Behavioural Economics

Sujoy Chakravarty

Centre for Economic Studies and Planning

What is behavioural economics?• Behavioural economics is a new branch of economics that uses

theories, tools and techniques of analysis from social sciences such as psychology or anthropology that are used to enrich the model of human behaviour that has been used traditionally in neo-classical economics.

• As it stresses observed agent behaviour rather than “logical” optimization algorithms, behavioural economists are often also experimental economists, who conduct lab and field experiments in the vein of psychologists.

• Observations of deviation from theory predictions may provide insights into building new theories, that improve upon existing ones. Eg.- herd behaviour, satisficingbehaviour, ecological rationality, other-regarding preferences and prospect theory

Why do we need this?

• Though economic theory predicts behaviour in a large number of economic problems, the predictions are quite narrow in scope.

• In the real world however we see a vast number of behavioural realizations:

The amount of contribution made to charities.

The proclivity towards acquiring resources through corrupt means.

Cooperation displayed towards teammates and co-workers

The wherewithal to take on monetary risks.

Consumption and saving behaviour.

Economic Theory• Over the last century has concerned itself more with “rational”

benchmarks and less with trying to model empirically observed behavior.

• According to Smith (1989) most economists feel that economics is an a-priori science rather than an observational one.

• According to Milgrom and Roberts (1987, p. 185) “no mere fact was a match in economics for a consistent theory.” Thus most economic theorists believe that economic problems and agent behavior therein can be fully conceptualized by thinking about them.

• Accordingly “after the thinking has produced sufficient technical rigour, internal coherence and interpersonal agreement, economists can then apply this to the world of data.” (Smith, 1989, p. 152)

The bottom line

The rational agent thus modeled is a self-interested maximizer always taking a decision that maximizes his expected wealth.

But from casual empiricism…• if we look around us we see serious violations

of this behavioural norm.

• Human beings are prone to voluntary acts of kindness sometimes motivated by altruism.

• Most people cooperate with their neighboursin the upkeep of their neighbourhoods.

• Most would trust another human being unconditionally often suffering negative consequences from this trusting behavior.

Predictably or systemically irrational• Are most people then ‘irrational’?

• If that were the case shouldn’t theory reflect this divergence from the norm especially as this divergence is often systematic and not random?

• Ariely (2008) refers to these divergences as “predictably irrational” ones.

• Basu (1983), Sugden (1986) and Coleman (1990) have attributed social norms (especially those that inculcate values and a sense of morality) as modifiers on our desire to maximize our material wealth.

Early glimmers of behaviourism

• Adam Smith in The Theory of Moral Sentiments (1759) builds on the work of David Hume (A Treatise of Human Nature, 1739)

• Here, Smith writes about an important psychological motivation that governs the way that economic agents conduct exchange.

• The particular moral sentiment that Smith describes at length is sympathy, i.e. – the feeling of compassion or concern for others.

• This tempers self-interest in socio-economic transactions and leads us to sacrifice narrow profiteering in order to maintain ties of affection with our fellow human beings.

So then why do we need economic theory at all?

• “Economists have traditionally avoided explaining behavior as less than rational for fear of developing many fragmented theories of mistakes.”Erev and Roth (1998, p. 848)

• Economic theory provides a behavioural(rational) benchmark of great generality against which we may compare observed behaviour.

The role of experiments

• The field of experimental economics (not to mention experimental social psychology) stands at the centre of this debate on observed behavioural deviations from rational theoretical prediction.

• The method of controlled experiments from the fifties onwards has allowed us to test game theoretic models as well as individual choice models with human subjects in the laboratory.

• Observed economic behaviors are compared to rational theoretical benchmarks, divergences from the rational norm are noted and in certain cases theories are advanced to explain these deviations.

A difference in approach• A fundamental point of divergence between

psychology/cognitive science and economics is related to the theoretical underpinnings behind various results.

• Most economists don’t really need a precise and accurate theory at the individual level, just as long as it is general enough to explain some of the observed behaviouraccurately and generate an aggregate prediction that is more or less accurate.

• So elegance and generality are generally desirable in economic theory, whereas psychologists and cognitive scientists are interested in modeling the precise nuances of behavior displayed by individuals.

