Module 7 - Understanding How Behavioural Economics Impacts Decision Making

Question 1

Explain the premise of behavioural economics.

Answer 1

“Behavioural economics” is a subfield of economics that draws on the psychological, social and cultural foundations of human decision making. It uses psychological experimentation to develop theories about decision making and has identified a range of “biases” (i.e., judgments that deviate from what would be considered desirable from the perspective of accepted norms or correct in terms of formal logic) that occur as a result of the way we think and feel.

The premise of behavioural economics is that we are not always self-interested, benefits-maximizing and costs-minimizing individuals with stable preferences— Our thinking is subject to insufficient knowledge, feedback and processing capability, which often involves uncertainty and is affected by the context in which we make decisions. Most of our choices are not the result of careful deliberation. We are influenced by readily available information in memory, automatically generated affect and salient information in the environment. We also live in the moment, in that we tend to resist change and are poor predictors of future behaviour, subject to distorted memory and affected by physiological and emotional states. Finally, we are social animals with social preferences, such as those expressed in trust, reciprocity and fairness; we are susceptible to social norms and a need for self-consistency.

Behavioural economics challenges the traditional theories regarding how we perceive value and express preferences.

Question 2

Outline the basic premise of rational choice theory.

Answer 2

Rational choice theory assumes that individuals have stable preferences and engage in maximizing behaviour. Decisions are the result of a careful weighing of costs and benefits and are informed by existing preferences. Optimal decisions are always made.

Question 3

Outline the basic premise of prospect theory.

Answer 3

“Prospect theory” is a behavioural model that shows how we decide between alternatives that involve risk and uncertainty. It demonstrates that we think in terms of expected utility relative to a reference point (e.g., current wealth) rather than absolute outcomes. Prospect theory was developed by framing risky choices. Responses are different if choices are framed as a gain or a loss (e.g., the one-month survival rate on a surgery is 90%, or there is a 10% mortality rate in the first month). Prospect theory suggests that we are risk-averse, and since we dislike losses more than an equivalent gain, we are more willing to take risks in order to avoid a loss. Decisions are not always optimal. Willingness to take risks is influenced by the way in which choices are framed, i.e., it is context-dependent.

Question 4

Explain how reference dependence influences our perceptions of value among decision choices.

Answer 4

“Reference dependence” is one of the fundamental principles of prospect theory and behavioural economics more generally. In prospect theory, we make decisions based on a consideration of changes in values from a reference point, rather than on the basis of absolute values. The reference point is the benchmark. When we evaluate whether or not we like something, we tend to implicitly ask ourselves, “Compared to what?” and then classify gains and losses. Reference dependence can apply to any decision involving risk and uncertainty. This psychological phenomenon is widespread.

Question 5

Explain the premise of bounded rationality

Answer 5

“Bounded rationality” is a concept that challenges the notion of human rationality as implied by the concept “homo economicus” (i.e., a view of humans in the social sciences, particularly economics, as self-interested agents who seek optimal, utility-maximizing outcomes). The premise of bounded rationality is that decision makers work under three unavoidable constraints:

(1) Only limited, often unreliable information is available regarding possible alternatives and their consequences.
(2) The human mind has only limited capacity to evaluate and process the information that is available.
(3) Only a limited amount of time is available to make a decision.

Therefore, even those of us who intend to make rational choices are bound to make “satisficing” (rather than maximizing or optimizing) choices in complex situations.

Question 6

Explain how the nature of the feedback we receive contributes to bounded rationality

Answer 6

Good information, experience and prompt feedback are key factors that enable individuals to make good decisions. However, good information, experience and prompt feedback are not always easy to obtain. Feedback is often limited to broad-based information. Broad-based information, which includes economic costs of the unhealthy behaviour and its potential health consequences, induces health-related behavioural change. Personal feedback on the implications of our own health choices is often delayed, and we are more likely to get feedback on previously chosen health choices than rejected ones. For example, because the effect of smoking on cells and internal organs is usually not visible, its impact is not noticeable for many years.

This type of feedback may not impact decision making. Feedback from behaviour-change programs, such as those employing smartphone stop-smoking apps that provide positive and personalized behavioural feedback (e.g., the number of cigarettes not smoked and money saved), along with the traditional information about health improvement and disease avoidance may have more impact on decision making.

