Key Terms Flashcards
What are the influences on decisions in markets?
- Economic expectations: conjectures about future economic events, based on three sources:
a) Past experiences
b) Learning processes
c) Knowledge and opinion about new circumstances - Consumer sentiment, “Consumer Climate”: Consumers’ expectations and intended actions Consumer sentiment and economic context
Which Consumer Sentiment Indices are there?
- Univesity of Michigan Consumer Sentiment Index: measures consumers’ subjective feelings about their indivdidual financial situation and overall economic conditions at present and in the future
- EU Consumer Sentiment Index: scores the consumers’ subjective views
- Conference board index
What is the profit maximisation principle?
Maximum result possible with the given quantity of resources
What is the cost minimisation principle?
Given result with minimum of resources
What are the axioms of preferences?
Basic assumptions about preferences that form the core of the rationality assumption
a) Completeness (A≥B; A≤B; A≈B)
actors can rank alternatives into a preference order
b) Transitivity (if A≥B and B≥C, then A≥C)
consistent preference order over alternatives
c) Reflexivity (A≈A)
every bundle of alternatives is just as good as itself
d) Non-satiation
actors prefer to possess more of a good and not less
e) Continuity
loss of a specific quantity of Good A can be compensated with receiving a specific quantity of another Good B
f) Convexity
actors possessing a small amount of Good A and a large amount of Good B will only be indifferent to the loss of part of A if they receive a proportionally larger quantity of B in return
What is homo economicus?
- Basic assumptions in economics: utility maximisation and rationality
- Homo economicus: paradigm of a utility-maximising and rationally behaving actor
• (neo-)classical economics
• Adopted by some psychological theories
What are psychological theories based on homo economicus?
- Exchange theories: relationships as exchange of material and immaterial resources
- Theses on social interaction (Nye, 1979)
• People making rational decisions
• People act and react in social interactions
• Benefits with some costs
• Behavioural patterns that have been rewarded in the past are repeated
• If no behavioural alternative promises a profit, people will attempt to hold costs as low as possible
• People are satisfied in their interactions when they get what they think they deserve
• Social contact is based on the norm of reciprocity
What are challenges to homo economicus?
Core question whether people actually want and are able to pursue their goals in the best possible, economically rational ways
What is economic psychology?
“Economical Psychology studies the psychological mechanisms and processes that underlie consumption and other economic behaviour. […]”
What is financial psychology?
- Studies experience and behaviour when dealing with money or highly liquid investments
What are similarities and differences between economic and financial psychology?
- Economics and psychology: similar interests, but also differences
• Approach: fundamental assumptions (prediction) vs inductive (theory)
• Methods: mathematical models vs statistical inference
• Data: aggregate and objective data vs observational and subjective data - Experiments
• Both in behavioural economics and economic psychology
• Differences in focus on learning, non-deception, financial incentives
What are decisions under certainty?
- Decisions where no probabilities are involved regarding the consequences of alternatives
- Decision-makers possess complete information about all possible alternatives and certainty about their consequences
What are decisions under uncertainty?
- Decisions where the consequences of alternatives do only occur with some probability
- Risky decisions: probabilities of consequences of alternatives are known
- Ambiguous decisions: probabilities of consequences of alternatives are only vaguely known
Which effects happen when it comes to preferences over decision types?
- Decisions under certainty to decisions under uncertainty
- Risky decisions to ambiguous decisions
• Ambiguity effect: decision-makers prefer risky decisions to ambiguous decisions
• Ellsberg paradox: decision-makers behave inconsistently between two formulations of the decision situation that have mathematically identical possible gains but differ in ambiguity. Demonstrates the ambiguity effect
What is the St. Petersburg paradox?
- Expected value theory
• Expected value = sum of products of probability and payoff
• Choose option with highest expected value
• St. Petersburg paradox illustrates that decision-makers do not base decisions on expected value
What is the Subjective expected utility theory?
- Subjective expected utility = sum of products of subjective probabilities and subjective utility of consequences
- Choose option with highest subjective expected utility
Which decisions models do exist?
- Normative decision models
• Specify how an (idealised) individual should make optimal decisions - Prescriptive decision models
• Use decision theory to offer step-by-step suggestions on how to proceed in a decision situation in order to make an optimal decision - Descriptive decision models
• Describe how individuals actually make decisions
What is the Ultimatum game?
