Lectures Behavioral Economics

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Lectures Behavioral Economics

Text of Lectures Behavioral Economics

  • 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 studentsP