Question 7

Explain how loss aversion can influence behaviour.

Answer 7

“Loss aversion” is an important behavioural economics concept associated with prospect theory and is encapsulated in the expression “losses loom larger than gains.” It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining, and since we are more willing to take risks to avoid a loss, loss aversion can explain differences in risk seeking vs. risk aversion. Loss aversion has been used to explain the endowment effect bias and sunk cost fallacy bias.

“Endowment effect bias” occurs when we overvalue a good that we own, regardless of its objective market value. It is evident when we become relatively reluctant to part with a good we own for its cash equivalent or if the amount that people are willing to pay for the good is lower than what we are willing to accept when selling the good. Put more simply, we place a greater value on things once they have established ownership. This is especially true for goods that wouldn’t normally be bought or sold on the market, usually items with symbolic, experiential or emotional significance.

We commit the “sunk cost fallacy bias” when we continue a behaviour or endeavor as a result of previously invested resources (i.e., time, money or effort). This fallacy can also be viewed as bias resulting from an ongoing commitment. Commitments are often used as tools to counteract our lack of willpower and to achieve behaviour change, such as in the areas of dieting or saving—the greater the cost of breaking a commitment, the more effective it is. By setting goals, we identify a particular value as a reference point against which to measure performance. If we do not meet the goal, we are likely to experience the disappointment as a loss.

Question 8

Explain how mental accounting can influence behaviour.

Answer 8

The overarching notion behind “mental accounting” is that we think of value in relative rather than absolute terms. For example, we derive pleasure not just from an object’s value, but also from the quality of the deal—its “transaction utility.” We often fail to fully consider opportunity costs and are susceptible to the sunk cost fallacy. We treat money differently, depending on such factors as the money’s origin and intended use, rather than thinking of it in terms of formal accounting. An important term underlying the mental accounting theory is “fungibility” (i.e., money is substitutable—Two $10 bills are viewed the same as one $20 bill). Mental accounting leads us to treat assets as less fungible than they really are. We frame or categorize them as “belonging to” current wealth, current income or future income. Marginal propensity to consume (i.e., the proportion of a rise in disposable income that is consumed) is highest for money in the current income account and lowest for money in the future income account. For example, small windfalls (e.g., a $50 lottery win) are generally treated as current income that is likely to be spent, whereas large windfalls (e.g., a $5,000 bonus at work) are considered wealth.

Question 9

Outline the basic premise of the dual-system theory.

Answer 9

The dual-system theoretical framework explains why our judgments and decisions often do not conform to formal notions of rationality. It assumes we have two systems of thinking. System 1 consists of thinking processes that are intuitive, automatic, experience-based and relatively unconscious. System 2 is more reflective, controlled, deliberative and analytical. System 1 is also called the “automatic system,” and System 2 is also called the “deliberative system.”

Question 10

Outline the most significant differences between the behavioural model of decision making and the standard economic model.

Answer 10

A behavioural model of decision making expands on the factors that influence decision making that are identified in the standard economic model. Two of the most significant factors not considered in the economic model are:

(1) We may process only the information that is most salient to us, filtering out some information. A piece of information is “salient” when it stands out, is novel or seems relevant against other pieces of information. Salience may lead us to miss key information and overlook critical consequences. The way in which information is presented has a great influence on whether it is absorbed and how judgments are reached. Salient cues can be provided in many ways, e.g., emphasizing negative or positive facts or rearranging the physical environment, for instance, placing water bottles close to the cashier in a grocery store.
(2) There may be a mismatch between intentions and actions. This is called the “intention-action divide.” Even if we understand the full consequences of our actions, we may make decisions that favour the present at the expense of the future, so we consistently fail to carry out plans that match our goals and fulfill our interests.

Question 11

Compare the automatic and deliberative systems of thinking. Provide examples of activities that are more likely to be primarily automatic and primarily deliberative.

Answer 11

Automatic System/System 1
Considers what automatically comes to mind (narrow frame)
Relatively unconscious
Effortless
Associative
Intuitive
Fast
Examples of use include speaking in your mother tongue, taking the daily commute and desiring cake.