- Decision-makers have to divide a good between themselves and another person
- If the other person rejects the proposed division, both leave empty-handed
- Rules
• From a budget m, Player A offers p to Player B
• If Player B accepts, B gets p and A gets (m-p)
• If Player B rejects, B gets 0 and A gets 0 - Game-theoretic prediction
• A gives minimum positive amount possible (e.g. 1€ out of 100€)
• B accepts because any positive amount is better than Zero (e.g., 1€ is better than 0€) - Empirical findings
• Higher offers than minimum are made (on average, 44% of the available total amount) and low offers (<30% of the available total amount) are rejected
• Variations occur, but even in very different societies, game-theoretic prediction is supported - It’s about generosity and strategy
• Strategic consideration may crowd out impulses of generosity
What is the dictator game?
- Decision-makers have to divide a good between themselves and another person
- The other person has to accept the proposed division
- Rules
• From a budget m, Player A offers p to Player B
• B gets p, A gets (m-p) - Game-theoretic prediction
• A gives nothing - Empirical findings
• Many people give something to the other person; on average, 28% of the amount - It’s about generosity
• Social norm for sharing
• Guilt aversion
• Generosity depends on social distance
What is the prisoner’s dilemma?
- Two decision-makers independently have to decide between cooperation and defection
- While from an individual perspective defection is the rational solution, the overall outcome is better if both cooperate
Game-theoretic prediction: both players defect
Empirical findings: many people cooperate, trusting that the other person will also cooperate
What is backward induction?
- Multiple rounds allow
• Learning about trustworthiness of partner
• Punishment for defection - Last round similar to one-shot game, therefore defection again rational strategy
- Backward induction
• Analysis of repeated decision problems
• Starts from considering rational solution in last round
• From that solution, rational solution in previous round can be derived, and so on
What are decision anomalies?
- Decision anomalies: deviations from rational model
• In complex everyday decision situations often the rule, not the exception: Anomalies are quite normal
• Even decisions of experts in companies, political and administrative institutions - Decision anomalies result from
• Information processing
• Emotions
• Time
• Heuristics
What is the Monty Hall dilemma?
- Decision-markers have to decide whether to revise a previous decision when presented with additional information
- Demonstrates that people have difficulties understanding probabilities
- Maximization strategy
• Switch - Empirical findings
• Very few people switch from their first choice
• Explanations:
-> Misunderstanding of probabilities
-> Regret
What is affective forecasting?
- Prediction of emotional reactions to future events
- Four components
• Valence
• Specific emotions
• Intensity
• Duration
What is impact bias?
• Duration and intensity of emotional reactions to future events often overestimated
What is the projection bias?
tendency to assume that one’s future feelings and preferences will be similar to the current feelings and preferences
• “hot” versus “cold” states
• Focus on particular event; ignore other events
What is time discounting?
- Subjective value changes with time; future benefits and costs valued less than present ones
- Time discounting
• Preference for immediate utility vis-à-vis delayed utility in decisions where consequences occur at different points in time - Problems:
• Short-term benefits vs long-term costs
• Discounting often inconsistent
What is fundamental law of effect?
- Increase in the probability of occurrence of the behaviour that receives the most reinforcement
- However, sometimes a less valuable alternative is selected
What is law of relative effect?
- Selection ratio of various behavioural alternatives is proportional to the subjective value of the reinforcements attached to these alternatives
- And inversely proportional to the time that passes between the behaviour and its reinforcement
What is Melioration?
- People often choose the alternative that puts them in a better position for the time being
- In the long run, melioration can counteract maximisation
What is the Better-than-average-effect?
• People believe they are better than others
• Positive traits more developed, negative traits less developed than those of other people
• Found in various areas such as
-> Skills (linguistic, didactic, driving)
-> Romantic relations
-> Health
-> Investment
• Often higher for low performers
• Serves to enhance self-worth
What is Peak and end rule?
• In retrospect, an experience is often not judged by its duration and the sum of all its elements, but is strongly influenced by outstanding elements and by the elements at the end
What is the hindsight bias?
• After learning an outcome, people tend to claim to have known that the event would turn out that way
• Found in various areas such as
-> Historical developments
-> Political elections
-> Economic developments
• Causes
-> Adaption of memories to enhance self-worth
-> Not remembering, but new prediction processes with outcome information as anchor and “motivated” answers
What are Heuristics?
