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Summary Readings for Psychology of Economics
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Summary of all the readings for the course Psychology of Economics. See the first page of the document to view which articles are included
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Readings Psychology of EconomicsReferences of all readings included in this summary
Thaler, R. H. (2016). Behavioral Economics: Past, Present, and Future. American Economic Review, 106, 1577-1600.
Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica: Journal of the
econometric society, 263-291.
Camerer, C. F. (2004). Prospect theory in the wild: Evidence from the field. In C. F. Camerer, G. Loewenstein, & M. Rabin, (Eds.),
Advances in Behavioral Economics, (pp. 148-161). Princeton University Press.
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal
of Political Economy, 1325-1348.
Morewedge, C. K., & Giblin, C. E. (2015). Explanations of the endowment effect: An integrative review. Trends in Cognitive
Sciences, 19, 339-348.
Frederick, S. (2005). Cognitive reflection and decision making. Journal of Economic Perspectives, 25-42.
Inbar, Y., Cone, J., & Gilovich, T. (2010). People's intuitions about intuitive insight and intuitive choice. Journal of personality and
social psychology, 99, 232-247.
Epley, N., & Gilovich, T. (2001). Putting adjustment back in the anchoring and adjustment heuristic: Differential processing of self-
generated and experimenter-provided anchors. Psychological Science, 12, 391-396.
Herzog, S. M., & Hertwig, R. (2009). The wisdom of many in one mind: Improving individual judgments with dialectical
bootstrapping. Psychological Science, 20, 231- 237.
Stewart, N., Chater, N., & Brown, G. D. (2006). Decision by sampling. Cognitive psychology, 53, 1-26.
Walasek, L., & Stewart, N. (2015). How to make loss aversion disappear and reverse: Tests of the decision by sampling origin of
loss aversion. Journal of Experimental Psychology: General, 144, 7-11.
Shalvi, S., Dana, J., Handgraaf, M. J., & De Dreu, C. K. (2011). Justified ethicality: Observing desired counterfactuals modifies
ethical perceptions and behavior. Organizational Behavior and Human Decision Processes, 115, 181-190.
Weisel, O., & Shalvi, S. (2015). The collaborative roots of corruption. Proceedings of the National Academy of Sciences, 112,
10651-10656.
Van Lange, P. A. (2000). Beyond self-interest: A set of propositions relevant to interpersonal orientations. European Review of
Social Psychology, 11, 297-331.
Fiedler, S., Glöckner, A., Nicklisch, A., & Dickert, S. (2013). Social Value Orientation and information search in social dilemmas:
An eye-tracking analysis. Organizational behavior and human decision processes, 120, 272-284.
Feinberg, M., Willer, R., Stellar, J., & Keltner, D. (2012). The virtues of gossip: reputational information sharing as prosocial
behavior. Journal of personality and social psychology, 102, 1015-1030.
Wu, J., Balliet, D., & Van Lange, P. A. (2015). When does gossip promote generosity? indirect reciprocity under the shadow of the
future. Social Psychological and Personality Science, 6, 923-930.
Halevy, N., Chou, E. Y., & Murnighan, J. K. (2012). Mind games: The mental representation of conflict. Journal of Personality and
Social Psychology, 102, 132- 148.
Meleady, R., Hopthrow, T., & Crisp, R. J. (2013). Simulating social dilemmas: promoting cooperative behavior through imagined
group discussion. Journal of personality and social psychology, 104, 839-853.
Gneezy, A., Gneezy, U., Riener, G., & Nelson, L. D. (2012). Pay-what-you-want, identity, and self-signaling in markets.
Proceedings of the National Academy of Sciences, 109, 7236-7240.
Balafoutas, L., Nikiforakis, N., & Rockenbach, B. (2014). Direct and indirect punishment among strangers in the field. Proceedings
of the National Academy of Sciences, 111, 15924-15927.
DeSteno, D., Breazeal, C., Frank, R. H., Pizarro, D., Baumann, J., Dickens, L., & Lee, J. J. (2012). Detecting the trustworthiness of
novel partners in economic exchange. Psychological Science. 0956797612448793.
Bonnefon, J. F., Hopfensitz, A., & De Neys, W. (2013). The modular nature of trustworthiness detection. Journal of Experimental
Psychology: General, 142, 143- 150.
