board lower salary districts - > predict impasse and then associated to strike likelihood 15  Some history… Prehistory (before psych existed as a field. Economists and moral philosophers were dealing with topics what psychologists deal today – A.Smith Early neoclassicals – some openness to psychology Postwar neoclassicals – open hostility against psychology Behavioral/psychological insights:  1980s Prospect Theory and Anomalies of choices  1990s Bunch of theory development (incorporating behavioral components into models)  Post2000 explosion: Bunch of lab and field studies Light/asymmetric paternalism – incorporating behavioral insights into public policy Neuroeconomics – whole new field 16 Adam Smith: First behavioral economist? Best known for Wealth of Nations (1776) However, amazingly insightful psychology in Theory of Moral Sentiments (1759) 17 Concepts and mechanisms that are central to BE were already acknowledged by him: 1. Loss aversion (losing hurts more than gaining the same amount) "breach of property, therefore, theft and robbery, which take from us what we are possessed of, are greater crimes than breach of contract, which only disappoints us of what we expected.“ 2. Overconfidence (thinking that your/company’s chances are better than they are): "over-weening conceit which the greater part of men have of their own abilities“ 3. Adaptation (getting used to things instead of changing them): "By the constitution of human nature, agony can never be permanent." Following a calamity, a person "soon comes, without any effort, to enjoy his ordinary tranquility.” 4. Failure to predict experienced utility (We cannot precisely predict how much we will enjoy/dislike a consumption in the future): “How many people ruin themselves by laying out money on trinkets of frivolous utility?” 18 Smith’s specific perspective (close to many contemporary ‘dual process’ models in psychology) Indulge! Would an honorable man do it? Passions/emotions “impartial on stakeholder spectator” Affect and Deliberation (A century-long detour) Dual process theories An ancient perspective... Reason Behavior Passion passion beinflusst reason und somit behavior Smith/Hume (late 18th) “Reason is, and ought only to be the slave of the passions, and can never pretend to any other office Passion than to serve and obey them.” Behavior David Hume Reason Bentham  Neoclassical economics (late 19th) Reason Behavior Modern behavioral economics  Utilitarian: Jeremy Bentham Introduction to Principles of Morals and Legislation (1789) “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure.... They govern us in all we do, in all we say, in all we think” Meaning of Utility here = Sum of all pleasures from an action minus pain Early neoclassical Construct new approach to economics on foundation of Bentham’s (hedonic) utility. E.g., Jevons (1871): “Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics. To satisfy our wants to the utmost with the least effort... in other words, to maximize pleasure, is the problem of Economics.” Evolution of utility concept early 1900s: Utility as happiness/enjoyment 1900-1930s: Utility as desire 1930s-1990s: Utility as preference (revealed by choice (Samuelson)) – Limits welfare implications (Pareto optimality) – Constrains analysis of individual reality (because whatever people do increases their utility, by definition) Late 1990s: Recognition (by Kahneman) of usefulness of multiple conceptions of utility – experienced utility (Benthamite: Sum of all pleasures from an action minus pain) – decision utility (revealed preference) These two may not (often not) coincide make it meaningful to ask novel questions – e.g., do people actually maximize (experienced) utility when making a choices? Or which utility they are maximizing?  ? Decision utility not = to experienced utility Framework for explaining biased choices. Some attempts to introduce psychology to economics prior to 1980 I. Fisher (Keynes): money illusion  Think in nominal rather than real terms Keynes - animal spirits vs mathematical calculations behind behavior  large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities (Keynes 1936, 161). Scitovsky – psychological insights into consumer behavior – need for stimulation expanded to societal level - Joyless Economy: We should spend our money on adventure, stimulation and relational goods rather than on comfort goods because we will adapt to them and will soon have no value. Expands to societal-level: educating our consumption with joy Challenges to assumption of rationality: H. Simon (bounded rationality – searching for the realistic underpinning of utility maximization behavior) 1980s: Emergence of Behavioral Economics Behavioral decision research (Kahneman & Tversky) – 1974 Heuristics and Biases (Science) availability (easily retrievable information is overweighted) and representativeness (hypotheses – 1979 Prospect Theory (Econometrica) that are well represented by evidence are thought to be likely) 1980 Richard Thaler “Toward a positive theory of consumer choice” (JEBO) – applies Prospect Theory to consumer behavior: Endowment effect Underweighting of opportunity costs Self-control – 1980s & 90s: Thaler publishes influential “Anomalies” column in J. Econ Perspectives 25 Economic Psychology – Decision Making: Normative Models and Anomalies Linda Dezső 01 March 2024 Rational choice theory Framework for formalizing social and economic behavior Looks at aggregate social behavior which is made up of individuals making their own choices. Preferences are given and we reveal them by choice  Complete – you can always rank alternatives or bundles of goods – you know whether you prefer apple over pears or vice versa or you are indifferent  Transitive – A>B and B>C then A>C No claim of describing choice process but rather predicting outcome or choice You have complete information  bounded rationality You know the probability of each outcome to happen (in case they are involved) and you perceive them on face-value - EV  If uncertainty is involved: you maximize your expected value but not always – expected utility theory. And you buy insurance and lottery ticket at the same time  prospect theory  If choice over time situation is involved: you discount alternatives happening in future and comparable discounted value - discounted utility  hyperbolic/beta-delta discounting You maximize your utility/happiness (whatever utility means…)  decision and experienced utility are separable You maximize on your wealth  reference dependent choice models (e.g., PT) 2 Economic assumptions about preferences Good 2 Good 1 Preferences are stable Preferences are coherent (e.g., complete, transitive) We know our own preferences Preferences take specific forms – e.g., time preferences, risk preferences, social preferences, Economic assumptions about preferences Good 2 Good 1 Preferences are stable Preferences are coherent (e.g., complete, transitive) We know our own preferences Preferences take specific forms – e.g., time preferences, risk preferences, altruism Earlier (18th century) refining the concept of preference was tied up with discussing decision making under risk Starting point – Expected Value (EV) utility wealth 5 St. Petersburg paradox (18th century – Bernoulli) Initial stake start at $2 and doubled every time coin lands on head. First time tail happens game is over and you get paid as much as you made until this point. Toss1: if tail you get $2, if head you get $4 Toss2: if tail you get $4 , if head get $8….. You win $2k where k is the number of tosses (k > 0 and integer). What is the maximum you would be willing to pay to play this game? Expected Value (EV) = ½*2+1/4*4+1/8*8+1/16*16 ….