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Behavioral Economics Natalia Shestakova Ural State University Spring 2010 Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 25

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  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 25

  • Behavioral Economics: Lecture 1

    OUTLINE

    Behavioral economics

    Keystones of traditional economics

    RationalityExpected Utility TheoryDiscounted Utility TheoryNash Equilibrium

    Adding psychological insights

    Class experiment (simple)

    Course outline

    Q & A

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 25

  • Behavioral Economics: Lecture 1 Introduction

    Behavioral Economics

    2002 Nobel prize in economics:

    Daniel Kahneman: "for having integrated insights frompsychological research into economic science, especially concerninghuman judgment and decision-making under uncertainty"Vernon L. Smith: "for having established laboratory experiments asa tool in empirical economic analysis, especially in the study ofalternative market mechanisms"

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 25

  • Behavioral Economics: Lecture 1 Introduction

    Behavioral Economics

    ... sometimes called "Economics and Psychology"

    Economics ...?

    mathematically elegant models of interaction between economic agentsbased on simplied assumptions regarding individual behavior

    Psychology

    experiments to understand how people think and behave

    Behavioral Economics

    incorporates psychological regularities into economic models whilestaying formal and predictiveruns experiments to test predictions of existing modelsuses experimental (and eld) evidence to motivate alternative modelsof decision makingapplies new models of DM to other elds: Finance, IO, Labor

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 25

  • Behavioral Economics: Lecture 1 Introduction

    Behavioral Economics

    Why to care?

    Strategies of real rms

    Ran Spiegler, 2006. "The Market for Quacks," RESpatient recovers with same probability no matter whether she receivestreatment from healerif all patients are rational, market remains inactiveif some patients reason anecdotally, market becomes activeanecdotal reasoning: patients react to random casual stories as if theyare fully informative of actual quality of healers treatment

    Policy recommendations

    school cafeteria example from "Nudge"kids are more likely to choose food displayed at eye levelyou do not want to remove unhealthy food from menuwhy not to display healthy food at eye level?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 25

  • Behavioral Economics: Lecture 1 Introduction

    Behavioral Economics

    What to read?

    Predictably Irrational, Dan Ariely, 2008

    http://www.predictablyirrational.com/ ... for videos

    Nudge, Richard H. Thaler and Cass R. Sunstein, 2008

    http://nudges.org/ ... for more nudges

    Behavior Economics: Past, Present, Future, Colin F. Camerer andGeorge Loewenstein, 2002

    Chapter 1 in Advances in Behavioral Economics

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 25

  • Behavioral Economics: Lecture 1 Keystones of traditional economics

    Rationality (MWG Ch.1)

    Rational preferences: what is that?

    Consider colors: green (G ), orange (O), blue (B)

    for each pair, dene preferred color: fG ,Og, fO,Bg, fG ,BgCompleteness

    for each pair, preference relation is denedeither G O, or O G , or none

    Transitivityif G O and O B, then should be G Bsame for indierence

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 25

  • Behavioral Economics: Lecture 1 Keystones of traditional economics

    Rationality (MWG Ch.1)

    Rational preferences: where do we use them?

    Utility function

    only rational preferences can be represented by utility functionany model that has consumers but goes without utility function?

    Consistent choices

    WARP: if consumer chose X when Y was available, then she willchoose Y only when X becomes unavailable.choice structure generated by rational preferences satises WARPnot every choice structure that satises WARP is necessarily generatedby rational preferences

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 25

  • Behavioral Economics: Lecture 1 Keystones of traditional economics

    Expected Utility Theorem (MWG Ch.6)

    Simple lotteriesset of possible outcomes, N elementsL = (p1, ..., pN ) ... simple lottery assigns prob pn to each outcome

    Continuity axiomsmall changes in probs do not change ordering between two lotteries

    Independence axiomL L0 if and only if L+ (1 ) L00 L0 + (1 ) L00, 2 (0, 1)

    Expected utility formassign numbers (u1, ..., uN ) to outcomes, s.t.U (L) = u1p1 + ...+ uNpN

    Expected Utility TheoremIf DMs preferences over lotteries satisfy continuity and independenceaxioms, then her preferences are representable by utility function withexpected utility form: L L0 if and only if U (L) U (L0)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 25

  • Behavioral Economics: Lecture 1 Keystones of traditional economics

    Discounted Utility

    Utility from consumption over time

    ct ... consumption at time tu () ... instantaneous utility function ... discount factor

    Exponential discounting

    UfctgTt=t0

    =

    T

    t=t0

    tt0u (ct )

    Time consistent choice

    suppose "X today" is chosen over "Y tomorrow"then "X in one month from today" should be chosen over"Y in one month and one day from today"

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 25

  • Behavioral Economics: Lecture 1 Keystones of traditional economics

    Nash Equilibrium (MWG Ch.7)

    Classic Prisoners dilemma

    two suspects are arrested but evidence is insu cient for convictionpoliceman asks each prisoner to testify for prosecution against anotherif both remain silent, they are sentenced to only six monthsif one betrays and another remains silent, betrayer goes free, silent onereceives 10-year sentenceif both betray, each receives 5-year sentencethey should decide simultaneously whether to stay silent or to betray

    Nash equilibrium

    each player chooses strategyno player can benet by changing his strategy while another player isnot changing his

    What is Nash equilibrium in Prisoners dilemma?

    (betray, betray)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Choose preferred color for slides:

    334400 335500 ...?335500 334400 ...?334400 335500 ...?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Choose preferred color for slides:

    335500 336600 ...?336600 335500 ...?335500 336600 ...?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Choose preferred color for slides:

    336600 337700 ...?337700 336600 ...?336600 337700 ...?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Choose preferred color for slides:

    337700 338800 ...?338800 337700 ...?337700 338800 ...?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Choose preferred color for slides:

    334400 338800 ...?338800 334400 ...?334400 338800 ...?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 16 / 25

  • Behavioral Economics: Lecture 1 Adding psychology into economics

    Violation of transitivity

    Most people are indierent in rst four choices

    334400 335500335500 336600336600 337700337700 338800

    Transitivity requires that

    334400 338800

    But usually it is not

    either 334400 338800or 338800 334400

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 17 / 25

  • Behavioral Economics: Lecture 1 Class experiment

    Rules

    keep silence

    imagine you are choosing magazine subscription

    read carefully description of all options

    choose one optionsubmit your answers

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 18 / 25

  • Behavioral Economics: Lecture 1 Class experiment

    Group #1

    three alternatives2nd alternative is denitely worse than 3rd alternative

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 19 / 25

  • Behavioral Economics: Lecture 1 Class experiment

    Group #2

    two alternativesdominated alternative is removed

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 20 / 25

  • Behavioral Economics: Lecture 1 Class experiment

    Discussion

    example taken from "Predictably Irrational"

    subjects from MITs Sloan School of Management/ our class

    Group #1

    Internet only subscription for $59 ... 16 students/ 4 studentsPrint only subscription for $125 ... zero student/ zero studentsPrint-and-Internet subscription for $125 ... 84 students/ 4 students