, Readings Psychology of Economics
Lecture 1 – Thaler: behavioral economics: past, present and future
Historical roots of behavioral economics
Economic theories assume that humans are rational (Econs) and behavioral economics looks at humans as humans, because
people are overconfident, have an aversion of loss and a low self-control. Some economists already seemed to realize that
psychology was important to include.
Explainawaytions
After WOII, economists didn’t include human behavior anymore, which made the models very implausible.
As if
Are people behaving ‘as if’ they are rational? Friedman said theories should be judged based on their ability to predict behavior.
We are not experts (e.g. chess) (even they can’t always maximize) and theories should be about normal people. But, if people
satisfy instead of maximize, the predictions will be average. Humans seem to make systematically biased judgments, using a
heuristic rule. Predictions are not ‘as if’ rational, but predictably biased. The prospect theory shows that people are risk averse in
the domain of gains but risk seeking in the domain of losses. Also, people choose different answers if you frame it in a different
way. Thus, people are not choosing ‘as if’ they are rational.
Experiments, incentives and learning
Economists weren’t really impressed by this research, because the effect is almost gone if the amounts of money go up and if you
give people a chance to learn. But, in the real world products are very expensive OR you have many opportunities to learn, not
both. Experiments show that sometimes learning doesn’t even work and that preference reversals (pay more for the one you don’t
want to have) raised if the stakes were raised.
The invisible handwave
E.g. eating too much in a restaurant because you paid for it. E.g. having a more expensive month membership for the gym to
make sure you’ll go. Both companies can’t make more money by turning them into rational humans. Thus, the market doesn’t
make us more rational, in fact the opposite occurs.
Thus, explainawaytions are not a good excuse to presume that humans will behave as if they were rational. We should modify our
theories.
Financial markets
Efficient market hypothesis: (1) there is no way to beat the market (lack of predictability), and (2), the prices are right (you can’t
prove they are wrong). We can describe this market with two factors, but can we also do this with other markets? E.g. labor
markets are very unequal, is that due to productivity? Some industries just pay more? What about CEOs?
One theory, two tasks
Even these most efficient markets are inconsistent with theories based on rational choice makers. Theories should give the
optimal solution but should also describe how humans actually choose. E.g. the expected utility theory tells how decisions with
risks should be made and the prospect theory tells how people actually make such choices. Economic theories should abandon
inductive reasoning and adopt a deductive approach (observe behavior) (evidence). These behavioral theories can help to give
better predictions, but it is not needed to replace older successful theories. There is focus needed on two topics:
Behavioral preferences
Prospect theory predicts by using three assumptions about preferences: wealth is relative to your reference point, loss aversion
(losses > gains) and the importance of probabilities. Other research shows that people have present biased preferences (bigger
difference between now and later and between later and even later). The two-self model says that people have a long-sighted
planner and myopic doer, but this model is less popular than simpler models. Also, people are not completely selfish.
Behavioral beliefs
There are no rational expectations, e.g. relying too much on recent trends or overconfidence. There are many biases (anchoring,
availability, hindsight, etc.).
Supposedly irrelevant factors
Economists don’t think that supposedly irrelevant factors influence choices, but they do (e.g. framing, order, salience). E.g.
retirement saving with the default option.
,Lecture 2 – Kahneman: prospect theory
The expected utility theory, the utilities of outcomes are weighted by their probabilities. But, people overweight outcomes that are
considered certain, relative to outcomes which are merely probable (certainty effect). In the example, removing the .66 chance to
win 2400 changes the desirability of the choice. Re-writing options doesn’t lead to the same answers. Also, people rather choose
the option where winning is more probable, but if the chance of winning is minuscule, people rather choose the larger gain.
What happens if there can also be losses? There is a reflection effect: people rather take a higher loss for a certain percent than
a certain loss, but people rather take a certain profit than a change of a profit (e.g. 4$ 80% < 3$ 100% VS -4$ 80% > -3$ 100%). In
the positive domain there is risk aversion but in the negative domain there is risk seeking.
Probabilistic insurances are often unattractive, because you don’t want to reduce the probability of losing to 50%, but to 0%.
People simplify the choice to focus on what distinguishes alternatives, but this can lead to inconsistent preferences (isolation
effect). The contingent certainty of the fixed return enhances the attractiveness of this option, relative to a risky venture with the
same probabilities and outcomes. Preferences can be altered by varying the representation of probabilities, but choices can also
be altered by varying the representation of outcomes.