= infinite YET! People would only pay a limited amount to play this bet. WHY? 6 Expected Utility Hypothesis - Bernoulli It is not the money (expected value) but the utility what matters u(w)=ln(w) 10 Diminishing marginal utility  utility of the gamble converges to 9 zero. 8 utility 7 Expected utility of the gamble is finite, the expected value is infinite. 6 5 4 0 2000 4000 6000 8000 10000 wealth Bernouli (1738) 7 (St. Petersburg paradox) How about when risk or uncertainty are involved? Risk = we know the probability distribution of an outcome – e.g., lottery numbers, roulette wheels - Observable Uncertainty = we do not know the probability distribution of an outcome – horse races, or most things in life - Not Observable UNCERTAINTY: RISK: You can bet $10 Euros on a specific horse without knowing the You have 10Euros and place a bet on rolling 2 on probability distribution of the outcome (final ranks among horses a dice. If you get 2 you make 10 time of your bet in the race). (1000 Euros). You have 1/6 to get 1000Euros – EV = Or, you are standing at u-bahn station at night and have no idea 1/6*1000Euros when the next u-bahn is coming. Or, you kick out your tenant from the appt you own and rent out and have no idea when he finds a new place. 8  We are (mostly) risk averse When sure thing worth less than the EV of a risky choice, we prefer less but sure thing. Bank account with minimal gain risk-averse Between B and C inflections points -> risk-seeking Explains why you buy a lottery (low p and high payoff) while you buy insurance (travel insurance) for events with mild p and mild payoffs. (income) Figure 2 - Friedman-Savage Double-Inflection Utility Function https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 3 Anomaly: Simultaneous insurance and lottery purchase You are here at B. At the inflection of risk-aversion and risk-seeking. You are given two gambles yielding: 1. You end up in A or stay in B (buying insurance) (income) 2. You end up in C or stay in B (buying lottery) Note, B is the status quo! Figure 2 - Friedman-Savage Double-Inflection Utility Function https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 4 Anomaly: Simultaneous lottery and insurance purchase You are here at B. At the inflection of risk-aversion and risk-seeking. You are given two lotteries yielding: 1. Lottery A or B - captured AB chord 2. Lottery B or C – captured as BC chord Recall, B is the status quo! Figure 2 - Friedman-Savage Double-Inflection Utility Function https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 5 Anomaly: Simultaneous lottery and insurance purchase Expected Utility of Lott1 is E(u) and Lott2 is E(u’) You are here at B. At the inflection of risk-aversion and risk-seeking. You are given two lotteries yielding: 1. Lottery to A or B - captured AB chord 2. Lottery B or C – captured as BC chord Note, B is the status quo! Figure 2 - Friedman-Savage Double-Inflection Utility Function https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 6 Anomaly: Simultaneous lottery and insurance purchase Expected Utility of Lott1 is E(u) and Lott2 is E(u’) 1. E(u) < than the utility of the expected outcome of Lott1, u(E(z)).  Risk-averse behavior is buying insurance : paying a premium to avoid getting into A. 2. E(u’) > than the utility of the expected outcome of Lott2, u(E(z’)).  Risk-seeking behavior is buying lottery: paying a premium to undertake the risk. Figure 2 - Friedman-Savage Double-Inflection Utility Function, Friedman-Savage, 1948 https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 7 Markowitz’s amazing insight.. Person is at F. would accept a gamble (lottery ticket) that could take him to F’. Conversely, this person would not buy an insurance against getting into F from F’. (huge losses with very low p). Figure 2 - Friedman-Savage Double-Inflection Utility Function https://web.archive.org/web/20070704160948/http://cepa.newschool.edu/het/essays/uncert/aversion.htm 8 Markowitz’s amazing insight.. 1. Disputes FS doubly inflected utility curves 2. Z is not income levels but rather changes income 3. [The origo is average income-level] 9 Departing from Expected Utility Theory (EUT) and Arriving to Prospect Theory (PT) (Kahneman & Tversky, 1979) – Descriptive model We are in the domain of decisions made under risks and uncertainty. PT Decisions based on Value values rather than outcomes PT Decisions based on Value values rather than outcomes Values are compared to a reference point (this can be many things: expectations, aspiration, We are in the domain past outcomes, believed norms, etc.) of decisions made under risks and uncertainty. Highlights importance of changes, and of relative comparisons PT Because you compare values to a reference point, you frame them as gains or losses. Decisions based on Value values rather than outcomes GAIN Evaluating gains and losses systematically differ LOSS Values are compared to a reference point (this can be many things: expectations, aspiration, past outcomes, believed norms, etc.) PT: Loss-aversion Value GAIN -5 Euros +5 Euros LOSS Losing 5 Euros hurts more than finding 5 Euros. Two phases of decision making in PT 1. Editing: Aims to reduce complexity Select a reference point  value = 0 We frame acts, outcomes  gain/loss compared to reference point Results in ordered values 2. Evaluation: We select the one with the highest value 15 Another important difference from EUT In EUT: utility of an outcome is weighted by its likelihood (some kind of “translation” of uncertainty) In PT: the value of an outcome is multiplied by the decision- weight, π(p) monotonic function of p though not the probability 16 Decision weight and its properties 1. Impossible events are discarded π(0) = 0 2. Scale normalized π(1) = 1 3. At endpoints not well behaved 4. Very low p  π(p) > p while π(p) + π(1-p) ≤ 1 Low ps are overweighted, moderate and high ps are underweighted. Tversky & Kahneman, 1981, Science 17 Decision weight and its properties 1. Impossible events are discarded π(0) = 0 2. Scale normalized π(1) = 1 3. At endpoints not well behaved 4. Very low p  π(p) > p while π(p) + π(1-p) ≤ 1 Low ps are overweighted, moderate and high ps are underweighted. 5. For any fixed probability ratio, the ratio of decision weights is closer to 1 when the probabilities are low than when they are high. E.g., π(0.1)/ π(0.2) > π(0.4)/ π(0.8) Tversky & Kahneman, 1981, Science 18 Consequences of the nonlinearities in Prospect Theory What is discussed today Loss aversion Equity premium puzzle WTP (willingness to pay) after we own the good o Shifted reference points once we own the good – most common explanation So, we anticipate loss aversion once we part with something as owning that thing is the new reference point and giving it away is a loss. 3  An implication: treating opportunity cost differently than “out-of- the-pocket” loss  Foregone gains are less painful than perceived losses Interesting finding: People do not display endowment effect (and also no loss aversion) when making a decision on the behalf of someone else  investing on behalf of someone else 4 Endowment effect influences fairness perception Kahneman, Knetsch and Thaler (1986, AER) Survey responded judged the fairness of several actions. The perception of fairness depended whether the transaction was framed as a reduction in a gain or an actual loss. Example: Imposing an extra charge (i.e., loss) is seen as unfair, while eliminating a discount (reduction of gain) is seen as fair. 5 Status quo effect Samuelson and Zeckhauser (1988, J of Risk and Uncertainty) We have a strong tendency to remain in the status quo (current situation) – Because the disadvantage of leaving it looms larger than the advantage of staying. Example: Inheriting a portfolio – people tend to stay with it even alternatives which are given as they see these more profitable. By contrast: inheriting the same amount of money. 