A brief about Behavioral Economics

7/27/2019 A brief about Behavioral Economics

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The field ofbehavioral economics is devotedto studying how consumers actually make

choices. It uses some of the insights frompsychology to develop predictions aboutchoices people will make and many of these

predictions are at odds with the conventionaleconomic model of rational consumers.


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In real life, people are strongly affected by how choices are presented

to them or framed.

E.g. : A faded pair of jeans in a thrift shop may be perceived very

differently than the same jeans sold in an exclusive store.

A store might sell dozens of copies of a book priced at $29.95,

whereas the same book priced at $29.00 would have substantially

fewer sales.

These all examples of framing effects are clearly a powerful force in

choice behavior. Much of marketing practice is based on

understanding and utilizing such biases in consumer choice.


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A serious disease threatens 600 people. You are offered a choice betweentwo treatments, A and B, which will yield the following outcomes.

Positive framing :Treatment A. Saving 200 lives for sure.

Treatment B . A 1/3 chance of saving 600 lives and a 2/3 chance of savingno one.

Which would you choose?

Now consider the choices between these treatments.Negative framing :Treatment C. Having 400 people die for sure.Treatment D. A 2/3 chance of 600 people dying and a 1/3 chance of noone dying.Now which treatment would you choose?


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The idea here is that peoples choices can be influenced bycompletely spurious information

In a classic study the experimenter spun a wheel of fortune andpointed out the number that came up to a subject. Thesubject was then asked whether the number of Africancountries in the UN was greater or less than the number onthe wheel of fortune. After they responded, the subjectswere asked for their best guess about how many Africancountries were in the UN. Even though the number shown onthe wheel of fortune was obviously random, it exerted asignificant influence on the subjects reported guesses.


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People often have trouble understanding theirown behavior, finding it too difficult to

predict what they will actually choose indifferent circumstances.


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A marketing professor gave students a choiceof six different snacks that they could

consume in each of three successive weeksduring class. In one treatment, the studentshad to choose the snacks in advance; in theother treatment, they chose the snacks oneach day then immediately consumed them.


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When the students had to choose in advance, they chose amuch more diverse set of snacks. In fact, 64 percent chose adifferent snack each week in this treatment compared to

only 9 percent in the other group.

When faced with making the choices all at once, peopleapparently preferred variety to exclusivity. But when it camedown to actually choosing, they made the choice with whichthey were most comfortable. We are all creatures of habit,even in our choice of snacks.


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In one experiment, two marketing researchers set up

sampling booths for jam in a supermarket. One

booth offered 24 flavors and one offered only 6.

More people stopped at the larger display, but

substantially more people actually bought jam atthe smaller display.

More choice seemed to be attractive to shoppers, butthe profusion of choices in the larger display

appeared to make it more difficult for the shoppers

to reach a decision.


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Two experts in behavioral finance wonderedwhether the same problem with excessivechoice showed up in investor decisions. They

found that people who designed their ownretirement portfolios tended to be just as happywith the average portfolio chosen by their co-workers as they were with their own choice.

Having the flexibility to construct their ownretirement portfolios didnt seem to makeinvestors feel better off.


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Psychologists and behavioral economists arguethat preferences are not a guide to choice;rather, preferences are discovered in part

through the experiences of choice.Conventional theory treats preferences aspreexisting. In this view, preferences explainbehavior

Once preferences have been discovered, albeit bysome mysterious process, they tend to becomebuilt-in to choices. Choices,once made, tend toanchor decisions.


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Imagine watching someone in the supermarketpicking up a tomato ,putting it down, thenpicking it up again. Do they want it or not? Isthe price-quality combination offeredacceptable?

Actually, you are seeing someone who is onthe margin in terms ofmaking the choice.They are, in the psychologists interpretation,discovering their preferences.


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Ordinary choice is complicated enough, butchoice under uncertainty tends to be

particularly tricky.

Law of small numbers Asset Integration and Loss Aversion


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A certain town is served by two hospitals. In thelarger hospital about 45 babies are born eachday, and in the smaller hospital about 15 babies

are born each day. About 50% of all babies areboys. However, the exact percentage varies fromday to day. Sometimes it may be higher than50%, sometimes lower. For a period of 1 year,each hospital recorded the days on which morethan 60 percent of the babies born were boys.

Which hospital do you think recorded more suchdays?


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Expected utility theory makes an implicitassumption that what individuals care about isthe total amount of wealth that they end up with

in various outcomes. This is known as the assetintegration hypothesis.

This is reasonable but generally peopletend to avoid too many small risks and accept too

many large risks. People arent really risk averse as much as they

are loss averse.


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Time inconsistency : A person may make aplan today about his future behavior, but

when the future arrives he will want to dosomething different.


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An interesting variation on self-control is the phenomenon ofoverconfidence.

Two financial economists, Brad Barber and Terrance Odean, studiedthe performance of 66,465 households with discount brokerage accounts.During the period they studied, households that traded infrequently receivedan 18 percent return on their investments, while the return for the households that

traded most actively was 11.3%. One of the most important factors thatapparently influenced this excessive trading was gender: the men traded a lotmore than women. Psychologists commonly find that men tend to haveexcessive confidence in their own abilities, while women, for the most part, tendto be more realistic.

Basically,men (or at least some men) tend to think their successes are a result

of their own skill, rather than dumb luck, and so become overconfident.This overconfidence can have financial repercussions. In the sample ofbrokerage accounts, men traded 45 percent more than women. This excessivetrading resulted in the average return to men that was a full percentagepoint lower than the return to women.


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Consumers seem to have a preference forfair divisions and will punish those who

behave unfairly.

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A brief about Behavioral Economics