- Rules of thumb that allow reaching a judgment or a decision quickly in a complex situation
- Advantages: easier and quicker than full analysis, often correct
- Disadvantages: can lead to systematic errors
• Several heuristics identified
• Availability heuristic, representativeness heuristic, anchoring and adjustment heuristic, mood-as-information herustic, affect heuristic
• Recognition heuristic, take-the-best heuristic, elimination heuristic
What are Mood-as-information heuristic?
• Mood: both encoding and retrieval – in a good [bad] mood, positive [negative] aspects are given more attention and later remembered
- Mood not only influences retrieval, but may also be used as information in itself
- Mood-as-information heuristic
• Judgments are based on the current mood
- Can lead to errors because relevant aspects are not considered, and mood may be caused by unrelated events
What is representativeness heuristic?
- Judgments are based on the similarity between an outcome and a model
- Relevant for judgements of category, frequency, probability, as well as evaluations or decisions based on these
- Can be correct because objects within a category share attributes
- Can lead to errors because similarity alone is not enough, and people neglect other important statistical rules:
• Essential attributes of population
• Sample size
• Randomness (gambler’s fallacy, hot hand fallacy)
• Combined probabilities (conjunction fallacy)
What is Gambler’s fallacy?
• Mistaken belief that, after a sequence of one outcome, the other outcome becomes more likely
What is hot hand fallacy?
• Mistaken belief that, after a sequence of successes, another success becomes more likely
What is conjunction fallacy?
• People do not consider that combined events cannot be more likely than the constituting single events
What is the anchoring and adjustment heuristic?
- Judgments are based on a starting value and (inadequately) adjusted from that value
- Relevant for judgments and estimations of quantities, as well as evaluations or decisions based on these
- Can be correct because starting value may be a valid cue about actual quantity
- Can lead to errors because of
• Insufficient adjustment
• Uninformative anchors: random anchors, implausible anchors, strategic anchors
What is affect heuristic?
- Judgements are based on cues from positive and negative affect
- Relevant for judgments of risk, probabilities, quantities, as well as evaluations or decisions based on these
- Can be correct if affect provides valid cue
- Can lead to errors
• Halo effects: consistent perceptions of unrelated aspects
• Neglect of relevant aspects such as quantity or probability - Phenomena
• Subjective judgements of risks and benefits often negatively correlated
• Quantities or probabilities neglected for affect-rich outcomes
What is fast and frugal heuristics?
- Idea: heuristics can be advantageous, part of “adaptive toolbox” developed over the course of evolution
- Fast and frugal heuristics: decision-making aids that allow a complex problem to be solved in a short period of time, using only a few pieces of information
- “frugal”
• Use only information about recognition (recognition heuristic)
• Use only one characteristic at a time (take-the-best heuristic, elimination heuristic)
What is recognition heuristic?
• Decisions are based on familiarity with objects
• When only one of two objects is recognised, that object is seen as more important
- Relevant for evaluations and decisions
- In cases where structure of environment fits with task, may provide advantages
What is the less-is-more-effect?
• In some cases, less knowledge can lead to better decisions because it allows using the recognition heuristic
- Not all characteristics are considered and evaluated simultaneously
What is take-the-best heuristic?
• Decisions are based on the one characteristic of options that seems especially relevant
What is elimination heuristic?
• Decisions are based on sequential elimination of alternatives
What is asian disease problem?
• Decision-makers need to choose between two intervention programmes with certain or risky consequences
• Demonstrates that risk preferences are influenced by framing effects
- Framing effects
• Decision-makers’ preferences depend on the problem presentation
- Critique on Asian disease problem
• In the scenarios, only the second descriptions give complete information whereas the first ones only mention how many die or survive
• Most study participants see the given numbers as approximate reference value, not absolute numbers
• Framing effects not found when number of affected people is smaller or when participants feel close to them
What is Prospect theory?
- Extension of subjective expected utility theory: people seek to maximize utility; probabilities and consequences matter, but several modifications
- Prospect theory
• Decision-making processes consist of an editing phase and an evaluation phase
• Major elements in the evaluation phase are the value function and the weighting function
What is the Editing phase?
- First stage of decision making
- Options are subjectively restructured and simplified
- Reference point is chosen that defines outcomes as gains or losses
What is Evaluation phase?