6 Sunk cost fallacy/effect You buy a yearly swimming pass (appr 280 Euros) to Stadthallenbad but you develop some bad sinus problems. This causes you pain and all sorts of discomfort. Yet, you force yourself to go swimming (increasing the cost of the sinus problem) by saying that you cannot live with the idea of having the pass’ cost sunk. You may feel averse towards wasting the pass However, from a traditional standpoint, these sunk costs should be ignored 7 Mental accounting (Thaler) You bought a theater ticket for 20Euros and when you arrive to the theater you find out that you lost the ticket. You arrive to the theater and want to buy the ticket (costs 20 Euros) and you realize you must have lost the money on the way to the theater. In which case would you buy a ticket? 8 Mental accounting (Thaler) You bought a theater ticket for 20Euros and when you arrive to the theater you find out that you lost the ticket. You arrive to the theater and want to buy the ticket (costs 20 Euros) and you realize you must have lost the money on the way to the theater. In which case would you buy a ticket? In the first case you don’t buy the ticket, in the second case you would buy the ticket. 9 Mental accounting (MA) Accounting: "the system of recording and summarizing business and financial transactions in books, and analyzing, verifying, and reporting the results." (Merriam-Webster Dict) Mental accounting: a description of how individuals do these things (mentally): Sources / purposes of the money, etc. Purposes of MA: – keep track of where there money is (and is going) – easier when on separate balances – self-control device – you can plan how much you will spend – diminish 'pain of paying' (not discussed by Thaler) – you have already assigned money for a certain purchase 10 Mental accounting violates … – consumption decisions are independent of financing decisions (in both directions) – consumption enjoyment is independent of financing decisions – purchases should always be financed to minimize Net Present Value (NPV) – money is fungible Any unit of money is substitutable for another. So, consumption decisions are based on the consumer’s total wealth. 11 Pros and cons Pro: 1. A big bonus  saving for something big vs higher monthly salary  upwards adjusting consumption 2. One can use it as a self-control device 3. Feel rich and poor simultaneously Cons: 1. Rigidity of tapping across accounts: We do not want to repay a car loan from the money put aside for our kids college education even though we could save paying a bunch of interest. 12 Consequences of different accounts 1. When sharing multiple good news (gains):  tell them separately, wrap Xmas gifts in different boxes  Because people experience separate gains which add up to more than one big compound gain  they are happy for each present 2. When sharing multiple bad news (losses):  Tell them all at once  Because people experience one compound loss which is less than experiencing loss for each thing/bad. 13 Economic Psychology Preference uncertainty – Constructed preferences Linda Dezső 03 May 2024 What is discussed today Preferences… 1. are unstable 2. are constructed on the spot 3. susceptible to context 4. Decoy effect, Compromise effect 5. Coherent arbitrariness Points 1 to 3 have significant consequences on marketing 2 Recall two things 1. Traditional assumptions about preferences 2. Different approach between economics and decision theory 3 1. Economic assumptions about preferences Good 2 Good 1 Preferences are stable Preferences are coherent (e.g., complete, transitive) We know our own preferences Preferences take specific forms – e.g., time preferences, risk preferences, social preferences, 2. Different approach between economics and decision theory Micro-focus of standard econ and decision research often different ECON DECISION RESEARCH good 1 good 2 good 3 attribute 1 attribute 2 attribute 3 bundle 1 good 1 bundle 2 good 2 etc. etc. good 2 attribute 2 good 1 attribute 1 5 Rationality axioms: Taken for granted, no need to prove them Transitivity: If A > B and B > C then A > C Completeness: when you compare your two alternatives you can only get: A < B, A> B or A = B. Reflexivity: An option is at least as good as itself. Revealed preference: If you choose A over B, you must prefer A over B. 6 Rationality principles: Extra assumptions- they are relevant in varying degree in specific situations Cancellation: Same outcomes should be ignored as we have once picked up preference on them. Dominance: If X is better at least in one dimension than Y and the same in all other dimensions, then you should prefer X to Y. Extensionality: You should have the same attitude towards a good irrespective of how it is described. Milk 3 % fat should be = milk 97 % fat free. Invariance: Different representations of the same choice should yield to similar preferences. Descriptive = no matter how you describe a choice (loss vs gain) and Procedural = no matter how you elicit choices: willingness to pay, ordering, etc. Utility maximization: with choice we always maximize utility. 7 Preference uncertainty Traditionally: (recall!) no uncertainty. We know and consistently reveal preferences by choice to maximize value and preferences are stable. Preferences are independent from context in which they are presented (i.e., other alternatives). So, if I prefer Apple over banana when only these two are available, I will still prefer A over B when orange is also available. But! This is often violated. Sometimes, a market share of a brand increases (vs decreases) after another brand is introduced. Marketers want to foresee how introducing a brand/product impacts existing ones and what is going to be the market share. 8 Preference uncertainty Softer approach: Preferences are uncertain nevertheless they do exist and just need to be discovered = Discovered Preference Hypothesis (DPH) (Plott, 1996) – we reveal them and they become stable over time. Harder approach: Preferences are uncertain, and there is nothing there until one is faced with a choice. Then, we construct them, Constructed Preferences (Slovic, 1995) 9 Constructed Preferences Given that people are uncertain about their own preferences, when called upon to make a decision, they use any available information to help resolve the uncertainty. This opens the door for many deviations from standard predictions about choices and the influence of the context in which options (mostly multiattribute) are presented. 10 Constructed Preferences Given that people are uncertain about their own preferences, when called upon to make a decision, they use any available information to help resolve the uncertainty. This opens the door for many deviations from standard predictions about choices and the influence of the context in which options (mostly multiattribute) are presented. This violates/contradicts regularity ( adding an alternative should not influence preference for other alternatives) 11 What is the context? 