Deliberative System/System 2
Considers a broad set of relevant factors (wide frame), all choices and possible outcomes
Controlled
Effortful
Based on reasoning/analysis
Reflective
Slow
Examples of use include learning a foreign language, planning an unfamiliar journey and counting calories.

Question 12

Explain why we tend to rely on the automatic vs. deliberative system of thinking to make decisions

Answer 12

When faced with a decision, we simplify the problem by making a representation of it in our heads and then reaching a judgment or decision based on that simplification. To do this, we can access both systems of thinking. Deliberative thinking, as when solving a difficult math problem or in trying to overcome an impulse in acts of self-control, is hard. It is cognitively taxing and can be exhausting. Our capacity to engage in it is limited. It is difficult to spend even a few minutes focusing attention in a concentrated manner. When we are under cognitive strain, it is even more difficult to access the deliberative system. Most of the time we use another mode of thinking with relatively little interference from the deliberative system—as when we detect anger in a face or make sense of speech in a fraction of a second. This is automatic thinking. Our minds are operating in automatic mode; thinking is effortless, fast and largely outside voluntary control. We evaluate alternatives quickly, based on what automatically comes to mind; rarely considering all the alternatives. Although often perfectly capable of more careful analysis, we are hardwired to use just a small part of the relevant information to reach conclusions. The mental reserves for this kind of thinking are vast.

Question 13

Differentiate between framing the way choices are described and framing as part of decision making.

Answer 13

The term “frame” applies to descriptions of decision problems at two levels:

(1) Description and presentation: The way choices are described and presented to decision makers is called a frame. This level of framing concerns what is done to the decision maker. Different types of framing approaches have been identified (e.g., risky choice framing, attribute framing and goal framing). Choices can be worded in a way that highlights the positive or negative aspects of the same decision, leading to the “framing effect”—changes in their relative attractiveness.

(2) Interpretation and mental editing: This level of framing concerns what the decision maker does; a part of decision making resulting in interpretations that we construct for ourselves, based on the way we mentally edit and interpret the information we receive. When situations are complex, ambiguous or entail missing information, heuristics, default assumptions and other mental models that we bring to a problem influence what we pay attention to and how we interpret what they perceive.

Question 14

Contrast the terms “heuristics” and “cognitive biases.”

Answer 14

“Heuristics” are commonly defined as cognitive shortcuts or rules of thumb we apply using our automatic thinking processes. The application of heuristics is often associated with cognitive biases. Use of heuristics simplifies decision making. Heuristics can work well or can turn into harmful cognitive biases. “Cognitive biases” are the systematic (i.e., nonrandom) errors in thinking we may be left with when we make decisions. A cognitive bias is a “systematic” error, in the sense that a judgment deviates from what would be considered desirable from the perspective of accepted norms or correct in terms of formal logic.

Question 15

Affect Heuristic

Answer 15

This represents a reliance on good or bad feelings experienced in relation to a stimulus. Affect-based evaluations are quick, automatic and rooted in experiential thought that is activated prior to reflective judgments. They are more pronounced when we do not have the resources or time to reflect. For example, reading the words “lung cancer” usually generates an affect of dread, while reading the words “mother’s love” usually generates a feeling of affection and comfort.

Question 16

Anchoring Heuristic

Answer 16

Initial exposure to a number serves as a reference point, influencing subsequent judgments about value. The process usually occurs without our awareness and sometimes occurs when our price perceptions are influenced by reference points. For example, the price of the first house shown to us by a real estate agent may serve as an anchor and influence perceptions of houses subsequently presented to us (i.e., as relatively cheap or expensive).

Question 17

Availability Heuristic

Answer 17

We make judgments about the likelihood of an event based on how easily an example, instance or case comes to mind. For example, as investors, we may judge the quality of an investment based on information that was recently in the news, ignoring other relevant facts.

Question 18

Recognition Heuristic

Answer 18

A conceptually similar heuristic to availability, recognition is an easily accessible cue that simplifies decision making and indicates that sometimes less knowledge can lead to more accurate inferences. For example, in judging which one of two cities had the greater population size, the vast majority of us will base our choice on recognition of the city name.

Question 19

Representativeness Heuristic

Answer 19

We judge the probability that an object or event A belongs to class B by looking at the degree to which A resembles B. For example, consider the following problem: Bob is an opera fan who enjoys touring art museums when on holidays. Growing up, he enjoyed playing chess with family members and friends. Which situation is more likely?

