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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


Behavioral Economics: Lecture 1 Introduction


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"




... sometimes called "Economics and Psychology"

Economics ...?

mathematically elegant models of interaction between economic agentsbased on simpli�ed assumptions regarding individual behavior

Psychology

experiments to understand how people think and behave


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




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?




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


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, de�ne preferred color: fG ,Og, fO,Bg, fG ,BgCompleteness

for each pair, preference relation is de�nedeither G � O, or O � G , or none

Transitivityif G � O and O � B, then should be G � Bsame for indi¤erence �



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 satis�es WARPnot every choice structure that satis�es WARP is necessarily generatedby rational preferences



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 prob�s do not change ordering between two lotteries

Independence axiomL � L0 if and only if αL+ (1� α) L00 � αL0 + (1� α) L00, α 2 (0, 1)

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

Expected Utility TheoremIf DM�s 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)



Discounted Utility

Utility from consumption over time

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

Exponential discounting

U�fctgTt=t0

�=

T

∑t=t0

δt�t0u (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"



Nash Equilibrium (MWG Ch.7)

Classic Prisoner�s 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 bene�t by changing his strategy while another player isnot changing his

What is Nash equilibrium in Prisoner�s dilemma?

(betray, betray)


Behavioral Economics: Lecture 1 Adding psychology into economics

Violation of transitivity

Choose preferred color for slides:

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





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





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





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





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




Most people are indi¤erent in �rst four choices

334400 � 335500335500 � 336600336600 � 337700337700 � 338800

Transitivity requires that

334400 � 338800

But usually it is not

either 334400 � 338800or 338800 � 334400


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



Group #1

three alternatives2nd alternative is de�nitely worse than 3rd alternative



Group #2

two alternativesdominated alternative is removed



Discussion

example taken from "Predictably Irrational"

subjects from MIT�s 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 e¤ect

preferences between options depend on what other options are inchoice set


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



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



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



Q&A

Ask now ...

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



Natalia Shestakova


Spring 2010



Lecture plan

Review: standard assumptions about preferences

Class experiment

problem solvingdiscussion of possible e¤ectspresentation of results, comparison with results usually obtained

Summary: most common anomalies in preferences

de�nitionshow it may lead to choice inconsistencypotential explanations

Modeling anomalies in preferences

reference dependencemental accounting

Applications

power of default option in saving for retirement


Behavioral Economics: Lecture 2 Review

Standard assumptions about preferences

completeness

for each pair of alternatives, X and Y , preferences uniquely de�nedeither X � Y , or Y � X , or none

transitivity

if X � Y and Y � Z , then should be X � Zsame for indi¤erence �

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 satis�es WARP



Procedure

problem solving

discussion of possible e¤ects

presentation of results, comparison with results usually obtained


Behavioral Economics: Lecture 2 Summary

Framing e¤ect

framing e¤ect:

way how choice problem is stated a¤ects 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



Anchoring e¤ect

anchoring e¤ect:

irrelevant factors a¤ect which values are assigned to alternativeshowever, relative values are not a¤ected... coherent arbitrariness


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



Endowment e¤ect

endowment e¤ect:

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


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

one explanation:

"yeah, whatever" heuristic



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



Context e¤ect

context e¤ect:

presence of other alternatives in choice set a¤ects choice


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�



Anomalies: common explanations

preferences are constructedreference dependence & loss aversionmisleading but simple heuristics


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 a¤ects preferences



Loss aversion: De�nition


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 satis�es loss aversion:

x �s y implies that x �r y



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 indi¤erent between x and y at s-statethen she should prefer x to y at r -statewhat if she is indi¤erent between x and y at r -state?