An example• A typical economics experiment on attitudes towards risk

would have the researcher make an assumption about the form of the utility function (say constant relative risk aversion or CRRA) that the agents purportedly follow.

• Using this function and the choice response in the experiment, one can calculate some measure (maybe Arrow-Pratt) of risk aversion and then compare this across agents, over time, cross-culturally etc.

• If anyone questions the validity of using this functional form over another one, most of the time the answer that a theorist or an experimental economist would give you would be that it doesn’t matter as long as everyone’s attitude to risk is measured using the same CRRA specification.

The “as-if” approach to behaviour

• Most psychologists and cognitive scientists would be quite unhappy with this “as if” way of evaluation and would be more interested in the cognitive processes that govern the choice made by the decision maker.

• Economists on the other hand, some measure which has good internal validity but potentially scanty external support.

• According to Camerer (1995), most economists have a one-size-fits-all approach to studying economic problems vis-à-vis psychologists.

• if a task involves elicitation of a probability, most psychology experiments would frame the problem in a natural setting using a vignette. This would anchor the tasks to certain specific stimuli.

• Most economists would go ahead and attempt to elicit the same probability using a more decontextualised device such as a pair of dice or a bingo cage.

• This is in keeping with the ‘institution free’ pedagogy of neoclassical economics where elicitation of a probability is coming up with a specific statistical measure rather than an assessment of a contextualized measure of uncertainty.

One-size fits all

“Bounded” rationality• The origin of this ‘boundedly rational’ approach is from Simon’s

(1955) idea of “procedural” rationality whereby agents follow reasonable heuristics and on average achieve close to optimal outcomes.

• This is distinct from “substantive” rationality, where the agent considers the entire set of variables to make her decision.

• The idea of bounded rationality was one of failed optimization. Agents are unable to compute the optimum and settle for a second best “satisficing” outcome.

• The more modern idea of ecological rationality (Gigerenzer and Brighton, 2009) strongly opposes this idea that all heuristics are examples of failed optimization.

Heuristics: A new look at “bounded” rationality• Notice that the idea of “bounded” rationality implies that heuristics, which

do not attempt to optimize an objective function with respect to all the relevant variables is a result of cognitive limitations which force the decision maker to perform shoddy “second best” computations.

• In contrast Gigerenzer and Brighton (2009) find that heuristics are efficient cognitive processes that ignore information.

• In contrast to the widely held view that less processing reduces accuracy, their study of heuristics shows that less information, computation, and time can in fact improve accuracy. Gigerenzer and Brighton specifically show that there is a trade-off between bias and variance. More variables decrease bias but increase variance.

• According to this “fast and frugal” or “ecologically rational” approach to computation, “Homo Heuristicus” has a biased mind and ignores part of the available information, yet a biased mind can handle uncertainty more efficiently and robustly than an unbiased mind relying on more resource-intensive and general-purpose processing strategies.

What exactly is a controlled experiment in econ ?• It is a way of obtaining data on how economic agents behave (i.e.- the

actions they take) in a game, decision problem or a market.

• Subjects are recruited in a randomized way to be agents in a stylized environment that studies a particular economic problem.

• The interaction is described to the participating subjects (i.e.- the economic agents) with the help of laboratory instructions that present in detail the tasks that he or she needs to perform.

• Monetary incentives are provided in a salient way, so that agents can map the action space to the payoffs.

• In other words, the laboratory interface is a “real” market or game that has agents motivated by financial incentives.

• Examples include a laboratory double auction market, an oligopoly game or a two-player Prisoners’ Dilemma.

Findings from experimental studies• Game theory – people are not as hyper-rational as predicted by

theory. Though self interest is an important motivator for decisions made, it is by no means the only one. People display preferences for altruism, reciprocity, spite and mutualism. E.g.- cooperation in prisoners’ dilemma, egalitarian shares in bargaining games. Culture and norms play a role in shaping agent behaviour.

• Individual decision making – Humans are prone to systemic biases making their behaviour diverge considerably from the model of the expected utility maximizer. E.g.- endowment effect, reflection effect. These are often to do with the procedures humans use to aggregate payoffs.

• Since most real world problems involve both individual decision making as well as interactive components we see procedural as well as preferential divergences from theory.

