Lesson 7

Question 1

1.1 Explain the premise of behavioral economics (5 points)

Answer 1

Subfield of economics that draws on the psychological, social and cultural foundations of human decision making.

Premise is that we are not always self interested, benefit maximizing and costs-minimizing individuals with stable preferences.

Most of our choices are not the result of careful deliberation. We are influences by memory, automatically generated affect and salient information in the environment.

We tend to resist change and are poor predicters of future behaviour.

Finally we are social and have social preferences such as trust, reciprocity, and fairness. We are susceptible to social norms and a need for self consistency.

Question 2

1.2 Outline the basic premise of rational choice theory

Answer 2

Assumes that individuals have stable preferences and engage in maximizing behaviour.

Decisions are the result of careful weighing of costs and benefits and are informed by existing preferences

Question 3

1.3 Outline the basic premise of prospect theory

Answer 3

Shows how we decide between alternatives that involve risk and uncertainty.

We make decisions based on a consideration of changes in values from a reference point rather than on absolute values.

This theory suggests we are risk averse and we dislike losses more than we like gains. Willingness to take a risk is influence by the framing of the option

Question 4

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

Answer 4

In prospect theory the reference is the benchmark.

We ask comparison questions and classify gains and losses.

Question 5

1.5 Explain the premise of bounded rationality (3)

Answer 5

The premise is that decision makers are working under 3 constraints:

1) Only limited information regarding alternatives is available

2) The human mind has a limited capacity to evaluate and process the information available.

3) Only a limited amount of time is available for decision making.

Therefore even if we intend to make rational choices we end up making satisficing choices

Question 6

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

Answer 6

Good information, experience and prompt feedback are key factors that enable individuals to make good decisions.

They can be hard to obtain though.

Feedback is often limited to broad based information which includes the economic costs of unhealthy behaviour.

Personal feedback of our own health decisions are often delayed and not reflected in decision making.

Question 7

1.7 Explain how loss aversion can influence behaviour

Answer 7

Loss looms larger than gains. Twice as large generally.

Loss aversion has been used to explain the Endowment effect bias

Question 8

1.7 Explain the Endowment effect bias

Answer 8

Occurs when we value what we own regardless of its objective market value. Especially goods that wouldn’t be normally bought or sold at market

Question 9

1.7 Explain the sunk cost fallacy bias

Answer 9

We continue a behaviour or endeavor as a result of previously invested resources rather than current evaluation of it as beneficial.

Question 10

1.8 Explain how mental accounting can influence behaviour

Answer 10

We think of the value in relative rather than absolute terms.

We treat money differently based on origin and intended use rather than as a truly fungible asset.

We frame or categorize assets as belonging to current wealth, current income or future income.

For example small windfalls will be treated as current income to be spent and larger windfalls are considered wealth.

Question 11

1.9 Outline the basic premise of the dual system theory

Answer 11

System 1 - thinking processes that are intuitive, automatic, experience based and relatively unconscious

System 2 - more reflective, controlled, dynamic and deliberative

Question 12

2.1 Outline the two most significant differences between the behavioral model of decision making and the standard economic model

Answer 12

The two factors not considered in the standard model are:

1) We may process only the most salient information. Salient information is novel, stands out or seems relevant. What we consider salient may cause us to overlook key information and can be influenced by how the information is presented.

2) There may be a mismatch between intention and action. Even if we understand the full consequences of our actions we may make decisions the favour the present at the expense of the future

Question 13

2.2 List 6 characteristics and an example of Automatic System thinking

Answer 13

1) Considers what automatically comes to mind

2) Relatively unconscious

3) Effortless

4) Associative

5) Fast

6) Intuitive

eg: speaking in mother tongue, takings a daily commute, desiring cake

Question 14

2.2 List 6 characteristics and an example of Deliberate System thinking

Answer 14

1) Considers a broad set of relevant factors

2) Controlled

3) Effortful

4) Based on reasoning/analysis

5) reflective

6) Slow

eg: learning a foreign language, planning an unfamiliar journey, counting calories

Question 15

2.3 Explain why we tend to rely on automatic rather than deliberative thingking

Answer 15

Deliberative thinking requires self control, is cognitively taxing, and can be exhausting.

Or ability to engage with it is usually limited and when we are under cognitive strain it’s even worse.

On automatic mode thinking is fast and effortless

Question 16

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

Answer 16

The term frame applies to decision making at two levels:

1) Description and presentation of choices to the decision maker

2) Interpretation and mental editing - what the decision maker does. The mental models that we bring to the problem influence how we pay attention and interpret what we percieve

Question 17

2.5 Contrast the terms heuristics and cognitive biases

Answer 17

Heuristics are commonly defined as cognitive shortcuts or rules of thumb.

Cognitive biases are systematic errors in thinking that 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 18

3.1 List 8 Heuristics

Answer 18

1) Affect
2) Anchoring
3) Availability
4) recognition
5) representativeness
6) 1/N
7) scarcity
8) take the best

Question 19

3.1 Define and provide an example of the heuristic:Affect

Answer 19

A reliance on good or bad feelings experienced in relation to a stimulus.

More pronounced when we have little time or resources to reflect.

For example “lung cancer” produces an affect of dread.

Question 20

3.1 Define and provide an example of the heuristic: Anchoring

Answer 20

Exposure to a number serves as a reference point influencing subsequent judgements about value.