1. Simultaneously presented multiattribute alternatives are the context. 2. Influence of the past (i.e., options that are not present) 12 Asymmetric dominance – important concept to know A is better than B on one attribute (light) and B is better than A on one attribute (location) Example: Tough choice: Does the advantage in the location light compensates for the darkness? A B location 13 In marketing, one can exploit context dependence Suppose, you want to increase share of a product. Context dependence suggests that expanding the set can lead to preference shifts toward original set members. Two ways: 1. The added option (the decoy) which is inferior to the target (of which you want to increase sales) while competitor asymmetrically dominates the target – decoy effect 2. The added option makes the target seem as a compromise – compromise effect 14 Trick1: Attraction /Asymmetric dominance/Decoy effect (Huber et al, 1982 and 1983) You want to increase sales of A (target). B is your competitor. Product A B Price 400 $ 300 $ Storage 30 GB 20 GB 15 Trick1: Attraction /Asymmetric dominance/Decoy effect (Huber et al, 1982 and 1983) You want to increase sales of A (target). Product A B C B is your competitor. Price 400 $ 300 $ 450$ You introduce C – decoy: Storage 30 GIB 20 GIB 25 GIB - Inferior to A (more expensive and less storage) You observe sales increase A when C is also offered. Violates independence of irrelevant alternatives! (An alternative that would not be considered should not influence choice) 16 Trick2: Compromise effect The closer the inferior alternative to the relative superior one, the more stronger is the compromise argument (Simonson, 1989, JCR). extras Added Inferior option option T C price 17 Why these tricks work? People seem to care about justifying their choices to themselves and to others – They seek good reasons for explaining their actions o Idea from social psychology – motives are various:  Enhancing self-esteem  Avoiding regret  Decrease cognitive dissonance  To perceive themselves are rational beings with good reasons So, giving people support/ways to justify their choice makes them feel happier 18 Evaluation mode reversals: Joint (JE) vs separate evaluation (SE) (Hsee, Loewenstein, Blount and Bazerman, 1999, Psych Bull) JE: Options are presented concurrently SE: Options are presented sequentially Experimental example from Hsee et al. Two candidates for a programming job. All subjects are asked how much salary they would pay each candidate, but JE subjects evaluated both candidates, whereas in SE each subject evaluated only one candidate at a time. Experience GPA joint separate Candidate J 70 KY programs in last 2 years 2.5 33.2K 26.8K Candidate S 10 KY programs in last 2 years 3.9 31.2K 32.7K Note: GPA-scale is anchored at 0-4 (4 is the best). 19 Two candidates for a programming job. All subjects are asked how much salary they would pay each candidate, but JE subjects evaluated both candidates, whereas in SE each subject evaluated only one candidate at a time. Experience GPA joint separate Candidate J 70 KY programs in last 2 years 2.5 33.2K 26.8K > case for preference reversal Candidate S 10 KY programs in last 2 years 3.9 31.2K 32.7K Note: GPA-scale is anchored at 1-5 (5 is the best). 20 What accounts for the preference reversal btw JE and SE presentation? The evaluability hypothesis candidate Att1: Att2: Att3: GPA JE SE Number of Number of KY years J 70 2 2.5 33.2 K 26.8 K S 10 2 3.9 31.2 K 32.7 K In SE mode: How many KY programs he has written is hard to judge – no background info about how many KY programs is reasonable to expect from someone. So, GPA which is meaningful for everyone guides behavior. In JE mode: KY attribute gains meaning and this information guides choice. 21 In sum… Preferences are reversed between JE to SE evaluation In JE – options are evaluated comparatively, in respect with each other. Attributes gain meaning in respect with each other. In SE – options are evaluated separately. Hard-to-understand attributes are ignored/gain less attention 22 Some applications: Coherent arbitrariness (Ariely, Loewenstein and Prelec, 2003, QJE) Implications of JE/SE research: Absolute judgments are often difficult to make Relative judgments simpler and more natural Problematic to examine absolute attitudes with relative methods Normatively irrelevant factors influence valuation Sometimes, normatively relevant factors do not affect valuations Findings challenge the idea of fundamental value in economic theory 23 Coherent arbitrariness Absolute valuations are arbitrary and sensitive to normative and nonnormative influences. But, once valued this serves as an anchor  imprinting. Then, relative valuations are coherent to the initial arbitrary valuation  locally coherent. 24 Example on commodities from Ariely, Loewenstein and Prelec, 2003, QJE. N = 55 MIT MBA students Shown six products: cordless mouse, cordless keyboard, average wine, rare wine, design book and Belgian chocolates Goods were described without mentioning the market price (mean retail price in fact was $70) Tasks: 1. Accept/Reject on a price equal to the last two numbers of your soc sec number? 2. Minimum WTP for each product Payoff compatibility was assured: 1. Random device  task1 or task2 is base for payment 2. Only one product was purchasable 25 WTP results: Subjects did not know how much they valued these items – anchored to SSN. But, then they kept the relative Ordering/ranks across categories of computer gadgets and wine. 26 Do we know our tastes at all? Do we know what is good/bad for us even after experiencing it (i.e., having a pre-existing sense of it)? Ariely, Loewenstein and Prelec, 2003, JEBO 27 You can influence people valuations for goods/experiences by randomly assigning them (i) getting paid for doing something or (ii) making them pay to do something. Even when this randomization is transparent to people. Experiment: n=146 MIT MBA students Half asked whether hypothetically they would be willing to pay $2 to listen to Ariely recite poetry. Other half asked whether they would be willing to accept $2 to listen to Professor Ariely recite poetry. All told that poetry reading scheduled for next week would be free, and indicated if they wanted to be notified about its location and time via email. Accept Group Would you attend Ariely recital for $2? 59% say Yes Would you attend Ariely recital for Free? 8% say Yes Pay Group Would you pay $2 to attend Ariely recital? 3% say Yes Would you attend Ariely recital for Free? 35% say Yes 28 To sum up… Important because this suggests that prices are endogenous to economy – e.g. new product’s price is published than we anchor to it and then behave coherently to this arbitrary price – prices could prevail because of collective anchoring or historical precedent 29 Economic Psychology Ambiguity (Some materials have already been covered) Linda Dezső 17 May, 2024 What is discussed today 1. Subjective Expected Utility 2. Ellsberg paradox 3. Ambiguity Aversion (AA) 4. Possible causes for AA 5. Alternative explanations for AA 6. Some empirical findings and implications of AA 2 How about when risk or uncertainty are involved? Risk = we know the probability distribution of an outcome – e.g., lottery numbers, roulette wheels - Observable Uncertainty = we do not know the probability distribution of an outcome – horse races, or most things in life - Not Observable UNCERTAINTY: RISK: You can bet $10 Euros on a specific horse without knowing the You have 10Euros and place a bet on rolling 2 on probability distribution of the outcome (final ranks among horses a dice. If you get 2 you make 10 time of your bet in the race). (1000 Euros). You have 1/6 to get 1000Euros – EV = Or, you are standing at u-bahn station at night and have no idea 1/6*1000Euros when the next u-bahn is coming. Or, you kick out your tenant from the appt you own and rent out and have no idea when he finds a new place. 