Prospect theory
There are two phases in the choice process: an early phase of editing and a subsequent phase of evaluation. In the editing
phase, the options are simplified for the evaluation and the choice:
• Coding: it looks at the gains and losses (which are relative to the reference point), and not at the final state of wealth
• Combination: it will combine probabilities with identical outcomes to simply.
• Segregation: segregate the riskless components from the risky components.
• Cancellation: not looking at components that are shared by the offered prospects (isolation effect)
• Simplification: rounding probabilities or outcomes
• Detection of dominance: scanning the offered prospect to detect dominated alternatives.
In the evaluating phase, the overall value of an edited prospect is expressed by the probability (decision weight) and the
subjective value of the outcome (depends on reference point). In a regular prospect, the value is defined on the prospects and the
value of the outcome is defined on outcomes. In strictly positive or negative prospects, prospects are first segregated into the
riskless (minimum gain/loss) or risky (additional gain/loss which is at stake) components.
Value
Values are attached to changes rather than to final states and decision weights do not coincide with
stated probabilities. The difference in gaining 100 or 200 is greater than the difference in gaining 1100
or 1200. Also, losing money gives more aggravation than gaining money gives pleasure.
Thus, the value function is defined on deviations from the reference point; generally concave for
gains and commonly convex for losses; and steeper for losses than for gains.
Weight
The decision weight is not the same as the probability, because it is inferred from choices between
prospects and is a subjective probability inferred from preferences. E.g. it could be influenced by
ambiguity. Outcomes contingent on an impossible event are ignored and the scale is normalized so
that the decision weight is the ratio of the weight associated with the probability to the weight
associated with the certain event.
We generally overweight very low probabilities, because we like lotteries and have insurances, or
we overestimate rare events. Subcertainty captures that the sum of the weights associated with
complementary events is typically less than the weight associated with the certain events.
Subproportionality means that for a fixed ratio of probabilities, the ratio of the corresponding
decision weights is closer to unity when the probabilities are low than when they are high.
(picture: probability is not well-behaved near the end-points, it is nonlinear).
,Lecture 2 – Camerer: prospect theory in the wild
They will describe ten regularities in naturally occurring data that are anomalies for expected utility theory but can all be explained
by three simple elements of prospect theory: loss-aversion, reflection effects and nonlinear weighting of probability.
1. Equity premium (stock market) (stock returns are too high relative to bond returns) (loss-aversion)
Stocks have a more variable annual price change than bonds (obligaties), because they bear a risk, but this premium is very
high. This is because people are loss averse and stockers are more frequently negative.
2. Disposition effect (stock market) (hold losing stocks too long, sell winners too early) (reflection effect)
People dislike incurring losses much more than they like incurring gains, therefore people hold on to stocks with a lost value
too long and will be eager to sell stocks that have risen in value.
3. Downward-sloping labor supply (labor economics) (NYC cabdrivers quit around daily income target) (loss aversion)
Cab drivers set an income target for the day and quit when they reach that target. But, they have to work long hours on bad
days and quit earlier on good days. They could better work the hours that are most profitable, more experienced cabdrivers
are doing this.
4. Asymmetric price elasticities (consumer goods) (purchases more sensitive to price increases than to cuts) (loss aversion)
Consumers dislike a price increase more than they like a price decrease.
5. Insensitivity to bad income news (macroeconomics) (consumers do not cut consumption after bad income news) (loss
aversion, reflection effect)
The model predicts that people consume a constant fraction of their total earning in their life (borrowing when younger and
saving when older, because incomes grow over time). But, people just spend a fraction of their current income and thus don’t
look at future or retirement. Also, people spend more if their future loan rises but don’t spend less if their future loan goes
down. Another model shows that people have a reference point that depends on the utility they get from consumption in each
period. People don’t want to spend below their reference point and they are taking the gamble that it won’t be that low next
year.
6. Status quo bias, default bias and buying-selling price gaps (consumer choice) (consumers do not switch health plans
choose default insurance) (loss aversion)
If there is no status quo, people have the preference for the default choice. Also, people who got a mug demand a price
about 2-3 times as large as the price that those without mugs are willing to pay (endowment effect). This is also seen in the
real world, thus there is price gap.