- Second stage
* Options are evaluated according to the value function and the weighting function
What is the value function?
- Describes the relationship between objective outcomes (gain or loss relative to a reference point) and their subjective values
- Concave in the gains region and convex in the loss region (‘S-shaped’)
- Steeper in the loss region
- “loss-aversion”: losses are experienced more strongly than gains of the same size
What is the weighting function?
- Describes the relationship between objective probabilities and subjective decision weights
- Low probabilities receive higher weights, medium to high probabilities lower weights
What is the endowment effect?
- A good immediately becomes more valuable after a person has taken possession of it
- Studies by eliciting selling and buying values in objectively identical situations
- Selling values about twice as high or higher as buying / choosing values
- Explanation:
• Different reference points
• “giving up” is perceived as loss
What is the sunk cost effect?
- More likely that an endeavour is continued when resources have already been invested, even when these resources are irretrievable
- Irretrievable resources: only future outcomes should matter
- Negative developments: “Throw good money after bad”
- Explanation:
• Reference point shift
• Diminishing sensitivity for losses
What is Mental accounting?
- People record the costs and benefits of various operations, and
- Remember and settle them in event-specific ways
- Specific sums of money budgeted for specific decision categories
• If budget is used up, the probability that more money will be spent in this area sinks, even if it would be advantageous
• If budget is full, people spend easily, even if it is not very prudent - Influences spending and saving decisions
What is hedonic framing?
- In mental accounting, gains and losses can be viewed in specific ways (integrated or separated) to increase satisfaction
- Building on the value function of prospect theory, for highest satisfaction
- Losses should be integrated: L(c) + L(d) > L(c+d)
- Gains should be segregated: G(a) + G(b) > G(a+b)
What is bounded rationality?
• Human ability to behave rationally is limited
What is the satisficing principle?
- In complex decision situations, decision-makers act within the limits of bounded rationality and
- Are content with a satisfactory alternative instead of the optimal alternative
What is the implicit favourite model?
- Decision-makers spontaneously choose one option,
- Then search for confirmation that this was the correct choice
- Decision makers often not aware that they have already made their choice
- Decision criteria isolated after the choice and calibrated to match the selected alternative
What is Groupthink?
• Groups make suboptimal decisions
• Occurs in highly cohesive groups
• Leads to suboptimal solutions through failure to define goals, selective information processing, insufficient evaluation of consequences and poor implementation plans
- Occurs even in expert groups
- Drivers of groupthink
• Cohesive group
• Isolated from other information sources
• Charismatic leader favours a certain solution
• High self-censorship and pressure to conform
• Invulnerability overestimated, collective rationalisation
What is garbage can model?
- Decisions occur as a coincidental combination of problems, solutions and decision-makers
- Describes decision-making in organizations
• Decisions, problems, solutions and members “float on through”
• Options and solutions only discovered coincidentally
• Decisions rationalized afterwards
What is muddling through?
- Decisions are taken in a step-by-step, incremental process
- Describes decision-making in political areas
• The more complex the task, the smaller the probability that rational strategies will be used
• Unsuitable coping attempts such as focusing only on easy subproblems or blindly imitating previous strategies
• Like walking through a swampland where the next step might bring doom: small steps in one direction, maintained until negative consequence occurs, then change
What is logic of success?
- Delineating concrete goals in complex decision situations
* Taking into consideration interactions between goals
What is RAWFS model?
- Describes decision-making processes in uncertain decision situations
- Application of the tactics Reduction, Assumption-based reasoning, Weighing pros and cons, Forestalling and Suppression
- Interviews with military officers reporting decisions that contained uncertainty shows tactics for
• Reducing uncertainty
• Accepting uncertainty
• Suppressing uncertainty - Developed into a model of decision-making
What is risk-defusing operators?
- Actions aimed at reducing the risk that negative consequences of a decision will occur
- Such actions can be taken
• Before a negative consequence arises or
• Afterwards - Risk-defusing operators before the negative consequence are more frequent if
• Probability of discovering the negative consequence is los
• Fixing the negative consequence is difficult
What are Nudges?
• Attempts to structure decisions in a way that induces rational behaviour without curtailing individual freedom
• Encourage or steer behaviour, but without mandating or instructing, and ideally without the need for financial incentives or sanctions
- ‘Libertarian paternalism’
What is MINDSPACE?