3 Subjective Expected Utility (Savage) 𝑆𝑆𝑆𝑆U 𝑥𝑥 𝑃𝑃 𝑠𝑠 𝑢𝑢 𝑥𝑥 𝑠𝑠∈𝑠𝑠 SEU = Expected utility plus the idea that people behave as if they held coherent subjective probabilities of uncertain gambles. In other words, in their decision making, people behave as if All uncertainties can be reduced to risks: We could assign numerical probabilities to uncertainty, but the transformation is subjective Assign degrees of beliefs to how likely uncertain things will happen When we are willing to place bets (amount of money) on uncertain events, we reveal the degree of our beliefs about that event  derive subject probabilities from preferences between bets. The subjective probability of event E is p if the decision-maker is indifferent between the prospect of receiving $X if E occurs (and nothing otherwise), and the prospect of receiving $X if a red ball is drawn from an urn that contains a proportion p of red balls. Ellsberg challenges that you could infer p from WTP or other measures of valuation. 4 RECALL: We are ambiguity averse – Ellsberg paradox – “devil we know” 90 balls in an urn 60 60 balls What 30 red color? ?green ?blue 1. Would you prefer to bet that the color will be red or green? 2. Would you prefer to bet that the color will be (red or blue) or (green or blue)? 5 We are ambiguity averse – Ellsberg paradox – “devil we know” BUT STOP! Subjective Expected Utility is violated – rule 2: we should compare (red or blue) to (green or blue) the same way we compare red to green. 90 balls in an urn 60 60 balls What 30 red color? ?green ?blue 1. Would you prefer to bet that the color will be red or green? 2. Would you prefer to bet that the color will be (red or blue) or (green or blue)? 6 We are ambiguity averse – Ellsberg paradox – “devil we know” P(red or blue) = P (red) + P (blue) and P (green or blue) = P (green) + P (blue) But first we say: P (red) > P (green)  should imply: P (red or blue) > (green or blue). Prefer known probability (risk) over unknown (ambiguity) 7 Two urn problem – Ellsberg paradox Two urns: Urn1 – 100 balls in total: red and black, but red/black = ? [0,1] Urn2 – 100 balls in total: 50 red and 50 black, red/black = 1 You are asked to bet. If you say, e.g., you bet on Red1, you mean you would choose from Urn1. If red is drawn, you get 100 Euros, if black you get 0 Euros. Somebody wants to measure your subjective probabilities to win the bet. S/he follows Savage (SEU) axioms. 8 Four questions asked 1. Which one do you prefer to bet on, Red1 or Black1, or are you indifferent? ( Drawing a ball from Urn1 on which even would you place a bet? Red, black, indifferent?) 2. Which one do you prefer to bet on, Red2 or Black2, or are you indifferent? ( Drawing a ball from Urn2 on which even would you place a bet? Red, black, indifferent?) 3. Which one do you prefer to bet on, Red1 or Red2, or indifferent? 4. Which one do you prefer to bet on, Black 1 or Black2, or indifferent? 9 Responses and what they mean 1. Which one do you prefer to bet on, Red1 or Black1, or are you indifferent? ( Drawing a ball from Urn1 on which even would you place a bet? Red, black, indifferent?) 2. Which one do you prefer to bet on, Red2 or Black2, or are you indifferent? ( Drawing a ball from Urn2 on which even would you place a bet? Red, black, indifferent?) 3. Which one do you prefer to bet on, Red1 or Red2, or indifferent? 4. Which one do you prefer to bet on, Black 1 or Black2, or indifferent? (P)Red1 = P(Black1) = 50%, P(Red2) = P(Black2) = 50%, P(Red2) > P(Red1), P(Black2) > P(Black1) – HOW IS THIS POSSIBLE? - People are inconsistent. We are unable to infer the probabilities they assign to event from their choices ( Savage Sure Thing Principle) 10  Ambiguity Aversion (AA) Tendency to prefer risky over uncertain events. Preferring or betting on events where the probability distribution is known, over when it is unknown. Ambiguity also effects probability judgments: 1. Subadditivity: probability judgments add to less than 1. 2. Most people prefer non-ambiguous gambles over ambiguous ones except at very low probabilities 3. Ambiguity decreases willingness to act 11 Possible causes of AA 1. People dislike making decisions when one is missing relevant information and believes that this missing information can be potentially sought out/known. 2. They wrongly transfer a heuristic which is otherwise (in real life) useful heuristic: Do not bet when you lack information. 3. They wrongly apply a decision-making rule/or fail to recognize its appropriateness 4. They are suspicious that the urns are rigged – in experimental settings 12 Alternative accounts of AA (behaviorally focused) 13 Competence hypothesis (Heath & Tversky, 1991) So far, we looked at events generated in chance setup – How about real life when there is a judgmental/epistemic uncertainty? Competence hypothesis states that people tend to bet on their (uncertain) judgement when they feel knowledgeable but on the chance event when they feel ignorant (non-knowledgeable). Order: Highest bet- on topics one feels knowledgeable, Lowest bet – on topics one does not feel knowledgeable, Intermediate bet – chance events. 14 Comparative ignorance (Fox & Tversky, 1995) When comparing two events: clear (probabilistic) and vague (uncertain) Jointly: clear bet and vague bet are present  AA arises Sequentially: clear bet and vague bet are presented one after another  AA disappears For jointly presented events, people experience a contrast which makes the clear event more informative relative to the vague event but people do not factor in this experience into their reasoning. In sum, AA arises in contrasting states where the context (jointly presented options) serve as context for the choice. 15 16 17 Pessimism/Optimism (Pulford, 2009) Optimistic people are far less AA But, pessimism was not found to be associated to AA. Via what mechanism? Optimists hold higher probability beliefs about the advantageous outcome Optimists have higher self-esteem and hold stronger beliefs that about their ability of being able to make good judgements 18 Economic Psychology Choice over time Linda Dezső 17 and 24 May 2024  What is discussed today 1. What is choice over time? Intertemporal choice? 2. Discounted Utility (DU) Framework 1. How DU works 2. Challenges? 3. Time-variant preferences, present-bias 4. Dynamic inconsistency and its implications on self-control 5. Hyperbolic discounting 6. Projection bias 7. Anticipated Utility 2 What is intertemporal choice = choice over time? Any choice made between consuming at two or more different points in time, i.e., across temporal prospects Specifically, when the benefits and the costs of a choice are separated by time – smoking, borrowing money, investment decisions, working hard for promotion, studying, exercising, dieting, etc. Many (if not all) of our daily life choices are intertemporal choices: o Grocery shopping today for the next week  predict food preferences o Lifestyle choices: smoking, food consumption, exercise o Borrowing money with interest o Studying hard now to get a good job later o Etc….  