7. Favorite-longshot bias (horse race betting) (favorites are underbet, longshots overbet) (overweight low p(loss))
Longshots have only a small chance of winning, but they are over overbet, thus favorites are underbet. Thus, they overweight
the low probabilities of winning. Research shows that bettors like longshots because they have convex utility and weight their
high chances of losing and small chances of winning roughly linearly. They hate favorites, because they like to gamble but
are disproportionately afraid of the small chance of losing when they bet on a heavy favorite.
8. End-of-the-day effect (horse race betting) (shift to longshots at the end of the day) (reflection effect)
Bettors tend to shift their bets towards longshots, and away from favorites, later in the racing day. Most bettors are behind by
the last race of the day and they want to cover their earlier losses. They take zero daily profit as a reference point and
gambling in the domain of losses to break even.
9. Buying phone wire insurance (insurance) (consumers buy overpriced insurance) (overweight low p(loss))
People buy insurances, even if the risk is very tiny. People don’t integrate their wealth and value the insurance according to
expected utility, they just overweight the probability of damage.
10. Demand for Lotto (lottery betting) (more tickets sold as top prize rises) (overweight low p(loss))
In the lottery game Lotto 6 numbers are chosen. You win if the randomly drawn numbers are the same. If no one has it
correct, the jackpot will roll over to the next week’s jackpot. But, people are more sensitive to the large jackpot than to the
correspondingly probability of winning.
The prospect theory can explain observed patterns of economic domains.
,Lecture 3 – Kahneman: Endowment effect
Economists assume that entitlements do not affect value, but empirical observations show that selling prices are higher than
buying prices. These effects are too large to explain by income. They think the difference between the prices reflects a genuine
effect of reference positions on preferences. The product becomes part of the individual’s endowment and selling it feels as a loss.
This means that there would be no endowment effect if the product is used for resale (e.g. a token).
Repeated market experiments
Participants received tokens, mugs or pens and could sell these, or they didn’t and could buy these. They could say at different
prices if they wanted to buy/sell. The market for the tokens had the same buying and selling prices, but the prices differed a lot for
the mugs and pens. The results also show that both buyers and sellers display a wide range of values, the distribution of selling
prices a single mode has, a small commission for trading (e.g. $0.25) would not alter the results, that the mugs were desirable,
and lastly, that neither demand nor supply changed much between the first and last markets.
Extra experiments are conducted, but if there are limited or no monetary incentives, the results stay the same. Also for monetary
incentives (consumption goods) the results stay the same. This means that features that were presented in both markets (e.g.
transaction costs) can’t be the reason. Even after a few markets, the discrepant evaluations are still there, so market experience
doesn’t seem to be the case.
Testing for misrepresentations
It could be that subjects thought they had to influence the price. In a fifth experiment, participants were told that the price would be
selected at random. This gave nearly identical results.
Reluctance to buy versus reluctance to sell
The endowment effect results from a difference between the relative preferences for the good and money. There is the reluctance
to sell and the reluctance to buy. In the sixth experiment, they add an extra group: the choosers. The choosers could choose
between a mug or cash. The choosers were quite similar to the buyers, thus there is relatively little reluctance to pay for the mug.
The only difference between the choosers and the sellers is that the sellers already owned the mug.
Bilateral bargaining and the Coase theorem
In the eight experiment, participants were paired. One of them won a chocolate bar and the other got a ticket with a value of $3.
The chocolate bar owners could receive $5 if they bought the ticket from the owner. Thus, there is a $2 surplus. 29/35 pairs
exchanged, with an average price of $4.09. The tickets owners gained on average $3.90 and the chocolate bar owners $0.76
(income effect of $3.14). Next, they could sell their chocolate bar if they wanted. Again, fewer trades were made than expected.
Endowment effect in choices between goods
Participants received a mug or a chocolate bar and could immediately change this if they wanted for a chocolate bar or a mug. A
third group could just choose between a mug or a chocolate bar. Participants mostly didn’t change it, thus staying with what the
first owned. This shows that undertrading even occurs when income effects are ruled out and if everyone owned the product.
Discussion
The value increases as soon as the individual gets the product. The reference point shifts and value changes. This is not due to
bargaining strategies and it is not the case at induced-value markets (e.g. tokens). It is primarily a problem for the sellers, because
there is a reluctance to sell. It is not a problem if it are tokens or if the product is meant to resell.
