Three waves of Behavioral Economics
1) Identify ‘‘anomalies’’ of economic theory and some alternatives conceptualizations
2) Formalize these alternatives in models and identify empirical validation
3) Fully integrate into economic analysis by embedding old and new assumptions as special cases of general models and formulate new theoretical results, empirical tests, and applications
Two premises of third-wave behavioral economics
Premise 1: Adding untraditional assumptions does not at all mean abandoning traditional methods.
Premise 2: Adding untraditional assumptions does not mean abandoning traditional assumptions.
Ways greater psychological realism can improve economic analysis
- Explaining behavior studied by economists that traditional analysis has had difficulties explaining
- Explaining behavior that seems economically important enough that one would have thought economists would have been studying—but haven’t been.
- Beyond explaining behavior, better understand normative/hedonic effects of observed behavior.
- Often by making our models more complicated and less tractable but more realistic in a trade off on the scale of what economists do all the time (when invoking more familiar assumptions)
Some concerns - 1
- More realistic preferences (Reference Dependence & Social Preferences)
Some concerns - 2
- Present-Biased Preferences
- Tendency to overpursue immediate gratification vs longterm preferences.
- Present bias:
-> Today matters more than the future and
-> Today we care roughly equally about well-being on any two future dates, - But when the future arrives and the first of these dates
becomes ‘‘today’’, then we care more about that first
date than about the second date - Exponential model is wrong
Some concerns - 3
- Quasi-Utility Maximization
Behavior reflects maximization of coherent utility function at
each moment in time
Focusing effects: We only consciously make choices in an infinitesimal percentage of the infinite number of choice sets we actually have available (too much importance on single detail)
Narrow bracketing: We don’t fully integrate our decisions with other decisions even when clear our utility would be higher if we did.
Mispredictions implications
1) Addiction/Habit Formation
2) Many Hard-toReverse Decisions (HOT)
3) Benefits of Cooling Off
4) Excess wealth-seeking/consumption
Prospect Theory: Summary
Prospect theory is a suitable replacement for EU because it can explain the economics anomalies mentioned as well as the regular phenomena EU explains.
However one weakness of prospect theory is the somewhat arbitrariness of reference point adjustment → it adjusts to tell whatever story it needs to.
The prospect theory says that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses
Value Function: Prospect Theory
- Changes in wealth or welfare, rather than the utility function for final
wealth levels as in EU - Gains and losses are defined relative to a reference point
- Perceptions are characterized by diminishing marginal sensitivity
- Loss aversion
Expected Utility Theory
Completeness, transitivity, continuity, and independence imply:
1) Linear expectation of a utility function
2) Asset integration–gambles are evaluated by integrating gains or losses with current wealth
Allais paradox
The Allais paradox is a choice problem designed to show an inconsistency of actual observed choices with the predictions of expected utility theory
Endowment effect
Endowment Effect: the phenomenon whereby people value a good or service once they actually possess it or the property right to it.
Loss aversion: The contribution of Behavioral Economics
Loss aversion towards the object implies that this will be higher than WTP.
Coase Theorem
Coase theorem is the idea that under certain conditions, the issuing of property rights can solve negative externalities
In the standard case, final allocation of resources should not depend on the initial assignment of property rights and an efficient solution could be reached
Expected Utility theory vs Property Theory
Expected Utility theory assumes individuals will choose the outcome which gives maximum utility given the probability of outcomes. Prospect theory allows for the fact that individuals may choose a decision which doesn’t necessarily maximise utility because they place other considerations above utility.
Time Inconsistency
- When the optimal decision at one point in time is no longer the optimal choice at another point in time
Time Inconsistency: What is the explanation and the alternative proposed by Behavioral Economics?
- Preferences are dynamically inconsistent because we do not discount all time periods uniformly (exponential discounting) → Discount factor differs among periods
- We overweight time periods that are closer to the present relative to time periods that are further in the future.
Hyperbolic discounting
Where people choose smaller, immediate rewards rather than larger, later rewards.
(people exaggerate discounting)
For example, we exhibit a higher discount rate between now and 1 year from now than over 7 years from now and 8 years from now.
Magnitude effect
Gains tend to be discounted more heavily than losses; that is, people are more patient for losses than they are for gains.
Magnitude effect or the amount effect – people tend to be more
patient as the amounts at stake rise
Commitment
Wertenbroch Experiment
- The “rational choice” would be to set all deadlines for the last day,
and then have the flexibility of setting your own deadlines. - However, the majority of deadlines were set before the last day,
suggesting that students do indeed demand commitment. - Performance was higher under the exogenous imposed deadlines than
under the self-imposed ones
Heuristics
Heuristics approximate a solution with little deliberation cost, but have
the potential to make systematic errors. (Mental shortcuts)
A heuristic is a mental shortcut that allows people to solve problems and make judgments quickly and efficiently.
Base Rate Neglect: our tendency to give more weight to the event-specific information than we should, and sometimes even ignore base rates entirely
Law of Small Numbers: people overestimate what can be accomplished with a small study
Gambler’s Fallacy
Misperception of chance and randomness even when the
sequence is short
After a long run of red on a roulette wheel, people believe that black is now “due” so that the wheel can correct itself
Illusion of Control
People believe that they can have an influence outcomes over events that they have no control over
- When rolling dice for craps, people tend to throw harder for high numbers and softer for low numbers
2 Availability heuristic
People often assess the probability of an event by the ease of which instances of its occurrence springs to mind (Likelihood of a middle-aged heart attack by recalling such occurrences among one’s acquaintances)