OUTCOMES

Prices, allocations

CHOICE

BEHAVIOUR

ENVIRONMENT

Agent values, costs,

endowment,

technology

INSTITUTIONS

Language of the market

Rules of communication and

contract

Extensive form structure

CULTURE and

DEMOGRAPHICS

Social Norms

Pre-1960 institution free theory

Post 1960 – institutions matter

Post 1980 – culture and demographics

matter.

Figure 1: Institutions, culture, environment and behaviour in economics (extended from Smith, 1989)

Prisoners and tragedies

• The meta analysed cooperation in 2 X 2 prisoner’s dilemma experiments show cooperation rates of greater than 50 %

• Public goods games show cooperation rates of 20-40 %

• Contribution to public goods is dependent on cultural norms with some populations showing very high cooperation and others close to Nash equilibrium behaviour (Henrich, et al., 2001, 2005)

• Chakravarty et al. (2013) find very high rates of cooperation (40-50 %) among high altitude village communities in Kumaon.

Altruism and warm glow• Altruism – Increase in utility from giving to an other with no

explicit or implicit reciprocity.

• Warm glow – Increase in utility from the act of giving with no concern regarding the recipient.

• In dictator games a meta give rate of 27 % is seen (Engel, 2011)

• Dictator giving is sensitive to contexts, framing, reference points and social environments.

• Banerjee and Chakravarty (2014) find that framing and implied property rights over the endowment determine dictator outcomes.

Trust and reciprocity• A trust or investment game is one where a proposer chooses

whether to keep his endowment E or send x, keeping (E-x). The respondent obtains 3x (original investment trebled) and decides the amount [0, 3x] to send back to the proposer.

• An ultimatum bargaining game is one where a proposer decides what part (x) of his endowment (E) he will give to the respondent. If the respondent accepts then the split is (E-x, x) if not then neither get anything (0, 0)

• What are the Nash equilibria of the above games?

• For TG, in giving x the proposer displays altruism and forward looking reciprocity and in returning y, the respondent displays strong reciprocity.

• For UBG, the respondent vetoes only at the cost of making zero payoff.

• How did experimental subjects behave ?

Trust and reciprocity

Berg at al. (1986) find that a substantial number of subjects do not send zero, i.e.- are trusting and a significant amount of trust is reciprocated.

Ultimatum bargaining [Bowles, 2004]Game Results Interpretation Citation

Standard Modal offer = ½Offers < 20 % rejected

Reciprocity by respondent

Guth, Schmittberger and Schwarze (1982)

Randomized Offers Few rejections of low offers.

Proposer not responsible

Blount (1995)

Roles chosen by quiz

Many low offers, very few rejections

Proposer is “deserving”

Hoffman, McCabe, Shachat and Smith (1994)

Exchange game Many low offers, very few rejections.

Situational framing

Hoffman, McCabe, Shachat and Smith (1994)

No “fair” offerspossible, only[(8,2), (10,0)]

Low offers not rejected Proposer’s intentions

matter

Falk, Fehr and Fischbacher(2003)

Punishment by third party

Most observers punish low offers by proposer

Generalized fairness norms

Fehr and Fischbacher (2001)

Standard: Au/Gnau Offers > ½ are common high and low offers are rejected w/ equal freq.

Endogenous situation

dependent prefs

Henrich, Bowles, Boyd, Camerer, Fehr, Gintis and

McElreath (2001)

Standard:Machiguenga

Many low offers, very few rejections

Endogenous situation

dependent prefsHenrich (2000)

A theory of ‘other-regarding’ or social preferences

• Says that an agent is not merely interested in increasing his own payoff from a game, but also concerned about the other agent’s payoff, i.e.- he is inequality averse.

• Thus Ui = Ui(πown, | πown – πother|), increasing in πown and decreasing in | πown – πother|)

• Fehr and Schmidt 1999, Falk and Fischbacher, 1998; Fehr and Schmidt, 1999; Bolton and Ockenfels, 1999; Rabin, 1993; Charness and Rabin, 1999; Levine, 1998 all have models of social preferences.

• Some of these models use reciprocity/reputation and are not static.

Norms and culture• A very important intellectual direction that emerged out of the

anomalies observed in laboratory experiments was the study of the effect of culture and demographics on economic behaviour through the formation and enactment of social norms.