    Group #2

    Internet only subscription for $59 ... 68 students/ 9 studentsPrint-and-Internet subscription for $125 ... 32 students/ 3 students

    context eect

    preferences between options depend on what other options are inchoice set

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 21 / 25

  • Behavioral Economics: Lecture 1 Course Outline

    Main Requirements

    Prepare experiment and participate in other experiments5 groups of 4 students10 points* for preparing experiment, 5 points for participating5 bonus points for participating in each paid experimentmax 30 points, plus 10 bonus points possible

    Apply behavioral theories for solving formal problemshome assignmentgroups of 2 studentsmax 20 points

    Find practical application of Behavioral Economicsessay/ research proposalgroups of 2 studentsmax 30 points

    Final testindividualmax 20 points

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 22 / 25

  • Behavioral Economics: Lecture 1 Course Outline

    Topics for experiments

    20/04: framing, anchoring & preference reversal27/04: do people choose according to EUT?04/05: do people discount exponentially?11/05: other regarding preferences18/05: cognitive limitations

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 23 / 25

  • Behavioral Economics: Lecture 1 Course Outline

    Experimental practices

    from Hertwig & Ortmann 2001

    Script enactment

    state action choices explicitly

    Repeated trials

    allow gaining experience with situation

    Financial incentives

    set goal to perform as well as possible

    Proscription against deception

    exclude second-guessing about purpose of experiment

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 24 / 25

  • Behavioral Economics: Lecture 1 Course Outline

    Q&A

    Ask now ...

    ... or contact by email: [email protected]

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 25 / 25

  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 18

  • Behavioral Economics: Lecture 2

    Lecture plan

    Review: standard assumptions about preferences

    Class experiment

    problem solvingdiscussion of possible eectspresentation of results, comparison with results usually obtained

    Summary: most common anomalies in preferences

    denitionshow it may lead to choice inconsistencypotential explanations

    Modeling anomalies in preferences

    reference dependencemental accounting

    Applications

    power of default option in saving for retirement

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 18

  • Behavioral Economics: Lecture 2 Review

    Standard assumptions about preferences

    completeness

    for each pair of alternatives, X and Y , preferences uniquely denedeither X Y , or Y X , or none

    transitivity

    if X Y and Y Z , then should be X Zsame for indierence

    invariance w.r.t.

    current endowment / consumption levelirrelevant alternativeselicitation procedure

    => consistency of choices

    WARP: if consumer chose X when Y was available, then she willchoose Y only when X becomes unavailable.choice structure generated by rational preferences satises WARP

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 18

  • Behavioral Economics: Lecture 2 Class experiment

    Procedure

    problem solving

    discussion of possible eects

    presentation of results, comparison with results usually obtained

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 18

  • Behavioral Economics: Lecture 2 Summary

    Framing eect

    framing eect:

    way how choice problem is stated aects choice

    may cause inconsistency:

    DM chooses X over Y when Y is presented in terms of lossesbut may choose Y over X when Y is presented in terms of gains

    one explanation:

    people are passive DMs: they rely on easily available heuristics

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 18

  • Behavioral Economics: Lecture 2 Summary

    Anchoring eect

    anchoring eect:

    irrelevant factors aect which values are assigned to alternativeshowever, relative values are not aected... coherent arbitrariness

    may cause inconsistency:

    DM assigns higher value to X than to Y when evaluates them togetherbut may assign higher value to Y than to X when evaluates separately

    one explanation:

    arbitrary number serves as original valuewhile nal value is product of adjusting original value

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 18

  • Behavioral Economics: Lecture 2 Summary

    Endowment eect

    endowment eect:

    ownership makes good more attractivepreferences for X and Y depend on which of them DM owns

    may cause inconsistency:

    DM chooses X over Y when she owns Xbut may choose Y over X when she owns nothing

    one explanation:

    "yeah, whatever" heuristic

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 18

  • Behavioral Economics: Lecture 2 Summary

    Preference reversal

    preference reversal:

    revealed preferences depend on elicitation procedure

    likely to cause inconsistency:

    DM chooses X over Y when asked directly to choosebut may request more money for giving up Y than for giving up X

    competing explanations:

    intransitivity: Y CY CX X Yoverpricing of Y , CY Y , underpricing of X , X CX

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 18

  • Behavioral Economics: Lecture 2 Summary

    Context eect

    context eect:

    presence of other alternatives in choice set aects choice

    may cause inconsistency:

    DM chooses X over Y when there is X in choice setbut may choose Y over X when X is removed

    one explanation:

    di cult to compare X and Ybut easy to notice that X is better than X

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 18

  • Behavioral Economics: Lecture 2 Summary

    Anomalies: common explanations

    preferences are constructedreference dependence & loss aversionmisleading but simple heuristics

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 18

  • Behavioral Economics: Lecture 2 Modeling anomalies in preferences

    Reference dependence

    (based on Kahneman & Tversky, 1991)

    choice set... X = fx , y , z , ...greference structure... indexed preference relations x r y

    r ... complete, transitive, continuous

    reference independence in standard theory

    x r y if and only if x s y for all x , y , r , s 2 X

    related questions

    what determines reference statehow reference state aects preferences

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 18

  • Behavioral Economics: Lecture 2 Modeling anomalies in preferences

    Loss aversion: Denition

    (based on Kahneman & Tversky, 1991)

    intuition... people dislike losses more than they like equivalent gains,shift in reference point turns gains into losses

    compare alternatives across two dimensions

    x ... work in Prague, y ... work in Ektb,r ... study in Prague, s... study in Ektb1st (location): x1 = r1 > s1 = y12nd (income): y2 > r2 = s2 > x2

    preference relation satises loss aversion:

    x s y implies that x r y

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 18

  • Behavioral Economics: Lecture 2 Modeling anomalies in preferences

    Loss aversion: Illustration

    DM at s-state compares:

    v1(x1 s1)gain

    + v2(x2 s2)loss

    v2(y2 s2)gain

    DM at r-state compares:

    v2(x2 r2)loss

    v1(y1 r1)loss

    + v2(y2 r2)gain

    => gain from x becomes loss from y

    loss averse DM

    dislikes losses more than likes gainsassume she is indierent between x and y at s-statethen she should prefer x to y at r -statewhat if she is indierent between x and y at r -state?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 18

  • Behavioral Economics: Lecture 2 Modeling anomalies in preferences

    Mental accounting

    (based on Kahneman & Tversky, 1984)

    choice problem

    store A: X costs 200RUB, Y costs 2000RUBstore B1: 20 min away, X costs 100RUB , Y costs 2000RUBstore B2: 20 min away, X costs 200RUB , Y costs 1900RUB

    minimal account

    disregard features that alternatives sharecompare only dierences between alternatives

    topical account

    relate consequences of possible outcomes to reference level

    comprehensive account

    incorporate other factors, incl. current wealth, possible earnings, etc.

