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Behavioral Behavioral Economics Economics

Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

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Page 1: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

BehavioralBehavioralEconomicsEconomics

Page 2: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it. Of this kind is pity or compassion, the emotion which we feel for the misery of others, when we either see it, or are made to conceive it in a very lively manner. That we often derive sorrow from the sorrow of others, is a matter of fact too obvious to require any instances to prove it; for this sentiment, like all the other original passions of human nature, is by no means confined to the virtuous and humane, though they perhaps may feel it with the most exquisite sensibility.

Adam Smith, The Theory of Moral Sentiments (1759)

Page 3: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 4: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 5: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

In the latter 20th century, anomalies in behavior unexplainable by economic theory could no longer be ignored.

In psychology in the 1960s, the view of the brain as an information-processing unit rather than a stimulus-response machine became dominant.

Problem-solving and decision-making gained interest among psychologists—topics relevant to economics.

Collaborative work revealed some explanations for anomalies, and the field of Behavioral Economics emerged in the early 1980s.

Page 6: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 7: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 8: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

• Ultimatum Game shows fairness counts.• Real world tests of offer rejection due to fairness concerns might be observed in:• Failures of legal cases to settle before trial• Costly divorce proceedings• Labor strikes.

• In the real world, we cannot tell if rejection of offers occurs because of:

Fairness or1.Reputation building in repeated games2.Agency problems, e.g., clients and lawyers3.Confusion

Experiment eliminates 1-3.

Page 9: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Advantages of Experiments

• Can control influences on decision-making, unlike in the complex real world.

• Easier to establish causality.

• Subjects can be interviewed afterwards about their understanding and thought processes.

• Easier for the general public to understand than other empirical techniques such as regression.

Page 10: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Disadvantages of Experiments

• Small samples

• Unrepresentative samples

•Behavior may be influenced by perceived expectations of the experimenter.

• Artificial environment

•No meaningful monetary consequences from decisions.

Page 11: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 12: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Anchoring Experiment-Part 2:

2nd group of students were asked questions in reverse order.1.First they were asked how happy they had been overall in the past month. 2.Then they were asked how many times they had gone on a date in the past month.

Correlation between responses to 1 and 2 was close to 0.•Happiness question was anchored by the dating question for the first group.•Order of questions matters.

Page 13: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Would you prefer:

Option A: 2% yearly pay increase after a year when there has been inflation of 4%

Option B: pay cut of 2% after a year when there has been zero inflation

What would rationality imply? Indifference between A and B.

Money illusion– Bias in the assessment of the real value of transactions induced by their nominal representation.

Page 14: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Dynamically Inconsistent Preferences

Maintaining Self-Controle.g., Diets, alcohol, drugs, smoking,…

Standard economic theory assumes preferences are dynamically consistent -- an individual’s preferences over the alternatives available at some future date do not change as that date approaches or once it arrives, i.e., he/she never loses self-control.

Page 15: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Experiments show that individuals often show present bias– a form of dynamic inconsistency involving a bias toward immediate gratification.

Individuals aware they might not follow through on their plans might choose pre-commitment -- a choice that removes future options.

e.g., resident rehab, weight-loss spas

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Page 17: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

NeuroeconomicsNeuroeconomics

Page 18: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

... imagine an ideally perfect instrument, a psychophysical machine, continually registering the height of pleasure experienced by an individual ... From moment to moment the hedonimeter varies; the delicate index now flickering with the flutter of the passions, now steadied by intellectual activity, low sunk whole hours in the neighbourhood of zero, or momentarily springing up towards infinity ... Francis Y. Edgeworth (1845-

1926)

Page 19: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Early economists lamented the inability to measure preferences directly.

Economists turned to the concept of “revealed preference” to enable prediction of economic decision-making, where observed choices are presumed to reveal individual preferences.

The utility-maximization apparatus yields predictions without measuring preferences directly.

Page 20: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Technical advances in neuroscience now make observation of brain activity related to preferences and choices possible.

NeuroeconomicsNeuroeconomics uses knowledge from neuroscience to inform economic theory about how the brain works in decision-making and strategic thinking.

Neuroscience also benefits from the conceptual structure of economics. (Paul W. Glimcher et al., “Neuroeconomics: The Consilience of Brain and Decision,” Science 306, 447, 2004).

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Page 22: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of
Page 23: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

• Notable features of the brain:

• Automaticity – brain processes and choices can occur without awareness.

• Sense-making – the brain seeks to make sense of the individual’s behavior

• Modularity – brain is organized into modules, sometimes anatomically distinct, which are tied to particular functions.• Modules can work independently

or in cooperation in brain processes

• Neuroscience can help to identify brain areas associated with different factors affecting decisions.

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Page 25: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Fig.2. Activation relatedto the presentation of anunfair offer. (A) Map ofthe t statistic for thecontrast [unfair humanoffer – fair human offer]showing activation of bilateralanterior insula andanterior cingulate cortex.Areas in orange showedgreater activation followingunfair as comparedwith fair offers (P <0.001). (B) Map of the tstatistic for the contrast[unfair human offer – fairhuman offer] showingactivation of right dorsolateralprefrontal cortex.A. G. Sanfey et al., Science 300, 1755 -1758 (2003)

Page 26: Behavioral Economics. How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of

Sanfey et al. (2003) conclude that their results are consistent with “the idea that the areas of anterior insula and DLPFC represent the twin demands of the Ultimatum Game task, the emotional goal of resisting unfairness and the cognitive goal of accumulating money... “

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