• Bob plays trumpet for a major symphony orchestra.
• Bob is a farmer.

A large proportion of us will choose the first option in the above problem, because Bob’s description matches the stereotype we may hold about classical musicians rather than farmers. When we use this heuristic, we neglect information about the general probability of the second option occurring. In reality, the likelihood of Bob being a farmer is far greater, because farmers make up a much larger proportion of the population.

Question 20

1/N Heuristic

Answer 20

A trade-off heuristic that assigns equal weights to all cues or alternatives. Resources are allocated equally to each of N alternatives. For example, we often hedge our money in investments by allocating equal amounts to different options. 1/N is a form of naive allocation of resources.

Question 21

Scarcity Heuristic

Answer 21

When an object or resource is less readily available (e.g., due to limited quantity or time), we tend to perceive it as more valuable. For example, product descriptions like “exclusive limited edition” or “new edition” can increase our willingness to pay more than we would if the product was not advertised as new or scarce.

Question 22

Take-the-best heuristic

Answer 22

A simple decision-making shortcut that we may apply when choosing between alternatives. It is a one-reason decision rule, a type of heuristic where judgments are based on a single “good” reason only; the one attribute that is perceived to discriminate most effectively between the options. For example, voters’ perceptions of how candidates would handle the single issue that voters regarded as most important.

Question 23

Explain the impact of confirmation bias on judgment and decision making. Provide an example.

Answer 23

Our reliance on automatic thinking means that the power of merely providing information to influence decision making is limited. “Confirmation bias” is the tendency to automatically interpret information in ways that support prior beliefs and gives rise to a biased information search. It occurs when we seek out or evaluate information in a way that fits with our existing thinking and perceptions. It contributes to overconfidence in personal beliefs. We may fail to recognize that we do not know what we claim to know, and we may fail to learn from new information. Persuasion and education must engage with the automatic system to overcome resistance to new points of view.

Question 24

Explain the impact of anchoring bias on judgment and decision making.

Answer 24

“Anchoring bias” is an extreme example of automatic thinking. It is a particular form of priming effect whereby initial exposure to a stimuli serves as a reference point, influencing subsequent judgments about value. The “prime” consists of meanings (e.g., words or numbers) that activate associated memories (models, stereotypes, attitudes, etc.). Sometimes the anchor will be obvious and appropriate. But sometimes the anchor will be inappropriate; the automatic system is grabbing on to anything it can to help it in its interpretation of a choice context. The aspect of the environment may have no direct relevance to a decision, but it nonetheless affects judgments. Anchoring bias usually occurs without our awareness and sometimes occurs when our price perceptions are influenced by reference points. Even subliminal anchors can affect judgment. These effects have also been shown in consumer behaviour whereby not only explicit slogans to buy more (e.g., “Buy 18 ice cream bars for your freezer”) but also purchase quantity limits (e.g., “limit of 12 per person”) or “expansion anchors” (e.g. “101 uses!”) can increase purchase quantities.

Question 25

Explain how present bias can create an intention-action divide. Provide an example.

Answer 25

Underlying many intention-action divides is “present bias,” an overweighting of the present relative to the future that results in inconsistencies in choices over time. Achieving goals often requires incurring a cost in the present for a payoff in the future. Since the present is more salient than the future, we tend to overweigh the costs relative to the benefits. The tendency increases the farther away the deadline lies. Later, we feel regret.

Question 26

Explain the concept of the “peanuts effect” bias. Provide an example.

Answer 26

The “peanuts effect” occurs when we do not consider the consequences of a small dollar transaction because we view small amounts of money as peanuts; as a result, they incur high costs or forgo lucrative opportunities. One of the most common examples is payday loans—If lenders highlight the small dollar cost of the transaction (e.g., $15 for a two-week loan of $100), we may be misled by the apparently low costs and fail to add up in our own minds the costs over time, thus failing to recognize the high implicit interest rate of the loans.

Question 27

Explain the concept of “money illusion” bias and its impact on decision making. Provide an example.

