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Big Questions:How can economists explain irrational behavior?What is the role of risk in decision-making?How does game theory explain strategic behavior?

Behavioral Economics is the field of economics that draws on insights from experimental psychology to explore how people make economic decisions.

Bounded Rationality proposes that although decision- makers want a good outcome, either they arent capable of performing the problem- solving that traditional theory assumes, or they arent inclined to do so.

Bounded RationalityBounded rationality can be explained in three ways:The information that the individual uses to make the decision may be limited or incomplete. The human brain has a limited capacity to process information. There is often a limited amount of time in which to make a decision.

Behaviors that do not fit assumptions about fully rational behavior:

Inconsistencies in decision- makingJudgments about fairness when making decisions

Inconsistencies in Decision- Making:

Framing Effects occur when people change their answer (or action) depending on how the question is asked or how the alternatives are presented.

Priming Effects occur when the ordering of the questions influences the answers.

Status Quo Bias exists when people want to maintain their current choices

Inconsistencies in Decision- Making:

Loss Aversion occurs when individuals place more weight on avoiding losses than on attempting to realize gains.

Intertemporal Decision-Making involves planning to do something over a period of time; this decision- making process requires valuing the present and the future consistently.

Judgments about Fairness:Proponents of fairness believe in progressive taxation, whereby the rich pay a higher tax rate on their income than those in lower income brackets. Likewise, some people object to the high pay of chief executive officers because they believe there should be an upper limit to what constitutes fair compensation.

The Ultimate Game is an economic experiment in which two players decide how to divide sum of money.

The Decision Tree forthe Ultimatum Game

The decision tree for the ultimatum game has four branches. If Player 1 makes a fair proposal, Player 2 will accept thedistribution and both players will earn $500. However, if Player 1 makes an unfair proposal, Player 2 may reject the distribution even though this decision means receiving nothing.Player 1Player 2Player 2Fair proposalUnfair proposalRejectAcceptAcceptReject

($999, $1)Unfair distribution: Player 2 earns $1. Both players are better off.($0, $0)This outcome is never observed.($500, $500)Fair distribution: Player 2 accepts($0, $0)Player 2 almost always chooses to reject.

Preference ReversalsExpected Value is the predicted value of an event. It is calculated by multiplying each possible outcome by its respective probability and then summing all of these amounts.

Preference reversal occurs when risk tolerance is not consistent.

Positive time preferences indicate that people prefer to have what they want sooner rather than later.

Preference ReversalsImagine that youre on a game show and could either win the monetary prize behind one of three doors or take a sure thing. Behind the door number 1 is $1. Behind door number 2 is $100. Behind door number 3 is $1000. There is an equal chance that you would win any of these amounts since you get to choose which door.Expected Value

1/3($1) + 1/3($100) + 1/3($1000) = $367

Risk-averse people prefer a sure thing over a gamble with a higher expected value.

Risk neutral people choose the highest expected value regardless of the risk.

Risk takers prefer gambles with lower expected values, and potentially higher winnings, over a sure thing.

Risk aversion: Risk taking BehaviorYou have a choice between selecting heads or tails. If your guess is correct, you earn $2,000. But you earn nothing if your guess is incorrect. Alternatively, you can simply take $750 without the gamble. You decide to take the $750.

The expected value of a 50/50 outcome worth $2,000 is $1,000. Therefore, the decision to take the sure thing, which is $250 less, is evidenceof risk aversion.You have a choice between (a) predicting the roll of a six- sided die, with a $3,000 prize for a correct answer, or (b) taking a sure $750. You decide to roll the die.

The expected value of the roll of the die is 1>6 X $3,000, or $500. Therefore, the $750 sure thing has an expected value that is $250 more. By rolling the die, you are taking the option with the lower expected value and also more risk. This indicates that you are a risk taker.

Game Theory is a branch of mathematics that economists use to analyze the strategic behavior of decision- makers.

Strategic Behavior and the Dominant Strategy

The Prisoners Dilemma occurs when decision makers face incentives that make it difficult to achieve mutually beneficial outcomes.

Strategic Behavior and the Dominant Strategy

10 years in jailWalter White25 years in jailJim PinkmanThe Prisoners DilemmaThe two suspects know that if they both keep quiet, theyll spend only one year in jail. The prisoners dilemma occurs because the decision to testify results in no jail time for the one who testifies if the other doesnt testify. However, this outcome means that both are likely to testify and get 10 years.10 years in jailgoes freegoes free25 years in jail1 year in jail1 year in jailKeep quietTestifyTestifyKeep quiet

Strategic Behavior and the Dominant StrategyDominant strategy exists when a player will always prefer one strategy, regardless of what his or her opponent chooses.

Nash equilibrium occurs when decision- makers cannot, on their own, change their strategy and make themselves better off.

Duopoly and the Prisoners Dilemma

$27,000 revenueAT-Phone$30,000 revenueHorizonThe Prisoners Dilemma in DuopolyEach company has a dominant strategy to serve more customers because it makes the most revenue even if its competitor also expands production. A high level of production leads to a Nash equilibrium at which both firms make $24,000. By colluding, AT- Phone and Horizon could agree to a low level of production and increase their revenue to $27,000 each, but the likelihood of cheating makes this an unstable equilibrium.

Collusion is an agreement among rival firms that specifies the price each firm charges and the quantity it produces.$27,000 revenue$22,500 revenue$30,000 revenue$24,000 revenue$24,000 revenue$22,500 revenueLow production: 300 customersHigh production: 400 customersLow production: 300 customersHigh production: 400 customers

Advertising and Game Theory

$100 million profitCoca-Cola$75 million profitPepsi Co$100 million profit$150 million profit$75 million profit$125 million profit$125 million profit$150 million profitAdvertisesDoes not advertiseAdvertisesDoes not advertiseThe Prisoners Dilemma and AdvertisingThe two companies each have a dominant strategy to advertise. We can see this by observing that Coca- Cola and PepsiCo each make $25 million more profit by choosing to advertise, given the other companys strategy. As a result, they both end up in the upper- left box, earning $100 million profit when they could have each made $125 million profit in the lower- right box if they had agreed not to advertise.

Escaping the Prisoners Dilemma in the Long RunTit-for-Tat is a long-run strategy that promotes cooperation among participants by mimicking the opponents most recent decision with repayment in kind. As the name implies, a tit- for-tat strategy is one in which you do whatever your opponent does. If your opponent breaks the agreement, you break the agreement too. If the opponent behaves properly, then you behave properly too.

The prisoners dilemma nicely captures why cooperation is so difficult in the short run. But most interactions in life occur over the long run. For example, scam artists and sketchy companies take advantage of short- run opportunities that cannot last because relationships in the long run with businesses and with people involve mutual trust. In long- run relationships, cooperation is the default because you know that the other side is invested in the relationship. Under these circumstances, the tit- for- tat strategy works well.