For example the price of the first house shown by a real estate agent may serve as an anchor and influence perceptions of subsequent houses

Question 21

3.1 Define and provide an example of the heuristic: Availability

Answer 21

We make judgements about the likelihood of an event based on how easily an example 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 22

3.1 Define and provide an example of the heuristic: recognition

Answer 22

Recognition is an easily accessible cue that simplifies decision making and indicates that sometimes less knowledge can lead to more accurate inferences.

For example judging which is the larger of two cities based on our recognition of the city name.

Question 23

3.1 Define and provide an example of the heuristic: Representativeness

Answer 23

We judge the probability that thing A belongs to class B by looking at how much 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 24

3.1 Define and provide an example of the heuristic: 1/N

Answer 24

Assigns equal weight to all cues or alternatives

Often we hedge money in investments by allocating equal amounts to different options. This is a form of naïve allocation of resources

Question 25

3.1 Define and provide an example of the heuristic: Scarcity

Answer 25

When an object is less readily available we perceive it as more valuable. For example limited edition products

Question 26

3.1 Define and provide an example of the heuristic: take-the-best

Answer 26

One decision making rule. Judges based on a single good reason to discriminate between options. For example, single issue voters.

Question 27

3.2 Explain the impact of confirmation bias on judgement and decision making

Answer 27

We automatically interpret information if a way that will support our prior beliefs. It contributes to overconfidence in personal beliefs. We may fail to recognize that we don't know what we claim to know and fail to learn from new information

Question 28

3.3 Explain the impact of anchoring bias on judgement and decision making

Answer 28

Sometimes the anchor is obvious and appropriate but sometimes it is inappropriate. Because this is part of automatic thinking the first thing that might help with the choice is grabbed onto even if it actually has no influence on the decision. e.g. purchase quantity limits can increase purchase quantities

Question 29

3.4 Explain how present bias can create an intention - action divide

Answer 29

We may overweight the present relative to the future in a way that results in inconsistencies over time. We tend to weigh current costs more heavily than future benefits

Question 30

3.5 Explain the concept of the "peanuts effect" bias

Answer 30

We don't consider the consequences of small dollar transactions because we view small amounts of money as peanuts

Question 31

3.6 Explain the concept of the "money illusion" bias

Answer 31

We prefer things that are high in numerical terms even if net they aren't the best For example preferring a 6% raise when there's 4% inflation over a 3% raise with no inflation

Question 32

4.1 Explain the significance of intertemporal choice for savings behaviour

Answer 32

The study of how we make choices about what and how much to do at various points in time. Choices at one time can influence choices at another and by the relative weight we assign to payoffs at different points in time. Most choices require decision makers to trade off costs and benefits at different times

Question 33

4.1 Explain the significance of the dual choice model for savings behaviour

Answer 33

Inconsistency between the patient long run self and the myopic short run self. Practically oriented research tries to make us feel more connected to our future selves

Question 34

4.2 Explain the significance of present bias to temporal discounting theories

Answer 34

In time discounting theories we weigh present events more heavily. This discounting is not linear and if rewards are very distant in time the cease to be valuable.

Question 35

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

Answer 35

Time inconsistency occurs when our present self fails to predict the preferences of our future self. The inability to appreciate fully the effect of emotional and physiological states on decision making is known as the (hot-cold) empathy gap.

Question 36

4.4 Explain the significance of forecasting and memory to judgement and decision making

Answer 36

When we make plans for the future we are often too optimistic. Similarly when we try to predict how we will feel in the future we overestimate the intensity of our own emotions.

Question 37

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

Answer 37

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 38

5.2 Explain the significance of trust for judgement and decision making

Answer 38

Trust is one of the explanations for discrepancies between actual behaviour and self interested models. Trust can reflect risk preferences but can also reflect social preferences. We take greater risks when faces with a given probability of risk vs the same probability of being cheated.

Question 39

`5.2 Explain the significance of dishonesty for judgement and decision making

Answer 39

While in standard economics dishonesty can be seen as a byproduct of self interested motives in relationships its seen as a violation of trust. Dishonesty is the product of situation's as well as both internal and external reward mechanisms which often involve self deception to appear less dishonest.

Question 40

5.3 Explain the significance of fairness and reciprocity for judgement and decision making.

Answer 40

Resistance to unfair outcomes is call inequity aversion. This can be disadvantageous since we are willing to forgo a gain in order to prevent another person from receiving a superior reward. Fairness is related to a human desire for reciprocity. This can be beneficial, a gift begets a greater gift, or lead to putative responses to negative actions.

Question 41

5.4 Explain the significance of social norms for judgement and decision making

Answer 41

Social norms signal appropriate behaviour and are an important component of identity economics. There are norms for exchanges and economic activities that influence economic decisions.

Question 42

5.5 Explain the role of consistency and commitment for judgement and decision making

Answer 42

We are susceptible to feedback about social norms as part of our desire to maintain a positive view of ourselves as people. When an outcome threatens this rather than change our behaviour we often change our attitudes or beliefs to reduce cognitive dissonance.

Question 43

5.6 Explain the significance of cognitive dissonance in behavioural economics

Answer 43

The uncomfortable feeling between two simultaneous and conflicting ideas or feelings. For example behaviour inconsistent with who we want ourselves to be. We are motivated to resolve this by changing our beliefs as this is easier than changing our actions.