How could we model and understand intertemporal choices? Make consumptions occurring at different time points comparable. o Figure out how much value we assign now to a consumption (could be a utility = reward or a disutility = pain/cost) that will occur in the future How to do this? We need to find a formula o that translates (i.e., discounts) the utility of the future consumption to a present utility (i.e., present value) OR o that translates (i.e., discount) the utility of the present consumption to a future utility (i.e., future value) Two important terms: o Time preferences = We prefer immediate utility (gratification, reward) over delayed utility (gratification, reward). We prefer things now rather than later. o Time discounting = encompasses any reasons for valuing future utility less – any reasons for discounting it. 4 Standard approach: Discounted Utility Model (DU) (Samuelson, 1938) Forget about the uncertainty of the future and focus on evaluating future consumption! Time-invariant preferences captured in Discounted Utility (DU) model ∞ Xt – utility of consuming X in time t U(x) = ∑δ U(x t ) δ – discount factor, where t t =0 δ=1/(1+r) and r is the discount rate larger r yields to smaller δ  Decision maker whose “r” is.8 will care less (i.e., values future consumption less) about the future than whose “r” is.2. DU is very simple (thus appealing), since all human factors (patience, impatience, feeling states, emotions, memories, etc.) are captured in constant “r” 5 Assumptions of DU 1. Final consumption what matters – we integrate new options into existing plans. 2. Utilities across periods are independent 3. Temporal and atemporal preferences are independent 4. Independence of atemporal preferences from outcomes in other periods 5. Constant discounting 6. Stationary atemporal preferences 7. Positive time preference 8. Diminishing marginal utility of consumption over time In reality, however … We are reluctant to delay imminent consumption of pleasure but more inclined delaying future consumption further away in the future = Giving up consumption now is a greater pain than – as we anticipate – giving up the same consumption later. Overconsuming on short run or immediately, even if this does not correspond to well- being on the long run, e.g, not saving, habit-formation, etc. The reason: Discount rate sharply declines in time causing nonstationary discount rates ( constant/time- invariant discounting) Solution: Time-variant preferences causing present biased behavior and dynamic inconsistency in the behavior Key terms Time-variant preferences: Preferences depend on the time of the consumption. When we discount consumption, we steeply discount those that need to be postponed from now to future BUT we do not discount the same consumption so much when it needs to be delayed from a future time point to a more remote time point. Present biased behavior: Consequence of time-variant preferences. We prefer consuming now than in the future and are willing to give up a significant proportion of the consumption for this. Dynamic inconsistency in the behavior: When we plan a consumption ahead of time (e.g., starting diet) we discount a future consumption much less than how much we discount it when we have to consume that thing on immediately. E.g., : Diet: You think that starting diet next Monday is no problem and eating carrots all Monday will not be as bad as when we actually arrive to next Monday. When, however, you find yourself in next Monday you value eating French fries more than the carrots. You discount the value of the diet (i.e., value of being healthy, etc) on the spot so much that the value of French fries is higher. Illustrating how time-variant preference leads dynamic inconsistent behavior Smaller reward: S Larger reward: B Preference reversal t0 (Ainslie, 1975, Psychol Bull) When both rewards are far off B (in t2) is preferred over S. When you are at t0 and think about t2. However, as t1 becomes closer in time its relative value increases and at t* it dominates B. Illustrating how time-variant preference leads dynamic inconsistent behavior Smaller reward: S Larger reward: B Preference reversal t0 (Ainslie, 1975, Psychol Bull) When both rewards are far off B (in t2) is preferred over S. When you are at t0 and think about t2. However, as t1 becomes closer in time its relative value increases and at t* it dominates B. Illustrating how time-variant preference leads dynamic inconsistent behavior Smaller reward: S Larger reward: B IN OTHER WORDS, WE HAVE SELF-CONTROL PROBLEMS CAPTURED IN DYNAMIC INCONSISTENCY Preference reversal t0 (Ainslie, 1975, Psychol Bull) When both rewards are far off B (in t2) is preferred over S. When you are at t0 and think about t2. However, as t1 becomes closer in time its relative value increases and at t* it dominates B. What this means? Time preferences are not invariant but they vary by how remote the consumption is: o Imminent consumption is heavily discounted o Remote consumption is not so heavily discounted People do not stick to their plans because it hurts more when you have to give up something good on the spot than as you anticipated how much it will hurt in the future 12 In other words … (1) We prefer “less sooner” over “more later” (e.g., one apple today over two apples tomorrow (Thaler, 1981) (2) We prefer immediate gratification over delayed gratification (e.g., cake today VS cake tomorrow) (3) We procrastinate on tasks that impose an immediate cost and delayed reward (e.g., starting going on a diet, saving money, etc.) …and we also display “anomalies” (1) Common Difference effect (Thaler, 1981) We are more sensitive to a given delay if it occurs earlier than later. (x,t) ~ (y,t+k)  (x,t+λ) ≼ (y,t+k+λ) k>0, λ>0, y>x (2) Magnitude Effect (Thaler, 1981, Econ Lett) Discount rates decline with the size of the reward.Example: $15 now ≈ $60 1 year; $250 now ≈ $350 1 year; $3000 now ≈ $4000 1 year; (3) Gain – Loss Asymmetry (Thaler, 1981, Econ Lett) Interest rate for gains are much higher than for losses. In other words, we discount delayed gains more than willing to pay for delaying a loss. You can get 100 Euros next and how much do you want to get next week instead of the 100 Euros now? Say, 110 Euros. BUT! You have to pay 100 Euros now and how much would you willing to pay extra if you would be able to delay paying the 100 Euros by a week? Say, 105 Euros. (4)  Delay – Speed up Asymmetry (Loewenstein, 1988, Man Sci) Delaying a consumption is discounted more than speeding up the same consumption. (3) + (4) = You value your patience more than other people’s (to whom you have to pay the fine, for instance) patience. Captured in hyperbolic discounting (HD) (Loewenstein & Prelec, 1992,QJE) Source: http://images.google.hu/imgres?imgurl=http://3.bp.blogspot.com/_ Exponential disc is steadier HD drops then levels out One consequence: Procrastination We like to delay doing unpleasant things and do more pleasant things instead. E.g.: Starting to prep for exam – we rather see a movie and believe that we will start tomorrow Starting to save – we rather buy this “one last thing” and be more frugal from tomorrow Starting to get exercise – we rather sleep in today and start going in the gym tomorrow. 