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 18

  • Behavioral Economics: Lecture 2 Applying knowledge of anomalies in preferences

    Saving for retirement problem

    standard economic theory suggests:

    calculate how much you will earn over lifetimegure out how much you will need when you retiresave up enough for retirement without sacricing too much now

    dened-benet retirement plans:

    pensions are proportion to salary and years of serviceadvantage: easy to participatedisadvantage: not friendly to those who change jobs frequently

    dened-contribution retirement plans:

    participants have personal accounts to make specied contributionsadvantage: completely portabledisadvantage: too many decisions to make

    main negative consequence of choice complexity:

    too low participation rate

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 18

  • Behavioral Economics: Lecture 2 Applying knowledge of anomalies in preferences

    Power of default option

    (based on Madrian & Shea, 2001)

    401k retirement plans in U.S.

    worker can choose portion of her wage to be contributed to her 401kaccount before income taxes are paid

    initial form:

    "Check this box if you would like to participate in a 401k. Indicate howmuch youd like to contribute."participation rate 38%

    updated form:

    "Check this box if you would not like to have 3% of your pay checkput into a 401k."participation rate 86%

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 16 / 18

  • Behavioral Economics: Lecture 2 Next lecture

    Food for thought

    How studied eects may change predictions of your favorite theories

    How studied eects may be used to explain seeming paradoxes

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 17 / 18

  • Behavioral Economics: Lecture 2 Next lecture

    Topics for experiments

    20/04: framing, anchoring & preference reversal

    27/04: do people choose according to EUT?04/05: do people discount exponentially?

    11/05: other regarding preferences

    18/05: cognitive limitations

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 18 / 18

  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 22

  • Behavioral Economics: Lecture 3

    Lecture plan

    Choice under risk and uncertainty:

    expected utility theoremrisk attitudeEUT at work

    Class experiment:

    common consequence eectcommon ratio eectreection eectfourfold pattern of risk attitude

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 22

  • Behavioral Economics: Lecture 3 Choice under risk and uncertainty

    Preferences over lotteries

    Simple lotteries:set of possible outcomes, N elementsL = (p1, ..., pN ) ... simple lottery assigns prob pn to each outcome

    Rationality:completenesstransitivity

    Continuity:there are no "jumps" in ordering of preferences=> preferences are not lexicographic

    EU form:it is possible to assign numbers (u1, ..., uN ) to outcomes, s.t.U (L) = u1p1 + ...+ uNpN

    Independence axiom:L L0 if and only if L+ (1 ) L00 L0 + (1 ) L00, 2 (0, 1)possibility to get L00 should not aect preferences between L and L0

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 22

  • Behavioral Economics: Lecture 3 Choice under risk and uncertainty

    Preferences over lotteries: Example

    Possible outcomes:X1... rainy, X2... cloudy, X3... sunnyassign numbers to weather conditions:X1 !?, X2 !?, X3 !?

    Lotteries = resorts:L = (p1, p2, p3), p1... prob rain, p2... prob clouds, p3... prob sunL... Barcelona in June, L = (?, ?, ?)EU form: U (L) =?

    Equilateral triangle with altitude=1:

    pn ... length of perpendicular from L to side opposite to vertex n

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 22

  • Behavioral Economics: Lecture 3 Choice under risk and uncertainty

    Independence axiom: Closer look

    Independence axiom implies that indierence curves are:

    straight: L L0 if and only if L 12L0 +12L (b)

    parallel: L L0 if and only if 13L+23L00 13L0 +

    23L00 (c)

    Illustration:

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 22

  • Behavioral Economics: Lecture 3 Choice under risk and uncertainty

    Expected Utility Theorem

    Assumptions on preferences over lotteries:

    rationalcontinuoussatisfy independence axiom

    Expected Utility Theorem:

    preferences are representable by utility function with EU formnotation: L L0 if and only if U (L) U (L0)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 22

  • Behavioral Economics: Lecture 3 Choice under risk and uncertainty

    Risk attitude

    Expected outcome vs. expected utility

    E (X ) = p1X1 + ...+ pNXNEU (L) = p1u (X1) + ...+ pNu (XN )

    Risk-neutral DM: EU (L) = U [E (X )]indierent between lottery and its expected outcome

    Risk-averse DM: EU (L) < U [E (X )]likes lottery less than its expected outcome

    Risk-seeking DM: EU (L) > U [E (X )]likes lottery more than its expected outcome

    How risk attitude aects shape of indierence curves

    more risk-averse DM has steeper I.C.s

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 22

  • Behavioral Economics: Lecture 3 Class experiment

    Do people choose according to EUT?

    Motivation:

    can EUT be supported empirically?

    Procedure:

    problem solvingdiscussion of possible eectspresentation of results, comparison with results usually obtained

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 22

  • Behavioral Economics: Lecture 3 Class experiment

    Common consequence eect

    Allais paradox #1:

    outcomes: X1... $5, 000, X2... $1, 000, X3... $0S 0 = (0, 1, 0) vs. R 0 = (0.1, 0.89, 0.01)S 00 = (0, 0.11, 0.89) vs. R 00 = (0.1, 0, 0.9)

    Structure of choice problem:

    nonnegative monetary outcomes: X1 > X2, X3 = 0, CS = (0, p, 0, 1 p)R = (p, 0, (1 ) p, 1 p)C ... common consequence, should have no eect

    Experimental evidence:

    tendency to choose S when C = X2 (S 0 vs. R 0)tendency to choose R when C = X3 (S 00 vs. R 00)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 22

  • Behavioral Economics: Lecture 3 Class experiment

    Common ratio eect

    Allais paradox #2:

    outcomes: X1... $4, 000, X2... $3, 000, X3... $0S 0 = (0, 1, 0) vs. R 0 = (0.8, 0, 0.2)S 00 = (0, 0.25, 0.75) vs. R 00 = (0.2, 0, 0.8)

    Structure of choice problem:

    nonnegative monetary outcomes: X1 > X2, X3 = 0S = (0, p, 1 p)R = (p, 0, 1 p)... constant ratio of winning probabilitiesp should have no eect