• Sen (1973) alludes to social norms when he discusses the prevalence of cooperative action in the Prisoner’s Dilemma game.

• Arrow (1982) clearly states that “The model of laissez-faireworld of total self-interest would not survive for ten minutes; its actual working depends on an intricate network of reciprocal obligations, even among competing firms and individuals.”

Preference reversals• Problem 1: Choose Between the following two risky bets, A or B:

A. 2,500 with probability of .33,

2,400 with probability of .66,

0 with a probability of .01

B. 2,400 with certainty

----------------------------------------------------------------• Problem 2: Choose between the following risky bets C or D:

C: 2,500 with probability .33, 0 with probability .67

D: 2,400 with probability .34, 0 with probability .66.

N = 72 A [18%] and B [82 %]

Majority display preferences of this type:

U(2,400) > .33U(2,500) + .66U(2,400) --- (I)

N = 72 C [83%] and D [17%]

Thus most people displayed preferences of the form:

.33U(2,500) > .34U(2,400) --- (II)

(I) and (II) are opposite to each other. This was first documented by Maurice Allais (1953)

Loss domain• Problem 3:

A: 4000 with prob = 0.8

0 with prob = 0.2

B: 3000 with certainty

Problem 4:

C: - 4000 with prob = 0.8

0 with prob = 0.2

D: - 3000 with certainty

The reflection effect

• Preferences are risk averse over gains and risk preferring over loss domains. We are also loss averse, i.e.- attach a greater weight to a loss as compared to a gain.

• Chakravarty and Roy (2009) documents this over both risky and ambiguous preferences.

Prospect theory

• Formulated by Kahneman and Tversky(1979). Its salient points:

• People overweight the importance of unlikely events and correspondingly overweight near certain events.

• People respond to framing, i.e.-equivalent outcomes are treated differently depending on the manner in which the outcomes or the decision setting are described.

• Provides a conceptual framework for dealing with situation-dependence. If the utility function is to explain behaviour its arguments should be changes in states or events rather than the states themselves. Thus, the value individuals place on states depends on the relationship of the state to the status quo (initial wealth, state enjoyed by peers, etc).

Equity Premium Puzzle• Given the return of stocks and bonds over the last century, an unreasonably

high level of risk aversion would be necessary to explain why investors are willing to hold bonds at all (Mehra and Prescott (1985)).

• Benartzi and Thaler (1995) combined two behavioral concepts—loss aversion (Kahneman and Tversky (1979)) and mental accounting (Thaler (1985))—to provide a theoretical foundation for the observed equity premium puzzle.

• Thaler et al. (1997), Gneezy and Potters (1997), and Gneezy, Kapteyn, and Potters (2003) have all observed individual behavior consistent with the Myopic Loss Aversion (MLA) conjecture.

• Individuals are loss averse and often have myopic (short term) ways in which they evaluate their portfolios. Both of these traits make them choose bonds over equities.

• It is assumed that with an increase in evaluation periods (i.e.- less myopic decision making) may make people hold less of their wealth in bonds.

Equity-premium puzzle experiments

• Haigh and List (JoF, 2005) conduct an experiment in lottery choices and show that MLA is important in decisions made not just by students but also by 54 professional futures and options pit traders from the Chicago Board of Trade.

• The traders display more MLA than the students.

Anchoring and reference points• Anchoring effects-Initial impressions become reference points

that anchor subsequent thoughts and judgments.

• Salesperson has three items for sale-expensive, medium high priced, and cheap. Show the customer the expensive item first, which acts as an anchor. Makes it easier to sell the medium high priced item.

• Dramatic or easy-to-recall events often become strong anchors. For example, the vividness of the horrible events of September 11 caused many to view airline travel as too risky, but many experts believe that travel has never been safer.

• When NYSE trading begins traders are more careful but over the day their behaviour becomes more risk preferring and by closing time they are almost risk neutral. Why is this happening?

Framing and preferences• Tversky and Kahneman (1981) told people to

assume there was disease affecting 600 people and they had two choices:

• Program A, where 200 of the 600 people will be saved .

• Program B, where there is 33% chance that all 600 people will be saved, and 66% chance that nobody will be saved.

• They then offered them another two choices:• Program C, where 400 people will die, 200

people live.• Program D, where there is a 33% chance that

nobody will die, and 66% chance that all 600 people will die.