16 Many, many empirical studies supporting these implications of HD Ariely and Wertenbroch (2002): Procrastination with home-work assignment MBA students have 3 homework assignments; assigned to 3 experimental groups: (1) do the homework whenever they like (2) self-set binding completions dates (with penalties for lateness) (3) instructor-set binding completion dates 17  Results Ariely and Wertenbroch (2002): procrastination. MBA students have 3 homework assignments; assigned to 3 experimental groups: (1) do the homework whenever they like (2) self-set binding completions dates (with penalties for lateness) (3) instructor-set binding completion dates Major findings: binding is helpful for performance (groups 3 & 2 > group 1) some demand for self-control (based on group 2 setting completion dates before the final date) self-set dates not optimal (group 3 > group 2) 18 Are there any individual differences? (O’Donoghue & Rabin, 2001, QJE)  Sophisticated people: Aware that will have self-control problems: Knowing that future preferences will not accord with current preferences, but this prediction is also incorrect  Either succumb or overly refrain (since they are worried about developing a habit and thus overconsuming in the future).  These people can display, for instance, future biases: working too much for a promotion and loose a bunch of utility in the meantime while focusing too much on and assigning too utility to a future promotion (or any kind of event).  Naïve people: Unaware of having self-control problems: Believing that future preferences will accord current preferences  Succumb  Partially naïve people: Aware of having self-control problems, but underestimate its magnitude  displaying projection bias (discussed in this class) Predicting future taste/preferences We often need to make choices now which are realized (i.e., outcome utility) at a later time point o Whom we get married o Where to live o How many kids to have o What to study o Where to spend a vacation o How much to save for retirement But! How can we know our future preferences?  We try to predict them. But, we can only make predictions based on what we know and feel. 20 1. Classic example: Shopping on empty stomach – Predicting hunger …“Shoppers who have not eaten for several hours think, "Surely I will want several bags of corn chips and a couple of cartons of ice cream next week," failing to adjust for the fact that they will often be full during the week and not experiencing the same cravings.” Wilson and Gilbert, 2003. [Consistent with folk wisdom!] -People buy more junk food when shopping on an empty stomach Example: -Imagine that you will have to all the junk food you bought – what will be your utility when consuming? -You adjust to when the consumption would happen (bacon-cheese pringles for b-fast vs bacon- cheese Pringles for lunch)! -But, you are not adjusting by your current level of hunger. The answer is: Not always = Projection bias When predicting future tastes/choices (i.e., preferences), we anchor our predictions to our current states.  STATE DEPENDENT PREFERENCES Order food hungry – we may order a lot and do not take into account satiation. Ordering a very warm sweater when very cold Signing up for another kid when it is very easy with the current one(s) WHY IS THIS? We underappreciate how much our tastes will change and project our current tastes/preferences in the future. This leads to a systematic under/over-appreciation of current states and a hot-cold empathy gap In a hot state we cannot imagine how we will behave in a cold state and vice versa. Implications on many behaviors involving hot states: Sexual behavior – trying to get people to use condoms in the heat of the moment on a class education… Food/Drug craving –a satiated mindset/physiology vastly differs from a non-satiated one… Mental health – interventions – when? When depressed? When not depressed? And many more 22 Intuitively Generalization to all forms of state-dependent preferences Future tastes often differ from current tastes. Recall why! Due to (1) psychological and physiological reasons, (2) habit formations, (3) addictions, (4) maturation. Taste change can be described by changing “states” Ideally, when relevant tastes for decisions that affect the future are the tastes that prevail when consequences are experienced Projection bias = People under-appreciate effects of changes in future states. They project their current preferences onto the future. More formally 𝑈𝑈𝑡𝑡 (𝑐𝑐𝑡𝑡 , 𝑠𝑠𝑡𝑡 ) Utility at time t, 𝑈𝑈𝑡𝑡 , depends on 𝑐𝑐𝑡𝑡 - what you consume and 𝑠𝑠𝑡𝑡 what state you are in. State can be anything that influences your consumption utility: hunger, cold, sex drive, drug craving, past consumption, etc. You need to predict at time t (now) your future utility from consumption 𝑐𝑐𝜏𝜏 when you are in 𝑠𝑠𝜏𝜏 , where 𝜏𝜏 > 𝑡𝑡. 𝑢𝑢 (𝑐𝑐𝜏𝜏 , 𝑠𝑠𝜏𝜏 ) = αu(𝑐𝑐𝜏𝜏 , 𝑠𝑠𝑡𝑡 ) + (1- α)u(𝑐𝑐𝜏𝜏 , 𝑠𝑠𝜏𝜏 ) α is the degree of your projection bias, 0 ≤ α ≤ 1. Measures how much how much you mispredict your future taste. The overestimation is coming from: 1. Resemblances = you overestimate how much your future taste will resemble to your current taste. 2. Impact = you under/overestimate how much that state will influence your utility. Anticipated utility Utility from savoring – waiting for something good to happen, imagine and linger on the thought, image also gives utility  ppl are willing to delay good things Disutility from dreading – dreading something bad to happen decreases its utility  summer romance feels worse if you think about summer ending and your partner travelling away. Or, waiting for a dentistry treatment  you would rather get over it sooner than delaying it.  To avoid dread, we are willing to speed-up the timing of mild discomfort. Not willing to speed up larger loss/discomfort 26 Economic Psychology Choice architecture Linda Dezső 07 and 14 June 2023  What is discussed today 1. Most common problems types 2. Interventions types 3. Asymmetric Paternalism/Libertarian paternalism 4. Taxonomy of policy interventions 5. Choice architecture – nudge 1. Obesity 2. Increasing retirement savings 3. Increasing organ donation 4. Increasing tax compliance through norms nudging 2 Problems that can be addressed (remedied or at least mitigated) by well designed policies 1. Negative externalities: Second-hand smoke 2. Asymmetric information: Laypeople are in an inferior position to judge a competence of a professional: doctors 3. Misaligned incentivizes: Involved party’s incentivizes are in conflict: doctors want to increase revenue (private) while patients want to be healthy at lowest costs 4. Internalities: Delayed cost/benefits of choices which we fail to internalize: health consequences of smoking, bad diet, etc. Internalizing externalities – vaccine uptake avoidance  virus mutates 5. Bounded rationality: Decision-maker succumbs to biased choices 6. All sorts of consumer biases: Taking up too much credit due to present bias 3 The ultimate goal of interventions 1. Reduce harm arising from suboptimal choices – most individual level – “protecting people from themselves” – this is complicated… 2. Increase overall welfare (even though admittedly hard to measure) 4 Ways to remedy these problems with targeted policies 1. Conventional economic policy = economic solutions such as taxes, incentives, regulations to remedy problems arising from externalities, misaligned incentives or information asymmetries. 