Week 1
Psychological 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
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller zctpfru. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for £7.16. You're not tied to anything after your purchase.