- Framework for nudges
- Summarises nine robust effects on behaviour: Messenger, Incentives, Norms, Defaults, Salience, Priming, Affect, Commitments and Ego
- Components:
• Messenger: who communicates information
• Incentives: responses shaped by mental shortcuts and loss aversion
• Norms: what others do
• Defaults: pre-set options
• Salience: what is novel and seems relevant
• Priming: small cues influence information processing and behaviour
• Affect: emotional associations
• Commitment: consistency with public promises, reciprocity
• Ego: act in ways that make us feel better about ourselves
What is EAST?
- Framework for nudges
- For a specific behaviour to be encourages, it should be made Easy, Attractive and Social, and nudges should occur Timely
- Components:
• Easy: people are more likely to do what is easy
• Attract: people are attracted by what catches their attention and what appears attractive
• Social: people follow the herd
• Timely: interventions are more likely to influence behaviour before habits have been formed or when undesired behaviour has been disrupted
What is the Theory of social representations?
- Opinions are a complex result of experiences, emotionally loaded judgments, and information that is subjectively experienced, transformed and cognitively available
- Social representations consist of core elements and peripheral elements
- Social representations are formed through processes of anchoring and objectification
- Core idea: individual opinions are not idiosyncratic, but shared within a community
- Social representations as common sense
• Sum of knowledge within a community that forms the basis for actions - Social representations broader concept than attitudes, more like belief systems
- Attitudes
• Summary evaluations of objects
• Can refer to all kinds of objects
• Evaluate such objects from negative to positive
What is the structure of social representations?
- Core elements
• Central parts
• Define the meaning of a social representation
• Organize the social representation
• Explicit and implicit basis for discourse - Peripheral elements
• Make the core more concrete and understandable
• Adapt to the temporal development in context
• Protect the stable core of the social representation
What is the development of social representations?
- Anchoring
• Process where the social representation is linked to existing categories of representations
• During the process, existing categories and representations can change - Objectification
• Process where the social representation is made vivid through quasi-physical objects
• “drawing a picture”
• Abstract concepts are represented as images, symbols or metaphors
What is Belief in a just world?
• People have the need to assume they live in a world that is just, and where outcomes are not determined by random events
• A just world is one where people get what they deserve, and where they deserve what they get
- Belief in a just world correlates negatively with support for social security
What is social categorisation theory and assimilation and contrast effects?
- Information about persons and objects is cognitively represented in schemata that are formed through categorisation
- Processes of social categorization help to structure social events and therefore offer a basis for actions
- Assimilation effects
- Similarities within a category are perceived as more pronounced than they actually are
- Contrast effects
- Differences between categories are perceived as more pronounced than they actually are
What is social identity theory?
- People strive for a satisfactory self-concept
- Part of the self-concept is determined by membership in groups
- Social identity arises from categorisation processes in which the social environment is divided into ‘own’ and ‘other’ environment
What is cognitive-development theory?
• Intelligence develops through adaption processes of assimilation and accommodation
• Four stages: sensorimotor intelligence, preoperational though, concrete operational thought, formal operations
- With increasing age, children develop specific steps in cognitive abilities (e.g., perspective taking, independence of a concrete object)
What is Financial literacy and what is it related to?
- The ability to understand and use financial concepts
- Often very low levels of financial literacy in general population
- Financial literacy related to
• Socio-economic factors (women, groups with low general education, minority groups fare worse)
• Unfavourable economic outcomes (e.g., less savings)
• Potential vicious circle - Financial literacy related to relevant economic behaviours
• Retirement planning
• Credit card debt among students
• Consumer debt
• Higher costs on credit card borrowing and mortgage - Financial literacy can come from parents, work experience or financial education
- Financial education
• evidence mixed: specific goals better than general financial literacy
• overall positive effect, but very small; ‘just-in-time’ education more efficient
What is financial capability?
- includes financial literacy, but also • skills • confidence • and attitudes regarding financial concepts - Five domains in addition to financial knowledge: • Managing money – making ends meet • Managing money – keeping track • Planning ahead • Choosing products • Staying informed - Variations in financial capability are less a matter of information but more a matter of psychological differences (biases): • Mental accounting • Information overload • Status quo bias • Procrastination • Regret • Loss aversion - Financial capability programs should take into account such biases
