What is Behavioral Economics

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Oct 28, 2013 (3 years and 7 months ago)

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What is Behavioral Economics



An Illustration: Guess the Number Game


The Decision: Choose a number between 0 and 100


Goal: Win the game by choosing the number closest to 2/3 of the average of
the guesses.


Complete knowledge, Self
-
Interested Nash Equilibrium: All guess zero


Typical average: 19, so a winning guess might be 13 rather than zero.


Best choice depends upon your ability to judge how others will think


One possibility: All pick at random, so average is 50. Then the best guess
for you is 33.


But, you should pick 22 if you think others will pick 33. As in chess,
deeper thinking by others requires even deeper thinking by you for
success.


An Illustration: Hyperbolic Discounting


Which do you prefer?


$100 today, or $105 a week from now.


$100 a year from now, $105 a year and a week from
now


An Illustration: Frame

Question: Will you have the surgery?


Frame 1:
Of 100 people having
surgery,
90
live through
the post
-
operative period, 68
are alive at
the end of the first year and 34
are
alive
at the end of
five years.


Frame 2:
Of 100 people having
surgery, 10 die during
surgery or the
post
-
operative
period, 32
die by the end of the first
year, and
66 die

by the end of five years.

O

Behavioral
Economics Definitions


Behavioral economics
is the name we give to the research enterprise that seeks
to
augment and amend the
existing body
of classical and neoclassical economic theory to
achieve a more realistic picture
of economic process. (Herbert Simon)


The
introduction of insights drawn from social psychology into (macro)
economic
behavior (
George
Katona

)


A research approach to economics which (1
)
rejects the notion that positivism is the sole
methodological foundation for economic research, (2)
refuses
to accept the use
of
deductive
reasoning as a sufficient basis for a (social) science,
(
3)
dislikes static
analysis
of equilibrium
as representing outcomes relative to disequilibrium processes, and (
4)
object to
the
simplistic economic
model of rational agents exhibiting optimizing
behavior (1984, p. 1).
(
Gilad
,
Kaish
, and
Loeb)


Behavioral economics
is a school of thought distinguished by
the fact
that it is much less
narrow, rigid, intolerant, mechanical, separate, and individualistic
than mainstream
economics (
Tomer
).


Key Contributors to Behavioral Economics


George
Katona
: Starting in late 1940, used surveys to support the idea that the level of
consumption spending has a highly psychological component. Referred to by some as
the Father of Behavioral Economics.


Herbert
Simon (Nobel Aureate) :
In 1950s, replaced maximization assumption with
satisficing assumption. Limited cognitive capacity typically precludes maximization,
spawning the term bounded rationality. Under bounded rationality, behavior is
determined by a pair of scissors, where one blade is the decision maker’s cognitive
limitations and the other blade is the particular environment.


James March and Richard
Cyert
: Developed a theory of how firms behave using
bounded rationality as the underlying basis.


Gerd

Gigerenzer
: Heuristics are developed that are tailored to particular decision
making environments that effectively allow the decision maker to effectively cope with
limited cognitive capacity.


Reinhard

Selten

(Nobel Aureate) :
Game theory applications of limited cognitive
capacity.


Harvey
Leibenstein
: Applications of bounded rationality to understanding the efficiency
and inefficiency that may exist within a firm.


Daniel
Kahneman

(Nobel Aureate)
and Amos
Tversky
: People predictably violate
rationality axioms when the outcome of a choice is uncertain and when the decision
context changes in certain ways.





Key Contributors to Behavioral Economics


Richard
Thaler
: Identified biases in behavior relative to that predicted by traditional
economic theory. Many practical applications of behavioral economics.


George
Akerlof

(Nobel Aureate) :
Applications of bounded rationality to labor market,
savings, education. A theory showing how identity can influence economic behavior,
connecting economics and sociology.


Vernon Smith (Nobel Aureate) : A pioneer of experimental economics, including much
thought about behavioral issues.


Richard Nelson and Sidney Winter: Applications of evolutionary theory to explain
development of habits
and routines.