Asian Disease Problem

• The majority of people selected A, showing a preference for certainty or risk aversion.

• Most people now selected D, seeking to avoid the loss of 400 people.

• Notice how the framing makes the difference. Prospects A and C are the same, and B and D are the same.

• Framing the prospect as a gain makes people risk averse. Framing the prospect as a loss makes people risk takers.

Status quo bias and endowment effect

• The endowment effect is people’s tendency to value something more highly when they own it than when they don’t

• Example: experiment in which median owner value for mugs was roughly twice the median non-owner valuation

• Some economists think this reflects something fundamental about the nature of preferences

• Incorporating the endowment effect into standard theory implies an indifference curve kinked at the consumer’s initial consumption bundle– Smooth changes in price yield abrupt changes in consumption

Endowment Effect

• Half the participants were given mugs available at the campus bookstore for $6

• The other half were allowed to examine the mugs• Each student who had a mug was asked to name the lowest sale price• Each student who did not have a mug was asked to name the highest

purchase price• Supply and demand curves were constructed and the equilibrium price

was obtained• Trade followed• There were four rounds of this

Bias Toward the Status Quo:Default Effect

• When confronted with many alternatives, people sometimes avoid making a choice and end up with the option that is assigned as a default

• Example: Experiment showing that more subjects kept $1.50 participation fee rather than trading it for a more valuable prize when the list of prizes to choose from was lengthened

• Possible explanation is that psychological costs of decision-making rise as number of alternatives rises, increasing number of people who accept the default

• Retirement saving example illustrates the default effect when the stakes are high

13-40

Default effect: retirement

• Prior to April 1, 1998, the default option was nonparticipation in the retirement plan

• After April 1, 1998, all employees were by default enrolled in a plan that invested 3% of salary in money market mutual funds

• Only the default option changed

Dynamic inconsistency

• Hyperbolic discounting-people generally prefer smaller, sooner payoffs to larger, later payoffs when the smaller payoffs would be imminent; but when the same payoffs are distant in time, people tend to prefer the larger, even though the time lag from the smaller to the larger would be the same as before.

• When given a choice, some people would prefer $50 today to $100 one year from now, but would choose $100 six years from now versus $50 five years from now.

Examples• Lots of people want the IT dept. to withhold more

than they owe in taxes so they get a big refund check. This behavior amounts to giving the IRS an interest free loan.

• School teachers who work 9 months are given the option of receiving their salary over 9 months or over 12 months. Many choose the 12 monthly checks because they don’t “trust” themselves. They lose interest income.

• Before you choose a college think of the reputation the college has: is it a diploma mill or does it require hard work? Most people prefer the college to have a good reputation, but once they arrive, they often prefer easy classes.

Poverty and cognition• Recent work by Shafir and Mullainathan (2013) Poverty and all

its related concerns require so much mental energy that the poor have less remaining brainpower to devote to other areas of life.

• As a result, people of limited means are more likely to make mistakes and bad decisions that may be amplified by — and perpetuate — their financial woes.

• Their work could explain a conundrum of public policy: If you give an individual Rs. 1000, why does he not invest it (his marginal utility of a Rupee is high) and instead buy alcohol?

• Chakravarty and Warglien (unpublished, 2013) demonstrate that poor people may be much more myopic in their evaluation of time.

Minor temptations• Ariely and his colleagues gave thousands of people 20 number

problems. When they tackled the problems and handed in the answer sheet, people got an average of four correct responses.

• When they tackled the problems, shredded their answers sheets and self-reported the scores, they told the researches they got six correct responses. They cheated a little, but not a lot.

• He put cans of Coke and plates with dollar bills in the kitchens of college dorms. People walked away with the Cokes, but not the dollar bills, which would have felt more like stealing.

• He had one blind colleague and one sighted colleague take taxi rides. The drivers cheated the sighted colleague by taking long routes much more often than they cheated the blind one, even though she would have been easier to mislead. They would have felt guilty cheating a blind woman.

So…• Given that these minor moral transgressions are in of

themselves largely innocuous there is no real reason for us to correct them.

• However if everyone in the population performs them, can we end up with harmful social outcomes?

• How can we prevent these ?

• Dan Ariely (2012) “The (Honest) Truth About Dishonesty.”