    Experimental evidence:

    tendency to choose S when p is hightendency to choose R when p is low

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 22

  • Behavioral Economics: Lecture 3 Class experiment

    Reection eect

    Kahneman & Tversky (1979)

    related to framing eect

    Structure of choice problem:

    monetary outcomes: jX1 j > jX2 j, X3 = 0S = (0, p, 1 p)R = (p, 0, 1 p)

    Experimental evidence

    tendency to choose S when X1 > X2 > 0tendency to choose P when X1 < X2 < 0

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 22

  • Behavioral Economics: Lecture 3 Class experiment

    Fourfold pattern of risk attitude

    Domain of gains:

    risk averse when probability of winning is highrisk seeking when probability of winning is low

    Domain of losses:

    risk averse when probability of losing is lowrisk seeking when probability of losing is high

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 22

  • Behavioral Economics: Lecture 4

    Lecture plan

    Previous lecture:

    independence axiomrisk attitude

    Summary of class experiment:

    common consequence eectcommon ratio eectreection eectfourfold pattern of risk attitude

    Alternative theories of choice under risk and uncertainty

    generalizations of EUTprospect theorypriority heuristic

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Generalizying expected utility model

    "Fanning-out" hypothesis (Machina, 1982):

    agents become more risk-averse as lotteries become betterutilities assigned to outcomes are lottery-specicweak independence: L L0 i for each 2 (0, 1) there can found 2 (0, 1), s.t. L+ (1 ) L00 L0 + (1 ) L00 for any L00

    Theories with decision weights:

    EU (L) = (p1) u (X1) + ...+ (pN ) u (XN )standard theory: (pi ) = pi

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Reminder: reference dependence

    Choice set... X = fx , y , ..., r , s, ...gchoosing between x and y , while having either r , or s

    Reference structure... indexed preference relations x r yr , s ... complete, transitive, continuous

    Reference independence in standard theory

    x r y if and only if x s y for all x , y , r , s 2 X

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Reminder: loss aversion

    Intuition... people dislike losses more than they like equivalent gains,shift in reference point turns gains into losses

    Compare alternatives across two dimensions

    x ... unemployed in Prague, y ... work in Ektb,r ... study in Prague, s... study in Ektb1st (location): x1 = r1 > s1 = y12nd (income): y2 > r2 = s2 > x2

    Preference relation satises loss aversion:

    x s y implies that x r y

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 16 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Prospect theory (Kahneman & Tversky, 1979)

    1st phase of choice process:

    "edit" lotteries using decision heuristicsex.#1: eliminate lotteries that do not satisfy chosen criterionex.#2: classify outcomes in terms of gains and losses

    2nd phase of choice process:

    evaluate "edited" lotteries using decision-weighted formvalue of each outcome depends on its sign and size

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 17 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Prospect theory: valuation of outcomes

    Shape of value function:

    Properties:

    kinked at reference pointconcave for gains/ convex for losses , diminishing sensitivitysteeper in domain of losses , loss-aversion

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 18 / 22

  • Behavioral Economics: Lecture 4 Alternative theories of choice under risk and uncertainty

    Priority heuristic

    Search for:

    minimum payoprobability of minimum payomaximum payo

    Stop search if:

    dierence between minimum payos is > 10% of maximum payodierence between probabilities of minimum payos > 10%maximum payos are dierent

    Decide for lotteries with:

    larger minimum payosmaller probability of minimum payolarger maximum payo

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 19 / 22

  • Behavioral Economics: Lecture 4 Why do we need theory of decision making?

    EUT at work: Corruption

    Problem:

    took credit for opening new business but it may take too long

    Possible outcomes:

    X1... never open, X2... open in 1 year, X3... open in 1 month1, 2, 3... computed prots/ losses in each case

    Choice over two lotteries:

    L = (p1, p2, p3)... do everything legallyL0 = (p01, p

    02, p

    03)... give bribery of size B, pay ne of size F if caught

    Decision rule: give bribery if and only if

    p01u (1 B F ) + p02u (2 B) + p03u (3 B) p1u (1) + p2u (2) + p3u (3)

    Policy recommendations:

    eectiveness of measures against corruption

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 20 / 22

  • Behavioral Economics: Lecture 4 Why do we need theory of decision making?

    Food for thought

    How do we usually make theory-based policy recommendations?

    assume specic functional formsestimate parameters of functional forms using available datado comparative statics

    What if EUT is replaced with more general theory?

    more functional forms to imposemore parameters to estimaterecommendations are more "conditional"

    What to do? Where to go?

    open question, solutions welcomed

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 21 / 22

  • Behavioral Economics: Lecture 4 Next lecture

    Topics for experiments

    20/04: framing, anchoring & preference reversal

    27/04: do people choose according to EUT?

    03/05: do people discount exponentially?11/05: other regarding preferences

    18/05: cognitive limitations

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 22 / 22

  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 25

  • Behavioral Economics: Lecture 5

    Lecture plan

    Discounted utility model:

    historical originsmodelimplicit assumptions

    Discounted utility anomalies (class experiment):

    common dierence eectabsolute magnitude eectgain-loss asymmetrydelay-speedup asymmetry

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    Historical origins

    Eective desire for accumulation, Rae 1834:

    promoted by: bequest and self-restraintlimited by: uncertainty and gratication from immediate consumptionthese are determinants of intertemporal choice

    Systematic underestimation of future wants, Bohm-Bawerk 1889:

    intertemporal choice as decision about allocating resources to oneselfover dierent points in time

    Time preference, Fisher 1930:

    MRS of consumption today with consumption tomorrowshould controlled for diminishing MU of consumptioncombination of various (psychological) intertemporal motives

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    Simple formulation

    Discounted utility model, Samuelson 1937:

    all psychological motives compressed into discount rate ct , ..., cT ... consumption prolespreferences transitive, complete, continuousu (ct ) ... instantaneous utility functionUt (ct , ..., cT ) ... intertemporal utility function

    Ut (ct , ..., cT ) =Ttk=0

    D (k) u (ct+k ) , where

    D (k) =

    11+

    k= k ... discount function

    not psychologically plausiblenot normatively plausible

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    More formulas

    Intertemporal utility in continuous time:

    U t (ct , ..., ct 0 , ..., cT ) =Z Ttk=0

    eku (ct+k ) dt

    How to impute discount rate:

    given X at t, how big should be Y at t 0 to make you indierent?assumption: X at t and Y at t 0 are small relative to ct and ct 0then Ut (ct + X , ..., ct 0 , ..., cT ) = U

    t (ct , ..., ct 0 + Y , ..., cT )implies X = Ye(t

    0t)

    = 1t 0 t ln

    XY

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    Consumption independence

    Utility in period t + k is independent of consumption in period s

    X ,Y ,Z ... consumption possibilitiesX Y in period r when Z is consumed in period r 0 iX Y in period r when Z is not consumed in period r 0