Lecture 3 – Morewedge: endowment effect
Loss aversion
Buyers see it as gains and sellers as losses, relative to their status quo or reference point (ownership). People are loss averse and
thus want higher prices for the products that they own. Reference points (in this case ownership) are not only determined by
present circumstances, but also by future outcomes. You are not expect to keep money so there is no endowment effect for the
buyers.
Evolutionary advantage
Overvaluing a product is an advantage while bargaining, because you can get more resources. This is unlikely, because it differs
per culture, is due to learning, etc.
Strategic misrepresentation
Some suggest that is due to a misunderstanding, but this can’t explain the effect on its own.
, Reference prices
This are the comparing standards drawn from the external environment or retrieved from memory (market value). Some suggest
that people want to avoid a bad deal and therefore reduce or inflate their price. This seem to have some influence on the prices to
buy and sell.
Biased information processing
Buying, selling and choosing evokes cognitive frames or queries. These frames bias the search for, attention to, and recollection of
information, which will influence valuation. This can have influence on the prices to buy and sell. The gap will be a bit smaller if
people are prompted to consider frame-inconsistent information, but the gap will be the same if you only give them frame-
consistent information. It is not really clear how this influences valuation.
Psychological ownership
Sellers are owners, but buyers aren’t. This is not the factual ownership, but the psychological ownership.
• It could be that ownership creates an association between the self and the product (product becomes part of the self-
concept). The self is positive, thus the product is also positive. There is an emotional attachment and you are afraid to lose
the product (higher price if anxious attachment style). This shows that the sellers are the problem.
• It could also be that people have a better memory for products that they own (self-referential memory effect). This can lead
to framing, because attributes of a good may be more accessible to its owners and these are often positive. For bad
products, the opposite occurs (contradicts with product becomes part of the self). This second explanation is supported by
activation of the brain region.
The effect is bigger if the products are congruent with their self-concept. The effect is also bigger for individualistic cultures than
for collectivistic cultures.
Attribute sampling bias
They suggest the integrative attribute sampling bias theory. Framing increases the accessibility of frame-consistent attributes
during valuation. If you have to make a comparison or evaluation, the most positive attributes of the status quo are most
accessible and heaviest weighted (attribute sampling bias). Emotions are also important. They say it is a better explanation than
loss aversion. They predict that the effect must be higher if the product has a more positive value and must be also there for bad
products. They also predict that the magnitude of the endowment effect should vary with the range of attributes value associated
with the goods (higher effect if bigger range in prices) (prove: bigger gaps if vaguely defined attributes). Lastly, self-referential
memory can influence the size of the endowment effect.
Lecture 4 – Frederick: reflection and decision making
Intelligence is often not included when studying judgment and decision making. They introduce a three-item Cognitive Reflection
Test (CRT) to simply measure cognitive ability.
The Cognitive Reflection Test (CRT)
There are two types of cognitive processes: quickly with little conscious deliberation and slower with more reflective. The Cognitive
Reflection Test uses this to ask questions that has easily understood answers when explained, but reaching the correct answer
requires suppression of an erroneous answer that springs impulsively to mind.
Cognitive reflection and time preferences
Research tries to prove that more intelligent people are more patient. Several studies show that children who choose to wait for
their reward, are more intelligent. But, several others studies found no effect. Cognitive ability and time preference are somehow
connected, but more research is needed. They conducted a new study and found that participants who scored higher on the CRT
were generally more patient. But, if choice involved longer horizons, temporal preferences were weakly related or unrelated to
CRT scores. It could be that a thoughtful respondent has good reasons not to wait for the money (promise, inflation, wealthier).
Greater cognitive reflection fosters the recognition or appreciation of considerations favoring the later larger reward, but is unclear
if this also influences other determinants of intertemporal choices (e.g. pure time) (because not everything related to time was
significant (e.g. massage or shipping right now). The higher CRT did report themselves as less impulsive, more concerned about
inflation and less preoccupied with their future.
Cognitive reflection and risk preferences
Only little research has been conducted about risks and cognitive ability. A few studies found that educated respondents were
more likely to choose according to expected value. This study looked at this again. They found that people who score high on CRT
were more willing to gamble in the domain of gains, but this is not due to the expected value. Also, people who score high on CRT
were less risk seeking.
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