Answer 27

Reference points are behind what economists call “money illusion.” For example, research suggests that many of us would prefer a 6% income raise when there is a 4% inflation over a 3% raise with no inflation. We would prefer the former option, which is expressed in high numerical terms, even though the real dollar value of the latter option is higher. Reference points can mislead when they are established in terms of nominal rather than real values.

Question 28

Explain the significance of intertemporal choice and the dual-self model for savings behaviour.

Answer 28

“Intertemporal choice” is the study of how we make choices about what and how much to do at various points in time, when choices at one time influence the possibilities available at other points in time. Choices are influenced by the relative value we assign to two or more payoffs at different points in time. Most choices require decision makers to trade off costs and benefits at different points in time. Generally we are biased toward the present and tend to discount the future.

The “dual-self model” deals with the inconsistency between the patient long-run self and myopic short-run self. With respect to savings behaviour, concepts of the farsighted planner and myopic doer have been used to describe these dual selves. At any point in time, there is a conflict between those selves with two sets of preferences. Practically oriented research on savings behaviour has attempted to make us feel more connected to our future selves, making them appreciate that they are the future recipients of current savings. In an experiment, participants who were exposed to their future (as opposed to present) self in the form of an age-progressed avatar in virtual reality environments allocated twice as much money to a retirement account.

Question 29

Explain the significance of present bias to time (temporal) discounting theories.

Answer 29

According to “time discounting theories,” we weight present events more heavily than future ones. For example, many of us prefer to receive $100 now over $110 in a month’s time. Discounting is nonlinear, and its rate is not constant over time. Our preference for receiving $100 a week from now vs. $110 a month and one week from now will not be the same as our preference for receiving $100 a year from now vs. $110 a year and one month from now. Although the gap is one month in both cases, the value of events that are farther in the future falls more slowly than those closer to the present.

Once rewards are very distant in time, they cease to be valuable. Delay discounting can be explained by impulsivity and a tendency for immediate gratification. Hyperbolic discounting theory suggests that discounting is not time consistent. It is neither linear nor occurs at a constant rate. We are happier to wait an extra month for a larger reward when it is in the distant future. In hyperbolic discounting, values placed on rewards decrease very rapidly for small delay periods and then fall more slowly for longer delays.

Question 30

Explain how diversification bias and (hot-cold) empathy gap can contribute to time inconsistency in judgment and decision making.

Answer 30

“Time inconsistency” occurs when our present self fails to predict accurately the preferences of our future self, a point illustrated well by diversification bias. For example, if we make combined choices of quantities of food when shopping for multiple future consumption episodes (e.g., breakfast cereal for the next month), we may choose the variety pack of cereal, only to realize two weeks later that we would have enjoyed breakfasts more if we had just stuck to our favourite cereal. In the case of food, diversification bias should be particularly strong if we make a purchasing decision when satiated (e.g., right after a meal). This inability to appreciate fully the effect of emotional and physiological states on decision making is known as the “(hot-cold) empathy gap.” This gap occurs when we underestimate the influence of visceral states (e.g., being angry, in pain or hungry) on our behaviour or preferences. For example, in medical decision making, a hot-cold empathy gap may lead to undesirable treatment choices if, as a cancer patient, we are asked to choose between treatment options right after being told about our diagnosis.

Question 31

Explain the significance of forecasting and memory to judgment and decision making.

Answer 31

When we make plans for the future, we are often too optimistic. We are subject to committing the planning fallacy by underestimating how long it will take us to complete a task and ignoring past experience. Planning fallacy is an example of the overconfidence effect, observed when our subjective confidence in our own ability is greater than our objective (actual) performance. Similarly, when we try to predict how we will feel in the future, we may overestimate the intensity of our emotions. The level of happiness that we expect to feel during our next vacation, for example, is likely to be higher than how we will rate it during the actual experience. There are different explanations for this error, including how we remember past events. Our memory of a past holiday is likely to be nonrepresentative of the holiday overall, and we may evaluate the last vacation based on the most pleasurable points and its end, for example, rather than the average of every moment of the experience (the “peakend rule”). Finally, as vacation days go by, we will simply get used to it, and happiness will level out. According to the concept of hedonic adaptation, changes in experiences tend only to induce happiness temporarily as we get used to new circumstances.

Question 32

Describe the underlying premise of the social dimension of behavioural economics.