    Example (Samuelson 1952):

    X ... wine, Y ... milk, Z ... beerr ... today, r 0... yesterdayassume X Y in period r when Z is not consumed in period r 0is it true that X Y in period r when Z is consumed in period r 0?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    Constant discounting and time consistency

    Discount function

    general form: D (k) =k1n=0

    1

    1+n

    form imposed in DU model: D (k) =

    11+

    k= k

    constraint: constant per-period discount rate, n = 8n

    Time-consistent intertemporal preferences:

    later preferences "conrm" earlier preferencesif (X at r) t (Y at r + d) for some r , then(X at r) t (Y at r + d) for all r

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 25

  • Behavioral Economics: Lecture 5 Discounted utility model

    Other implicit assumptions

    Utility independence

    distribution of utility across time makes no dierencee.g. if higher utility at r in one consumption prole is compensated byhigher utilities at r 1 and r + 1 in another consumption prole, twoproles are treated as identical

    Stationary instantaneous utility

    u (ct ) = u (ct+1) if ct = ct+1that is, tastes do not change over time

    Diminishing marginal utility

    motivates to spread consumption over time

    Positive discount rate

    motivates to concentrate consumption in present

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 25

  • Behavioral Economics: Lecture 5 Class experiment

    Discounted utility anomalies

    Motivation:

    can DU model be supported empirically?are deviations, if any, systematic?

    Procedure:

    problem solvingdiscussion of possible eectspresentation of results, comparison with results usually obtained

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 25

  • Behavioral Economics: Lecture 5 Class experiment

    Common dierence eect

    Predictions of DU model:

    extra consumption: X at t or Y at t 0

    = 1t 0t lnXY

    only dierence between t 0 and t matters, not their values

    Experimental task:

    C1: (A) 1 apple today or (B) 2 apples tomorrowC2: (A) 1 apple in 365 days or (B) 2 apples in 366 days

    Experimental evidence:

    [some] people choose A in C1 and Bin C2this suggests dynamic inconsistency: people claim that Bis betterthan A, but, once 365 days pass, they choose Aover B

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 25

  • Behavioral Economics: Lecture 5 Class experiment

    Absolute magnitude eect

    Predictions of DU model:

    extra consumption: X at t or Y at t 0

    = 1t 0t lnXY

    only ratio between X and Y matters, not their absolute values

    Experimental task:

    Q1: amount to be received in 1 month (Y ) that would make youindierent to 100RUB now (X )Q2: amount to be received in 1 month (Y 0) that would make youindierent to 100, 000RUB now (X 0)

    Experimental evidence:

    proportion in Q1XY

    is usually lower than in Q2

    X 0Y 0

    this implies that is lower for higher absolute values of X

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 25

  • Behavioral Economics: Lecture 5 Class experiment

    Gain-loss asymmetry

    Predictions of DU model:

    gains/ equivalent losses: X at t or Y at t 0

    = 1t 0t lnXY

    only ratio between X and Y matters, not their signs

    Experimental task:

    Q1: friend cannot return you X today, how much would you requirehim to return in one month (Y )?Q2: you cannot return X today, how much would you oer to return inone month (Y 0)?

    Experimental evidence:

    answer in Q1 (Y ) is usually higher than in Q2 (Y 0)this implies that is lower for losses than for gains

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 25

  • Behavioral Economics: Lecture 5 Class experiment

    Delay-speedup asymmetry

    Predictions of DU model:

    extra consumption: X at t or delay/ speedup Y /Y 0 to t + 1/t 1 = 1t 0t ln

    XY

    ratio YX should be same as

    XY 0

    Experimental task:

    Q1: have chance to receive Y at t 1 instead of X at tQ2: have chance to receive Y 0 at t + 1 instead of X at t

    Experimental evidence:

    proportion in Q1YX

    is usually lower than in Q2

    XY 0

    this implies that is lower for higher absolute values of X

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 25

  • Behavioral Economics: Lecture 6

    Lecture plan

    Discounted utility anomalies

    summary of class experiments

    Alternative models of intertemporal choice

    hyperbolic discounting modelsrole of self-awarenessreference-point modelsmental accounting

    Why do we need models of intertemporal choice?

    saving and consumption over timeaddiction

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 25

  • Behavioral Economics: Lecture 6 Class experiments: summary

    Discounted utility anomalies

    Median responses from Thaler 1981:X today equivalent Y discount equivalent Y discount

    in 3 months rate in 1 year rategain $15 $30 277 $60 139gain $250 $300 73 $350 34loss $15 $16 26 $20 29

    Discount rate is lower for:

    more distant time horizonsbigger gainslosses

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 25

  • Behavioral Economics: Lecture 6 Class experiments: summary

    Discounted utility anomalies

    Discount factor =

    11+

    as function of time:

    increasing, implying decreasing discount rate constant if 1st period removed

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 16 / 25

  • Behavioral Economics: Lecture 6 Alternative models of intertemporal choice

    Hyperbolic discounting

    Discount function introduced in Phelps & Pollak 1968:

    D (k) =1 if k = 0

    k if k > 0

    declining discount rate between today and future periodsconstant discount rate between two periods in future

    1 apple today or 2 apples tomorrow:

    A vs. 2A

    1 apple in 365 days or 2 apples in 366 days:

    365A vs. 3662A => A vs. 2A

    Time inconsistency when:

    < 12 but >12

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 17 / 25

  • Behavioral Economics: Lecture 6 Alternative models of intertemporal choice

    Role of seld-awareness

    Naive DM

    believes that future preferences will be identical to currentfrequently has "planning fallacy"

    Sophisticated DM

    correctly predicts how preferences will change over timedemand for commitment: intention to exclude tempting futurealternatives

    Partially naive DM

    knows that will experience self-control problems but underestimatestheir magnitude

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 18 / 25

  • Behavioral Economics: Lecture 6 Alternative models of intertemporal choice

    Reference dependent utility

    Instantaneous utility function

    u (c, r) = v (c r)r... reference point, determined by past cons, expectations, etcv () concave over gains, convex over lossesv () allows loss-aversion

    Implications

    explains most anomalies experimentally observedexplains failure of Permanent Income Hypothesis: anticipated changesin wages aect consumption growth rate while they should not

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 19 / 25

  • Behavioral Economics: Lecture 6 Alternative models of intertemporal choice

    Mental accounting

    Basic idea

    money spent on dierent purposes are not same as dierentexpenditures are assigned to dierent "mental accounts"like keeping money in labeled jarsconsumption of particular item is linked to payment for it

    Implications

    dierent ways of nancing purchase can lead to dierent decisionspreference for prepaymentpreference for getting paid after doing work