Behavioral Observations


Anchoring


Cognitive Dissonance


Endowment Effect


Mental Accounting


Confirmatory Bias


Hindsight
Bias


Status Quo Bias


Law of Small Numbers Bias


Vivid Information Bias


Framing effects


Learning


Use of Rules of Thumb in Decision
-
Making




Behavioral Observations


Overconfidence


Wishful Thinking


False Consensus Effect


Curse of Knowledge


Preference Reversals


Fairness


Herding


Procrastination





Behavioral
Theories/Models


Loss Aversion


Endowment Effect


Hyperbolic Discounting


Social Preferences


Satisficing


Reference dependent utility


Diminishing Sensitivity


Reciprocity


Gift Exchange


Efficiency Wage


Internality


Sophisticated versus
Naïve Discounters


Criteria for Evaluating Theories


Prediction Accuracy (Stigler)


Generality (Stigler)


Tractability (Stigler)


Parsimony (Rabin)


Realism (Simon)


Positivism (Hume)


Falsifiability (Popper)


Existence of
a Reasonable Competing
Theory (
Lakatos
)


Sample Applications


Loss Aversion

o
C
onsumers
are more
averse to
lowering consumption in
response
to bad
news about income than they are
to increasing
consumption in response
to good news


Fairness

o
Subjects contribute
to public goods more
than can
be
explained by pure
self
-
interest

o
Wage decreases are viewed with a special disdain, implying
wages are sticky in the downward direction, keeping
unemployment from being eliminated


Reciprocity

o
If others conserve water, you are more likely to conserve

o
An employee who feels mistreated is more likely to sabotage
the firm.

Sample Applications


Law of Small Numbers Bias

o
We underestimate how
often a good
financial analyst
will
be wrong a few times in
a row
. and how often a
clueless
analyst will
be right a few times in a
row.

o
People
tend to
generate spurious
explanations for
long
streaks
that are determined by
chance

o
The gambler’s fallacy


Anchoring

o
Overestimate happiness gain from winning lottery


Hindsight Bias

o
Hearing the report of a mass shooting increases the
perceived probability of such an
occurance

o
“I knew it all along,” (but your really did not)


Sample Applications


Hyperbolic Discounting

o
Pay a Gym Trainer

o
Christmas savings clubs

o
In general, act to restrict your options


Confirmatory
Bias

o
We
ignore information that does not support our initial
hypothesis

o
Ambiguous information further affirms our initial
hypothesis


Status Quo
Bias

o
Libertarian Paternalism (Nudge)


Savings plan opt
-
out rather than savings plan opt
-
in


Put fruit in front of higher calorie desserts



Criticisms of Behavioral Economics


Too many behavioral theories with too few
applications


The many assumptions underlying behavioral
models need to be reduced to a smaller number of
more primitive assumptions


Not clear how to identify equilibrium versus non
-
equilibrium behavior




How Economics May Become More Behavioral


Model decision
-
making using learning processes, whereby a
decision maker becomes more sophisticated as learning
occurs.


Environment dependent sophistication (or decision ability)


Less representative agent models, more heterogeneity


More use of our understanding of human cognition in
modeling decision making.


More focus on developing theories that explain observations
(descriptive theories) and less focus on developing theories
that are axiomatically consistent (What
Thaler

calls
normative theories)


More focus on how emotions influence choice




References

Fundenberg
, Drew (September 2006) Advancing Beyond Advances in Behavioral Economics
Journal
of Economic
Literature

44, 694

711.


Hosseini
, Hamid (2003). The Arrival of Behavioral Economics: From Michigan, or the Carnegie
School in the 1950s and the Early 1960s?
Journal of Socio
-
Economics

32 (2003) 391

409.


Rabin
, Mathew (March, 1998). “Psychology and Economics,”
Journal of Economic Literature
, 36: 11
-
46


Thaler
, Richard (Winter, 2000). From Homo
Economicus

to Homo Sapiens.”
Journal of Economic
Perspectives

14(1), 133
-
141.


Thaler
, Richard H. and Cass
Sunstein

(2003). “Behavioral Economics, Public Policy, and Paternalism:
Libertarian Paternalism,”
American Economic Review, Papers and Proceedings
93: 175
-
179.


John
Tomer
, “What Is Behavioral Economics?,”
Journal of Socio
-
Economics
, 36(3), June 2007, 463
-
479.