Answer 32

Behavioural economics does not assume that humans make choices in isolation or to serve their own interest. Aside from cognitive and affective (emotional) dimensions, an important area of behavioral economics also considers social forces, in that decisions are made by individuals who are shaped by—and embedded in—social environments.

Question 33

Explain the significance of trust and dishonesty for judgment and decision making.

Answer 33

Trust is one of the explanations for discrepancies between actual behaviour and that predicted by a model of self-interested actors. Trust makes social life possible and permeates economic relationships; it has been related to positive economic outcomes, such as macro level economic growth and micro level intrinsic motivation and work performance. While trust can make us vulnerable, and thereby reflect risk preferences, it may also be the result of social preferences. For instance, trust has been linked to the concept of betrayal aversion; we take greater risks when we are faced with a given probability of bad luck than the same probability of being cheated by another person.

While, in standard economics, dishonesty can be seen as a natural by-product of actors with self-interested motives, in human relationships, deception is often considered a violation of trust. The behavioural economics perspective does not consider humans to be more honest; rather, it takes a more social-psychological perspective by showing that dishonesty is not just about trade-offs between external incentives (such as material gain) and costs (such as punishments). Dishonesty is the product of situations as well as both internal and external reward mechanisms, which often involve self-deception—the reframing of dishonest acts (e.g., not declaring all of your income to the tax authorities) in a way that makes them appear less dishonest.

Question 34

Explain the significance of fairness and reciprocity for judgment and decision making.

Answer 34

Our resistance to unfair outcomes is known as “inequity aversion,” which occurs when we prefer fairness and resist inequalities. In some instances, inequity aversion is disadvantageous, since we are willing to forego a gain in order to prevent another person from receiving a superior reward. Inequity aversion has been studied through experimental games, such as dictator, ultimatum and trust games. “Fairness” is related to a human desire for reciprocity, our tendency to return another’s action with another equivalent action. Reciprocity, however, can have positive and negative aspects. Research in this area has shown that our responses to positive actions are often kinder than a self-interest model would predict. For example, charities sometimes use reciprocity to their advantage. One field experiment investigating donation behaviour showed that people who received a large gift with a donation solicitation letter had a 75% higher donation frequency compared to a no-gift baseline condition. On the flipside, reciprocity can also lead to punitive responses to negative actions.

Question 35

Explain the significance of social norms for judgment and decision making.

Answer 35

“Social norms” are implicit or explicit behavioural expectations or rules within a society or group of people. Social norms signal appropriate behaviour. They are an important component of identity economics, which consider economic actions to be the result of both monetary incentives and people’s self-concepts. Norms vary across cultures and contexts. For example, while market norms would dictate that payment is required for a good or service, social norms are quite different—You pay for a meal in a restaurant but would not offer to pay a family member for the meal that he or she has prepared for you. Sometimes social norms of exchange, such as reciprocity and market norms, coexist in the same sphere. For instance, while market exchange norms dictate that I will charge a client for a consulting job, I may also give that client free advice, on some occasions, in the hope that the favour will be reciprocated in the future.

Question 36

Explain the role of consistency and commitment for judgment and decision making.

Answer 36

Human susceptibility to feedback about social norms is related to our desire to maintain a positive view of who we are as a person. When the outcome of an action threatens this desire, we may change our behaviour, though we often simply change our attitudes or beliefs. When this happens, we usually resort to rationalization, which is a form of cognitive dissonance reduction. Unlike the rational choice view of human decision making, where preferences guide choices, rationalization implies the opposite—Sometimes preferences can justify actions after the fact.

Question 37

Explain the significance of cognitive dissonance to behavioural economics.

Answer 37

Cognitive dissonance is an important concept in social psychology. It refers to the uncomfortable tension that can exist between two simultaneous and conflicting ideas or feelings—often as we realize we have engaged in a behaviour inconsistent with the type of person we like to be or want to be seen publicly to be. According to the theory, we are motivated to reduce this tension by changing our attitudes, beliefs or actions. For example, a smoker rationalizing his or her behaviour by holding self-exempting beliefs, such as “The medical evidence that smoking causes cancer is not convincing” or “Many people who smoke all their lives live to a ripe old age, so smoking is not all that bad for me.” Arousing dissonance (uncomfortable tension) can be used to achieve behavioural change.