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 20 / 25

  • Behavioral Economics: Lecture 6 Why do we need models of intertemporal choice

    Addiction within DU model

    Rational addiction, Becker and Murphy 1988

    well-being depends on consumption of nonaddictive goods, addictivegoods and addictive stateaddictive state: " with use of substance, # with abstinencetolerance: well-being # when addictive state "addiction: MU of addictive good " when addictive state "

    Justifying government intervention

    educational policies to inform people about eectsPigouvian tax per unit = marginal external damage imposed on others

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 21 / 25

  • Behavioral Economics: Lecture 6 Why do we need models of intertemporal choice

    Problematic empirical observations

    Unsuccessful attempts to quit

    70% of current smokers express desire to quit completely, 41% stopsmoking for at least one day, only 4.7% abstained for more than threemonths

    Starting again caused by cues

    change in environment helpsstress and "priming" may bring addiction back

    Self-control through precommitment

    voluntary "lock-up" into rehabilitationmedication that generate unpleasant side-eect if substance used

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 22 / 25

  • Behavioral Economics: Lecture 6 Why do we need models of intertemporal choice

    Addiction within hyperbolic discounting model

    Hyperbolic discounting, Gruber and Koszegi 2001

    true preferences correspond to standard exponential discountingdecision-making according to hyperbolic discountingpresent-biased preferences

    Nonstandard policy implications

    Pigouvian tax should count for "internalities"... externalities imposedon future selveseducational policies not su cient as they do not address causes ofpresent bias

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 23 / 25

  • Behavioral Economics: Lecture 6 Why do we need models of intertemporal choice

    Addiction as decision-process malfunction

    Two individual modes, Bernheim and Rangel 2004

    "cold" mode: properly functioning decision-making process"hot" mode: decisions and preferences may divergeprobability of entering "hot" mode depends on: addictive state, chosenlifestyle, random eventsaddiction: " use of substance ) " addictive state ) " probability ofhot mode

    Nonstandard policy implications

    important: policies should not harm those who choose to usesubstances in cold stateconsumption in hot mode is less sensitive to taxes ) higher taxesneeded ) distorted decisions in cold mode ) e.g. higher probabilityof committing crimeelimination of problematic cues helps (advertising, peer eects)promotion of counter-cues ("smoking kills")

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 24 / 25

  • Behavioral Economics: Lecture 6 Next lecture

    Topics for experiments

    20/04: framing, anchoring & preference reversal

    27/04: do people choose according to EUT?

    03/05: do people discount exponentially?

    11/05: other regarding preferences18/05: cognitive limitations

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 25 / 25

  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 27

  • Behavioral Economics: Lecture 7

    Lecture plan

    Introduction to Game Theory

    historical originsbasic elements and concepts

    Do people play as theory predicts? (class experiment)

    ultimatum gamedictator gametrust game

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 27

  • Behavioral Economics: Lecture 7 Introduction to Game Theory

    Historical origins

    Von Neumann and Morgenstern 1944

    mathematician and economist created Game Theorymathematical tool to describe human behavior in strategic situationswhen payos depend also on actions of othersVon Neumann as member of US Atomic Energy Commission

    1994 Nobel prize in Economics

    for pioneering analysis of equilibria in theory of noncooperative games

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 27

  • Behavioral Economics: Lecture 7 Introduction to Game Theory

    Simultaneous game: Prisoners dilemma

    Game:Prisoners cannot communicate Prisoner ABoth suspected of a crime Confess DenyPrisoner B Confess {3 years, 3 years} {1 year, 10 years}

    Deny {10 years, 1 year} {2 years, 2 years}

    Players: Prisoner A, Prisoner BActions: Confess or Deny for both playersPayos: numbers represent rational preferences over possibleoutcomes s.t. higher number implies higher desirability

    Equilibrium: {action of Prisoner A, action of Prisoner B}Applications for oligopoly:

    enter price war or keep prices constant at high levelstart advertising campaign or not

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 27

  • Behavioral Economics: Lecture 7 Introduction to Game Theory

    Sequential game: Market entry

    Game: low-cost airline decides whether to enter Aeroots market

    if low-cost airline does not enter, Aeroot keeps market powerif low-cost airline enters, Aeroot should decide whether to lower pricesif Aeroot does not lower prices, low-cost airline gets big market shareif Aeroot lowers prices, low-cost airline does not survive

    Players: low-cost airline, AerootActions: Enter or Not Enter, Fight or AccommodatePayos: positively correlate with possible protsStrategies: same as actions, conditional on low-cost airlines actionsEquilibrium: {action of low-cost airline, strategy of Aeroot}

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 27

  • Behavioral Economics: Lecture 7 Introduction to Game Theory

    How to nd equilibrium

    Nash equilibrium ... set of actions

    given particular outcome, does any player have incentive to deviateincentive to deviate ... possibility of higher payo from dierentaction assuming that another player does not deviateequilibrium if there are no such incentives to any playercan be found using elimination of dominated actionssometime there are no dominated actions but NE exists

    Subgame perfect Nash equilibrium ... set of strategies

    given particular outcome, does any player have incentive to deviateincentive to deviate ... possibility of higher payo from dierentstrategy assuming that another player does not deviateequilibrium if there are no such incentives to any playerfound using backward inductionSPNE is subset of NE, "empty threats" are excluded

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 27

  • Behavioral Economics: Lecture 7 Introduction to Game Theory

    Underlying assumptions

    Rational players

    complete and transitive preferences over payos

    Common knowledge

    each player knows that other players are rationalhe also knows that they know that he knows that they are rationaland so on...

    Complete information

    possible actions and payos are known to all players

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 27

  • Behavioral Economics: Lecture 7 Class experiment

    Do people play games as theory predicts?

    Motivation:

    what are conditions under which theory works (if any)?if there are any deviations, are they systematic?