Mental accounting


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 di¤erences between alternatives

topical account

relate consequences of possible outcomes to reference level

comprehensive account

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


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 lifetime�gure out how much you will need when you retiresave up enough for retirement without sacri�cing too much now

de�ned-bene�t retirement plans:

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

de�ned-contribution retirement plans:

participants have personal accounts to make speci�ed contributionsadvantage: completely portabledisadvantage: too many decisions to make

main negative consequence of choice complexity:

too low participation rate


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 you�d 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%


Behavioral Economics: Lecture 2 Next lecture

Food for thought

How studied e¤ects may change predictions of your favorite theories

How studied e¤ects may be used to explain seeming paradoxes




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


Spring 2010



Lecture plan

Choice under risk and uncertainty:

expected utility theoremrisk attitudeEUT at work

Class experiment:

common consequence e¤ectcommon ratio e¤ectre�ection e¤ectfourfold pattern of risk attitude


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 αL+ (1� α) L00 � αL0 + (1� α) L00, α 2 (0, 1)possibility to get L00 should not a¤ect preferences between L and L0



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



Independence axiom: Closer look

Independence axiom implies that indi¤erence curves are:

straight: L � L0 if and only if L � 12L0 + 1

2L (b)parallel: L � L0 if and only if 13L+

23L00 � 1

3L0 + 2

3L00 (c)

Illustration:



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)



Risk attitude

Expected outcome vs. expected utility

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

Risk-neutral DM: EU (L) = U [E (X )]indi¤erent 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 a¤ects shape of indi¤erence curves

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



Do people choose according to EUT?

Motivation:

can EUT be supported empirically?

Procedure:




Common consequence e¤ect

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� = (αp, 0, (1� α) p, 1� p)C ... common consequence, should have no e¤ect

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)



Common ratio e¤ect

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)


nonnegative monetary outcomes: X1 > X2, X3 = 0S� = (0, p, 1� p)R� = (λp, 0, 1� λp)λ... constant ratio of winning probabilitiesp should have no e¤ect


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



Re�ection e¤ect

Kahneman & Tversky (1979)

related to framing e¤ect


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

Experimental evidence

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



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



Lecture plan

Previous lecture:

independence axiomrisk attitude

Summary of class experiment:

common consequence e¤ectcommon ratio e¤ectre�ection e¤ectfourfold pattern of risk attitude

Alternative theories of choice under risk and uncertainty

generalizations of EUTprospect theorypriority heuristic


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-speci�cweak independence: L � L0 i¤ for each α 2 (0, 1) there can foundβ 2 (0, 1), s.t. αL+ (1� α) L00 � βL0 + (1� β) L00 for any L00

Theories with decision weights:

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



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 y�r , �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



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 satis�es loss aversion:

x �s y implies that x �r y



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



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



Priority heuristic

Search for:

minimum payo¤probability of minimum payo¤maximum payo¤

Stop search if:

di¤erence between minimum payo¤s is > 10% of maximum payo¤di¤erence between probabilities of minimum payo¤s > 10%maximum payo¤s are di¤erent

Decide for lotteries with:

larger minimum payo¤smaller probability of minimum payo¤larger maximum payo¤


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 monthπ1, π2, π3... computed pro�ts/ 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 (π1 � B � F ) + p02u (π2 � B) + p03u (π3 � B) �p1u (π1) + p2u (π2) + p3u (π3)

Policy recommendations:

e¤ectiveness of measures against corruption


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 speci�c 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





27/04: do people choose according to EUT?

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




Natalia Shestakova


Spring 2010



Lecture plan

Discounted utility model:

historical originsmodelimplicit assumptions

Discounted utility anomalies (class experiment):

common di¤erence e¤ectabsolute magnitude e¤ectgain-loss asymmetrydelay-speedup asymmetry


Behavioral Economics: Lecture 5 Discounted utility model

Historical origins

E¤ective desire for accumulation, Rae 1834:

promoted by: bequest and self-restraintlimited by: uncertainty and grati�cation 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 di¤erent 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



Simple formulation

Discounted utility model, Samuelson 1937:

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

Ut (ct , ..., cT ) =T�t∑k=0

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

D (k) =

�1

1+ ρ

�k= δk ... discount function

not psychologically plausiblenot normatively plausible



More formulas

Intertemporal utility in continuous time:

U t (ct , ..., ct 0 , ..., cT ) =Z T�t

k=0e�ρku (ct+k ) dt

How to impute discount rate:

given X at t, how big should be Y at t 0 to make you indi¤erent?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�ρ(t 0�t)

ρ = � 1t 0 � t ln

�XY

�



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 i¤X � 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 0

is it true that X � Y in period r when Z is consumed in period r 0?