2. Purely behaviorally focused interventions = solutions address internalities, bounded rationality – Choice architecture – nudging ppl towards more desirable behaviors 3. Hybrid solutions! BUT! Choice architecture is only one of the behaviorally oriented interventions. 5  How it started In 2003 two sets of research teams proposed applying behavioral economics to public policy o One set (C. Camrer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin) - ”Asymmetric Paternalism” o Other set (R. Thaler and C. Sunstein) – “Libertarian Paternalism” They had the same goal: Identify and propose an approach to public policy that would appeal across the political spectrum. 6  Type of problems Problems: 1. Traditional economic E.g.: Negative externalities from producing clothes, second hand smoke E.g.: Information Asymmetries 2. Behavioral E.g.: Internalities E.g.: Bounded rationality 3. Hybrid (Econ+Behav) E.g.: Firms exploiting consumer biases 7 Type of interventions 1. Traditional economic policies Taxes Subsidies Mandatory information disclosure 2. Behaviorally informed policies Choice architecture – nudges 3. Hybrid policies Carefully framed taxes/subsidies* * Recall that framing matters from earlier courses in semester. 8  9 Loewenstein & Chater, 2017, Behavioral Public Policy  Only one without behavioral component Loewenstein & Chater, 2017, Behavioral Public10Policy  With behavioral component Loewenstein & Chater, 2017, Behavioral Public11Policy Cell C Problem = Traditional economic: e.g., second hand smoking or non- smokers also bear the health-care costs of smoking – not only in a social- insurance system but also in private insurance systems Intervention alternatives = 1. Traditional: taxing smoking 2. Behavioral: psychologically informed policies = nudging people against smoking Note, Debate (open question) on how much the system/government should paternalistically intervene into one’s choice his own welfare 12 Cell G Problem = behavioral economic – people do not internalize the cost of smoking when actually smoking because they misestimate risk, are present-biased, or they underappreciate the power of habit formation Intervention alternatives: 1. Traditional: taxing smoking 13 Column BEH: hybrid interventions Psychologically informed traditional economic interventions are mixed so, their impact is enhanced. E.g., you pay them money to do something (traditional approach) that is good for them but the way you design the paying schema includes psychological tricks. Exploiting loss aversion = Make it into a tax than a subsidy – smokers pay taxes rather than nonsmokers getting subsidy Separate rather than integrate tax costs: cigarette price = its tax separately presented – mental accounting Deposit contract – e.g.: steering people into doing regular exercise, or to comply with regular medicine intake. Put own money in fund. Money is lost if goal unmet and doubled when met. 14 Row DEF: hybrid rationales Profit maximizing firms exploit consumer frailties: present-bias, inattentiveness. Pay-day loans Large penalties for overdrawing from bank account Penalties if someone spends LESS than the credit card limit (crazy, right?) Etc…  they take advantage of people’s limited/bounded rationality Here you need to …: 1. test with some behavioral analysis whether people would notice and respond to any information. E.g.: would they notice if pay-day loans interest rates and how they compound are explicitly stated? 2. Analyze with conventional econ analysis what borrowers will do if pay-day loans are banned and how would firms react to these regulations. 15  Nudges are only 1/9 of interventions options Loewenstein & Chater, 2017, Behavioral Public Policy 16 This implies Many interventions need to address problems both on their structural root and on the level of individual biases. However, structural reforms are often politically loaded and take long to carry out. In the meantime, marginal nudges can make some progress/improvement on the individual level (e.g., loosing weight) with perhaps some broader societal implication (e.g., defaulting people into being an organ donor) 17 Examples for nudging towards more beneficial behaviors 18 Choice architecture to nudge people towards optimal behaviors “…any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap” (Sunstein & Thaler, 2008) Easy to implement Cheap to implement Overt and not covert No restriction on choice – preserve the freedom of choice No forcing into any options - preserve the freedom of choice No changing of the incentive structure Remember: Nudge is only one of multiple tools to incorporate behavioral insights into public policy! 19 Problems where nudging could work/have work/ed 1) (Fighting against) obesity – no much success 2) Retirement saving – clearly successful 3) Increase organ donation – clearly successful 4) Getting people pay their tax dues – successful 20 1. Obesity is a huge problem This is only obesity – much more people are overweight! Source: www.hivehealthmedia.com 21 https://www.oecd.org/els/health-systems/Obesity-Update-2017.pdf Source: www.hivehealthmedia.com  Who is obese and who is overweight? “Overweight and obesity are defined as abnormal or excessive fat accumulation that presents a risk to health. A crude population measure of obesity is the body mass index (BMI), a person’s weight (in kilograms) divided by the square of his or her height (in metres). A person with a BMI of 30 or more is generally considered obese. A person with a BMI equal to or more than 25 is considered overweight.” https://www.who.int/topics/obesity/en/ 23 Summary Obesity is one of the leading risk factors for premature death. It was linked to 4.7 million deaths globally in 2017. 8% of global deaths were attributed to obesity in 2017. There are large differences – 10-fold – in death rates from obesity across the world. 13% of adults in the world are obese. 39% of adults in the world are overweight. One-in-five children and adolescents, globally, are overweight. Obesity is determined by the balance of energy intake and expenditure. Rates have increased as the calories have become more readily available. Source: https://ourworldindata.org/obesity 24 Health behavior – Overweight & Obesity Overweight and obesity impose a huge cost on health-care and on society, Overweight and obesity are the fifth leading risks for death: Consequences: - cardiovascular diseases (mainly heart disease and stroke), which were the leading cause of death in 2012; - diabetes; - musculoskeletal disorders (especially osteoarthritis – a highly disabling degenerative disease of the joints); - some cancers (including endometrial, breast, ovarian, prostate, liver, gallbladder, kidney, and colon). (source: https://www.who.int/news-room/fact-sheets/detail/obesity-and-overweight) The problem is getting worse rapidly BUT! It is preventable - needs a combination of local and also structural changes Causes of deaths Load this link: https://ourworldindata.org/obesity - how this changes by year. Source: https://ourworldindata.org/obesity 26 Main reasons: Bad diet, little/lack of exercise, decreased physical activity and structural problems Source: https://www.who.int/news-room/fact-sheets/detail/obesity-and-overweight Individual reasons could be explained by preference toward immediate gratification and present bias: Eating unhealthy food young/early ages and then, this consumption backf