    Procedure:

    problem solvingpresentation of results, comparison with results usually obtained

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 27

  • Behavioral Economics: Lecture 7 Class experiment

    Ultimatum game

    Roles:

    Player A: propose share of endowment to Player BPlayer B: accept or reject

    Rules:

    if Player B accepts, then endowment is divided as proposedif Player B rejects, everybody gets nothingyou know your role but not with whom you are matched

    Game theory predictions:

    Player A proposes minimum possiblePlayer B accepts whatever is proposed

    Common results:

    average oer is 40%oers below 20% are rejected

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 27

  • Behavioral Economics: Lecture 7 Class experiment

    Dictator game

    Roles:

    Player A: allocate endowment between yourself and Player BPlayer B: passive

    Rules:

    whatever Player A proposes is acceptedcompletely anonymous

    Game theory predictions:

    Player A gives nothing to Player B

    Results:

    40% of Players A give nothing40% of Players A split evenly

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 27

  • Behavioral Economics: Lecture 7 Class experiment

    Trust game

    Roles:

    Player A: invest share of endowment to Player BPlayer B: return share of "accumulated capital" to Player A

    Rules:

    endowment invested by Player A is multiplied by factor kwhatever Player B returns is accepted

    Game theory predictions:

    Player A invests nothingPlayer B keeps everything

    Results:

    trust: positive amounts investedtrustworthiness: positive amounts returned

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 27

  • Behavioral Economics: Lecture 8

    Lecture plan

    Human behavior in simple games

    discussion of class experiments

    Alternative theories of interactive behavior

    inequity aversionfairness equilibrium

    What is game theory good for

    monopoly pricing as ultimatum game

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Experimental practices

    from Hertwig & Ortmann 2001

    Script enactment

    state action choices explicitlyclear connection between action and payo"clear" means there is no confusion, though uncertainty is possible

    Repeated trials/ practice rounds

    allow gaining experience with situationfeedback makes connection between action and payo more clear

    Financial incentives

    set goal to perform as well as possible

    Proscription against deception

    exclude second-guessing about purpose of experiment

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Ultimatum game

    Comparison across countries, Roth et al. 1991:country 1-10 11-20 21-30 31-40 41-50 51-100 mean

    oer frequencies

    USA 0.04 0.33 0.63 0.46Japan 0.17 0.34 0.48 0.43Israel 0.03 0.13 0.20 0.57 0.07 0.35Slovenia 0.03 0.27 0.70 0.47

    conditional rejection frequenciesUSA 1.00 0.22 0.12 0.19Japan 0.20 0.10 0.14 0.14Israel 0.00 0.25 0.17 0.12 0.00 0.13Slovenia 1.00 0.63 0.05 0.24

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Ultimatum game

    Other interesting ndings:

    farmers in developing countries, children and chimpanzee make onaverage lower oers and accept lower amountsthey are more self-interested than adults in developed countries

    Potential explanation:

    people are born selsh but social norms make them more altruisticpunishment and its anticipation

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Dictator game

    Role of nancial incentives and social distancecondition 0 1-10 11-20 21-30 31-40 41-50 51-100 mean

    frequency of allocation to other person

    without pay 0.14 0.11 0.26 0.47 0.02 0.38with pay $5 0.35 0.28 0.05 0.09 0.18 0.05 0.23with pay $10 0.21 0.17 0.13 0.29 0.21 0.24recipients ID 0.28 0.08 0.03 0.10 0.18 0.30 0.03 0.26mutual ID 0.07 0.82 0.11 0.50+communic 0.06 0.06 0.12 0.05 0.41 0.30 0.48

    stakes do not matter much

    reputation matters

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 16 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Trust game

    Discriminating between trust and altruism:

    treatment A: standard trust game

    treatment B: player B cannot return anything

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 17 / 27

  • Behavioral Economics: Lecture 8 Class experiments: discussion

    Trust game

    Discriminating between trustworthiness and altruism:

    treatment A: standard trust gametreatment C: player A is passive, player B decides which proportion toreturn from amounts received by players B in treatment A

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 18 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Inequity aversion: basic idea

    Fehr & Schmidt 1999

    Intuition:

    there is fraction of subjects who dislike inequitable outcomes

    Utility function:

    two players with payos xi and xjrational preferences represented as

    Ui (x) = xi i maxxj xi , 0

    | {z }disadvantageousinequality

    i maxxi xj , 0

    | {z }advantageousinequality

    assume i i and 0 i < 1

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 19 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Inequity aversion: illustration

    Preferences with inequity aversion

    utility loss from being better o is lower than from being worse o

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 20 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Inequity aversion: implications

    Constraints on parameters

    i i : loss-aversion in social comparisonsi 0: no subjects who like to be better o than otherswhat if i = 1... ?what if i 1... ?

    Applied to Ultimatum game

    no oers above 0.5oers of 0.5 are always acceptedacceptance threshold is j/

    1+ 2j

    where j is Responder

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 21 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Fairness equilibrium: basic idea

    Rabin 1993

    Main idea is to incorporate following stylized facts:

    people reward those partners who are nice to themand they punish those who are mean to thememotions have stronger eect as material costs become smaller

    Done with including following elements into utility function:

    your strategy... aiyour belief about other players strategy choice... bjbelief about other players belief about your strategy... ci

    Equilibrium

    ai = bi = ci and aj = bj = cj

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 22 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Fairness equilibrium: utility function

    Kindness function fi (ai , bj ):how kind i is by choosing ai when she believes that j will choose bjhjbj/ lj

    bj... max/ min possible payos for j with strategy bj

    rjbj... avg possible payo for j with strategy bj

    jbj , ai

    ... actual payo for j with strategy bj when i plays ai

    fiai , bj

    = f

    j (bj ,ai )rj (bj )hj (bj )lj (bj )

    0 if hj (bj )=lj (bj )

    2 [1, 12 ]

    Kindness belief function:is belief about how kind j is being to him

    gjbj , ci

    = f

    i (ci ,bj )ri (ci )hi (ci )

    li (ci )

    0 if hi (ci )=li (ci )

    2 [1, 12 ]notations as before

    Utility function:

    Ui (ai , bj , ci ) = i (ai , bj ) + gj (bj , ci ) [1+ fi (ai , bj )]

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 23 / 27

  • Behavioral Economics: Lecture 8 Alternative models of interactive behavior

    Fairness equilibrium: behavioral implications

    When i believes that j is treating her badly:

    this implies that gjbj , ci

    < 0

    to compensate, i chooses ai s.t. fiai , bj

    < 0

    that is, i treats j badly

    When i believes that j is treating her nicely

    with same logic, i treats j nicely

    When material payos grow:

    as gjbj , ci

    and fi

    ai , bj

    are bounded, their relative impact on utility

    becomes lowerplayers care less about fairness

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 24 / 27

  • Behavioral Economics: Lecture 8 What is game theory good for

    Monopoly pricing as ultimatum game

    Game-theoretic approach to monopoly pricing

    c ... monopolists cost, v ... consumers valuationmonopolist picks market price p 2 [c , v ]consumer either accepts or rejectsalternatively, consumer selects reservation price r 2 [c , v ]SPNE... ?

    Evidence from Kahneman et al. 1986

    consumers see conventional monopoly prices as unfairthey refuse to buy even if price is lower their valuationlesson: monopolist cannot set as high prices as theory predicts

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 25 / 27

  • Behavioral Economics: Lecture 8 What is game theory good for

    Monopoly pricing as ultimatum game: fairness

    Consumer kindness

    fC (r , p) = f 0 if rp1 if r

    p... no fairness equilibriumr < p... no trade

    Monopolists kindness when p = r = z

    fM (z , z) = (c z) /2 (v c) < 0

    What if consumer deviates from p = r = z

    UC = f fM (z ,z )[1+1] if r

  • Behavioral Economics: Lecture 8 Next lecture

    Topics for experiments

    20/04: framing, anchoring & preference reversal

    27/04: do people choose according to EUT?