Constant discounting and time consistency

Discount function

general form: D (k) =k�1∏n=0

�1

1+ρn

�form imposed in DU model: D (k) =

�11+ρ

�k= δk

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

Time-consistent intertemporal preferences:

later preferences "con�rm" 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



Other implicit assumptions

Utility independence

distribution of utility across time makes no di¤erencee.g. if higher utility at r in one consumption pro�le is compensated byhigher utilities at r � 1 and r + 1 in another consumption pro�le, twopro�les 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



Discounted utility anomalies

Motivation:

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

Procedure:




Common di¤erence e¤ect

Predictions of DU model:

extra consumption: X at t or Y at t 0

ρ = � 1t 0�t ln

�XY

�only di¤erence 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


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



Absolute magnitude e¤ect


extra consumption: X at t or Y at t 0

ρ = � 1t 0�t ln

�XY

�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 youindi¤erent to 100RUB now (X )Q2: amount to be received in 1 month (Y 0) that would make youindi¤erent to 100, 000RUB now (X 0)


proportion in Q1�XY

�is usually lower than in Q2

�X 0Y 0

�this implies that ρ is lower for higher absolute values of X



Gain-loss asymmetry


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

ρ = � 1t 0�t ln

�XY

�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 o¤er to return inone month (Y 0)?


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



Delay-speedup asymmetry


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

t 0�t ln�XY

�ratio Y

X 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


proportion in Q1�YX

�is usually lower than in Q2

�XY 0

�this implies that ρ is lower for higher absolute values of X



Lecture plan


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


Behavioral Economics: Lecture 6 Class experiments: summary


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


Behavioral Economics: Lecture 6 Class experiments: summary


Discount factor δ =�

11+ρ

�as function of time:

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


Behavioral Economics: Lecture 6 Alternative models of intertemporal choice

Hyperbolic discounting

Discount function introduced in Phelps & Pollak 1968:

D (k) =�1 if k = 0

βδk 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. βδ2A

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

δ365A vs. δ3662A => A vs. δ2A

Time inconsistency when:

βδ < 12 but δ > 1

2



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



Reference dependent utility

Instantaneous utility function

u (cτ, rτ) = v (cτ � rτ)rτ... 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 a¤ect consumption growth rate while they should not



Mental accounting

Basic idea

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

Implications

di¤erent ways of �nancing purchase can lead to di¤erent decisionspreference for prepaymentpreference for getting paid after doing work


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 e¤ectsPigouvian tax per unit = marginal external damage imposed on others



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-e¤ect if substance used



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



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 e¤ects)promotion of counter-cues ("smoking kills")






03/05: do people discount exponentially?

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



Natalia Shestakova


Spring 2010



Lecture plan

Introduction to Game Theory

historical originsbasic elements and concepts

Do people play as theory predicts? (class experiment)

ultimatum gamedictator gametrust game


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 payo¤s 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



Simultaneous game: Prisoner�s 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 playersPayo¤s: 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



Sequential game: Market entry

Game: low-cost airline decides whether to enter Aero�ot�s market

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

Players: low-cost airline, Aero�otActions: Enter or Not Enter, Fight or AccommodatePayo¤s: positively correlate with possible pro�tsStrategies: same as actions, conditional on low-cost airline�s actionsEquilibrium: {action of low-cost airline, strategy of Aero�ot}



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 di¤erentaction 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 di¤erentstrategy 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



Underlying assumptions

Rational players

complete and transitive preferences over payo¤s

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 payo¤s are known to all players



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



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 o¤er is 40%o¤ers below 20% are rejected



Dictator game

Roles:

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

Rules:

whatever Player A proposes is acceptedcompletely anonymous


Player A gives nothing to Player B

Results:

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



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


Player A invests nothingPlayer B keeps everything

Results:

trust: positive amounts investedtrustworthiness: positive amounts returned



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


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



Ultimatum game

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

o¤er 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



Ultimatum game

Other interesting �ndings:

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

Potential explanation:

people are born sel�sh but social norms make them more altruisticpunishment and its anticipation



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 0.24recipient�s 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



Trust game

Discriminating between trust and altruism:

treatment A: standard trust game

treatment B: player B cannot return anything



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


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 payo¤s xi and xjrational preferences represented as

Ui (x) = xi � αi max�xj � xi , 0

| {z }disadvantageousinequality

� βi max�xi � xj , 0

| {z }advantageousinequality

assume βi � αi and 0 � βi < 1



Inequity aversion: illustration

Preferences with inequity aversion

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



Inequity aversion: implications

Constraints on parameters

βi � αi : loss-aversion in social comparisonsβi � 0: no subjects who like to be better o¤ than otherswhat if βi = 1... ?what if αi � 1... ?

Applied to Ultimatum game

no o¤ers above 0.5o¤ers of 0.5 are always acceptedacceptance threshold is αj/

�1+ 2αj

�where j is Responder



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 e¤ect as material costs become smaller

Done with including following elements into utility function:

your strategy... aiyour belief about other player�s strategy choice... bjbelief about other player�s belief about your strategy... ci

Equilibrium

ai = bi = ci and aj = bj = cj



Fairness equilibrium: utility function

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

�bj�... max/ min possible payo¤s for j with strategy bj

πrj�bj�... avg possible payo¤ for j with strategy bj

πj�bj , ai

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

fi�ai , bj

�= f

πj (bj ,ai )�πrj (bj )πhj (bj )�πlj (bj )

0 if πhj (bj )=πlj (bj )2 [�1, 12 ]

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

gj�bj , ci

�= f

πi (ci ,bj )�πri (ci )

πhi (ci )�πli (ci )

0 if πhi (ci )=πli (ci )2 [�1, 12 ]

notations as before

Utility function:

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



Fairness equilibrium: behavioral implications

When i believes that j is treating her badly:

this implies that gj�bj , ci

�< 0

to compensate, i chooses ai s.t. fi�ai , 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 payo¤s grow:

as gj�bj , ci

�and fi

�ai , bj

�are bounded, their relative impact on utility

becomes lowerplayers care less about fairness


Behavioral Economics: Lecture 8 What is game theory good for

Monopoly pricing as ultimatum game

Game-theoretic approach to monopoly pricing

c ... monopolist�s cost, v ... consumer�s 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


Behavioral Economics: Lecture 8 What is game theory good for

Monopoly pricing as ultimatum game: fairness

Consumer kindness

fC (r , p) = f 0 if r�p�1 if r<pr > p... no fairness equilibriumr < p... no trade

Monopolist�s 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<zv�z+fM (z ,z )[1+0] if r=z

Highest price consistent with fairness equilibrium

z� =�2v2 � 2cv + c

�/ [1+ 2v � 2c ] < v






03/05: do people discount exponentially?

11/05: other regarding preferences




Natalia Shestakova


Spring 2010



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: satis�cingbounded rationality: fast and frugal heuristics


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



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



Two cognitive systems

Automatic system Re�ective systemuncontrolled controllede¤ortless e¤ortfulassociative deductivefast slowunconscious self-awareskilled rule-following

most biases disappear when re�ective system is on

does it happen with anomalies in risky and intertemporal choices?

what determines which system is on?


Behavioral Economics: Lecture 9 Class experiments

Cognition and coordination

Motivation

does using re�ective system always lead to correct decisions?what your belief about others�rationality should be?

Procedure

problem solving: several trialsdiscussion of results



"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

everyone�s guess is 0requires iterated thinking

Typical results

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



"Beauty-contest" game

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



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 di¤erent



Market entry game

Individual strategies (Sundali et al. 1995):

s Index measures decision consistency

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


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 optimal�nding best option is cognitively demanding



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 bene�ts of further search to decide when to stopcomputing costs and bene�ts requires information and cognition



Bounded rationality: satis�cing

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?



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


Behavioral Economics: Lecture 9 Course summary


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?
