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ECON0040 Week 1
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Week 1Psychological Principles, Heuristics and Biases
Standard model
• An individual i at t=p maximises expected utility subject to beliefs about the probability
distributions regarding the state of the world
• The utility function U(x|s) is de ned over the payo of individual i
• For future decisions the discount factor is used in utility
• Agents maximise expected utility consequences with:
◦ Full self interest
◦ Full rationality
‣ Fully capable of evaluating alternatives and calculated expected outcomes
‣ Perfect sell knowledge (ie. Complete preferences, completeness outcome)
‣ Fully coherent preferences (transitivity axiom)
◦ Full self control
Shortcomings
• Non-standard preferences
◦ Risk preferences- reference dependence, probability weighting, loss aversion, ambiguity
aversion
◦ Time preferences- hyperbolic discounting
◦ Social preferences - eg. fairness, altruism and reciprocity
• Non-standard beliefs
◦ Overcon dence
◦ Misjudgement if probabilities and biases a ecting beliefs
◦ Beliefs may be a ected by the context or the presentation of th problem (framing)
• Non-standard decision making
◦ Emotions a ecting decision making
◦ Limited attention
◦ Limited cognitive ability
Behavioural economics
Behavioural economics argues that instead of being fully rational, actors have bounded rationality
Heuristics
• Anchoring - individual’s responses are anchored to other phenomena, even if they appear to be
irrelevant
• Availability- our tendency to use information that is more memorable and make decisions
accordingly
◦ This a ects our judgement if probability of events
• Representativeness- assessing similarity of a certain event to an existing mental prototype when
estimating the probability of the certain event
◦ The prototype of a set is characterise by the average values of the salient properties of its
members
◦ The prototype is highly accessible
, ◦ However, this can lead to bias as the prototype is not extensional, it is an average
Biases
• The conjunction fallacy- an inference from an array of particulars, in violation of laws of
probability, that a conjoint set of two or more conclusions is likelier than any single member of the
set
neglectof unconditionalp robabilities
◦ Can be caused by representativeness heuristic
1 in Bayas rule
• Base Rate neglect- the tendency to underweight base rate or prior information compared with
current information when estimating probability of an event
◦ Can be caused by representativeness heuristic
• Law of small numbers- the tendency to believe that a relatively small number of observations will
closely re ect the general population
• Gambler’s fallacy- the belief that the probability of a random event occurring in the future is
in uenced by previous instances of that type of event
• Hot-hand fallacy- the tendency to believe that someone who has been successful in an activity is
more likely to be successful again in further attempts
• Diversi cation bias- the tendency to choose more variety when choosing multiple items for future
consumption than when choices are made sequentially
• Projection bias- the tendency to believe that preference will remain the same in the future,
overestimate how much their future self will share the same preferences
• Hindsight bias- the tendency to overestimate the predictability of an unpredictable event after it
occurs
• Self-serving bias- the tendency to attribute positive events to your own actions, internal
characteristics, and negative events to external factors
◦ This causes the di usion of responsibility (feeling less responsible when there are
bystanders), and profusion of responsibility (people feeling underpaid compared to their
contribution)
• Mental accounting- the treating of one sum money di erently to an equally sized sum depending
upon which mental account the money is assigned to
• Framing e ect- the way that information is presented may in uence out decisions
• Money illusion- bias of judging money in nominal rather than real terms
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