    03/05: do people discount exponentially?

    11/05: other regarding preferences

    18/05: cognitive limitations

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 27 / 27

  • Behavioral Economics

    Natalia Shestakova

    Ural State University

    Spring 2010

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 1 / 15

  • Behavioral Economics: Lecture 9

    OUTLINE

    How do we think?

    predictable biases in judgmenttwo cognitive systems

    Class experiment

    "Beauty-contest" gamemarket entry game

    From rationality to bounded rationality

    always making best choice?optimization under constraintsbounded rationality: satiscingbounded rationality: fast and frugal heuristics

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 2 / 15

  • Behavioral Economics: Lecture 9 How do we think?

    Predictable biases in judgment

    Two tables (from Shepard 1990):

    Guess ratio of length to width of each tableTypical guesses: 5 to 1 for left, 1.5 to 1 for right

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 3 / 15

  • Behavioral Economics: Lecture 9 How do we think?

    Predictable biases in judgment

    Availability, accessibility, and salience

    familiar risk is seen as more serious than less familiar risk

    Representativeness

    trying to nd patterns in random sequences

    Anchoring and adjustment

    when guessing, you need to start from something but adjustment isusually insu cient

    Status quo bias

    tendency to stick with original choice

    Framing

    choice depends on whether problem is formulated as gains or losses

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 4 / 15

  • Behavioral Economics: Lecture 9 How do we think?

    Two cognitive systems

    Automatic system Reective systemuncontrolled controlledeortless eortfulassociative deductivefast slowunconscious self-awareskilled rule-following

    most biases disappear when reective system is on

    does it happen with anomalies in risky and intertemporal choices?

    what determines which system is on?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 5 / 15

  • Behavioral Economics: Lecture 9 Class experiments

    Cognition and coordination

    Motivation

    does using reective system always lead to correct decisions?what your belief about othersrationality should be?

    Procedure

    problem solving: several trialsdiscussion of results

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 6 / 15

  • Behavioral Economics: Lecture 9 Class experiments

    "Beauty-contest" game

    Rules

    everyone submits integer between [0, 100]average is computed and multiplied by k < 1number closer to resulting number wins

    Nash equilibrium

    everyones guess is 0requires iterated thinking

    Typical results

    peaks at certain levelswinning numbers between 10 and 20 (k = 2/3)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 7 / 15

  • Behavioral Economics: Lecture 9 Class experiments

    "Beauty-contest" game

    Distribution of choices (Bosch-Domenech et al. 2002)

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 8 / 15

  • Behavioral Economics: Lecture 9 Class experiments

    Market entry game

    Rules

    market capacity c is announcedeveryone decides whether to enterpayo k if stay outpayo k + r (c m) where m... number of entrants, r > k

    Nash equilibria: aggregate level

    pure strategy: m = c and m = c 1how is it decided who enters and who stays out?!

    Typical results

    NE at aggregate level is achieved!individual strategies are dierent

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 9 / 15

  • Behavioral Economics: Lecture 9 Class experiments

    Market entry game

    Individual strategies (Sundali et al. 1995):

    s Index measures decision consistency

    s Index = 30 ... pure strategiess Index = 15.8 ... mixed strategies

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 10 / 15

  • Behavioral Economics: Lecture 9 From rationality to bounded rationality

    Always making best choices?

    What is rationality [once again]?

    always leads to consistent choices

    What prevents you from always choosing best?

    nancial resources are limited (standard budget constraint)information is limiteduncertainty: what is ex ante optimal may not be ex post optimalnding best option is cognitively demanding

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 11 / 15

  • Behavioral Economics: Lecture 9 From rationality to bounded rationality

    Optimization under constraints

    Diamond paradox

    many examples when under perfect competition prices are higher thanmarginal costs

    Explanation

    consumer does not know price level at particular shop before visiting ittraveling to next shop is costlythere is no need in price undercutting for rms

    Crucial element: stopping rule

    compare costs and benets of further search to decide when to stopcomputing costs and benets requires information and cognition

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 12 / 15

  • Behavioral Economics: Lecture 9 From rationality to bounded rationality

    Bounded rationality: satiscing

    Simon 1956

    search continues until a priori set aspiration level is achieved

    Problems

    how aspiration level is set?how particular alternative is compared with aspiration level?which alternative is considered rst?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 13 / 15

  • Behavioral Economics: Lecture 9 From rationality to bounded rationality

    Bounded rationality: fast and frugal heuristics

    Early example: elimination by aspects

    searching for apartmentaspects to compare: price, distance from center, renovation, living areaeliminate ats with price > 15000 RUBwhat if there is perfect option for 15500 RUB?

    Recent example: priority heuristics

    see lecture on choice under risk and uncertainty

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 14 / 15

  • Behavioral Economics: Lecture 9 Course summary

    Behavioral Economics

    Standard economic models are practical and elegant butsometimes too abstractPsychological insights and understanding of human behavior ingiven situations help to make models more realisticBut they often lose their elegance

    especially, when authors attempt to keep generality

    Open question: how to solve trade-o between elegance andrealism?

    Natalia Shestakova (Ural State University) Lecture Notes Spring 2010 15 / 15

    Lecture1-intro.pdfBehavioral Economics: Lecture 1IntroductionKeystones of traditional economicsAdding psychology into economicsClass experimentCourse Outline

    Lecture2-preferences.pdfBehavioral Economics: Lecture 2ReviewClass experimentSummaryModeling anomalies in preferencesApplying knowledge of anomalies in preferencesNext lecture

    Lecture3-4-EUT.pdfBehavioral Economics: Lecture 3Choice under risk and uncertaintyClass experiment

    Behavioral Economics: Lecture 4Alternative theories of choice under risk and uncertaintyWhy do we need theory of decision making?Next lecture

    Lecture5-6-time.pdfBehavioral Economics: Lecture 5Discounted utility modelClass experiment

    Behavioral Economics: Lecture 6Class experiments: summaryAlternative models of intertemporal choiceWhy do we need models of intertemporal choiceNext lecture

    Lecture7-8-GT.pdfBehavioral Economics: Lecture 7Introduction to Game TheoryClass experiment

    Behavioral Economics: Lecture 8Class experiments: discussionAlternative models of interactive behaviorWhat is game theory good forNext lecture

    Lecture9-cognition.pdfBehavioral Economics: Lecture 9How do we think?Class experimentsFrom rationality to bounded rationalityCourse summary