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Summary Lectures Economic Psychology
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Summary Lectures Economic Psychology Major 2021/2022. As part of the Bachelor Psycholgy at Tilburg University.
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Summary Economic PsychologyHistory of economic psychology
Simple psychological principles:
1) Many choices are automatic
2) People are social animals (not only about what you have, but also what the other has)
3) People respond to mental models (not always an objective truth)
4) People are hard to mobilize (don’t optimise)
5) Small changes can have big effects not always easy to predict)
Counterproductive interventions (Cobra effect): e.g. poisonous snakes were killing people so reward
for killing snakes. But people now bred cobra’s to get money.
Adam Smith: beginning of modern economics: how to organise society in a way that’s best for most
people
- Self-interest / invisible hand: when everybody looks after his or her interests, this will do
good for the entire society (works good in societies where people can choose jobs that they
want, but not in today’s society).
- Moral sentiments: people have empathy towards others
Blaise Pascal: The value of future gain should be directly proportional to the chance of getting it
(value/fair price of a gamble) = expected value (start of division theory)
- Daniel Bernoulli: utility is better than expected value St. Petersburg Paradox
Jeremey Bentham: utilitarian thinkers think about how they can organise society in a way to get the
most pleasure for most people (progressive)
Pleasure is measured by hedonic calculus:
- Hedons: units of pleasure
- Dolors: units of pains
John Stuart Mill: utility/greatest happiness principle, holds that actions are right in proportion as they
tend to promote happiness, wrong as they tend to produce the reverse of happiness/pain
Clark: economists need psychologists and also the reverse is true
Economics Psychology
Development of mathematical models Creation of artificial conditions in the lab
Testing models with public data Control of variables
F-twist: Plausibility doesn’t matter but the Recruitment of participants
predictive value does
Normative theory: moral judgements on events Descriptive theory: describing object under
study
Assumptions about behaviour Research about behaviour
Deductive: conclusions by reasoning Inductive: inference of general laws
Anomaly: when people behave differently than theory (you need separate theories for these
deviations)
George Katona: Index of consumer sentiment: predicting economy with survey questions instead of
complex models, that measure people’s inclination to buy something in the near future, to say
something about the trust of the economy.
, The basic need for psychology in economic research is to discover and analyse forces behind
economic processes.
- Herbert Simon:
o bounded rationality: we’re bounded by cognitive limitations but still try to be rational
o satisficing: we don’t look for the best possible option, but for the option that’s good
enough
- Daniel Kahneman: heuristics and biases in judgement / prospect theory / risk aversion for
losses
- Richard Thaler: mental accounting / behavioural finance / fairness / self-control
Assumptions of economic theory:
- Stable preferences (over time and over situations)
- Self-interest
- Maximisation = greed
- No cognitive limitations
- Unlimited will-power
- Complete information (market transparency) – assumption that we choose the product that’s
best for us
- Long-time perspective
- No role for emotion and fairness
Rationality: how do you know what to do and what to choose when people decide what to do, they
look at what it gives them, and how likely it is that they get it.
- Expected value: the value of a future gains should be directly proportional to the chance of
getting it
- Biased probability estimation: often we’re wrong (e.g. when we know a student loves Sartre
we guess that he’s a philosophy student, but a better guess would be psychology students
despite the facts, because much more psychology students than philosophy students)
- Availability heuristic: we often look at things as how easy they come to mind (e.g. people
overestimate rare events because they’re brought to mind easily because it comes on the news)
lotteries and casino’s also make use of this.
- Cognitive heuristics: short-cuts or rules of thumb to arrive at probability or frequency
estimates quite useful but sometimes they lead to severe and systematic errors / biases ~
Tversky & Kahneman.
When less is more ~ Medvec, Madey & Gilovich: second place is the first place loser (a bronze
medallist is happier than a silver medallist, because of the contrast in comparisons. Silver looks at gold
and bronze looks at that he made it to the best 3 on the podium.
Lottery winners vs accident victims ~ Brickman et al: happiness assessed after a person winning the
lottery and a person becoming paraplegic after a car accidents. After 2 years relatively little difference
in quality of life and happiness.
Expected value & utility theory:
Rationality:
The gamble paradigm: making rational decisions in simple gambles
Expected value ~ Pascal/Fermat: the value of future gain should be directly proportional to the chance
of getting it (mathematical expectation). Calculate the expected value of each option and choose the
one with the highest EV
- Null-bet: when you on average win 0 (expected value = 0)
, St. Petersburg Paradox ~ Bernoulli: challenge for expected value that EV is indefinite,
probabilities become low but outcomes become very large (limitation of rational choice
model)
Gabiel Cramer: any amount beyond 20 million, does not make people happier/does not add
value
o Something wrong with this calculation because even when you have 20 million, you
might realise that 100 million is more
o Next attempt: the value of an additional unit should be more than 0, but diminish as
wealth increases. Value follows the square root of wealth (money gets less valuable
the more you get)
Bernoulli: the reason for the paradox: the gambler disregards the tiny probabilities of
winning, even f the gain would be very large, hence he sets all probabilities after a certain
round of a game to 0
Nikolaus Bernoulli (cousin): solved the problem: the utility of wealth follows the logarithmic
function: the utility/subjective value resulting from any small increase in wealth will be
inversely proportional to the quantity of goods already possessed. The determination of the
value of an item should not be based on the price, but on the utility it yields (a gain of
thousand dollars is worth more to a pauper than to a rich man though both gain the same
amount).
Utility:
In simple economics 2 things determine what people do:
- The pleasure people get from doing or consuming something
- The price of doing or consuming something
Pleasure is difficult to measure = utility
Jeremy Bentham: a measure of pleasure and pain
Kahneman et al:
o Decision utility: anticipated pleasure you feel at the time of decision
o Experienced utility: pleasure you actually feel from the consequences of your choices
Total utility: the satisfaction one gets from one’s consumption of a product
Marginal utility: the satisfaction one gets from the consumption of one additional unit of a product
above and beyond what you have consumed up to that point
- Diminishing marginal utility ~ Friedrich von Wieser: at some point, the marginal utility
received from each additional unit, decreases. As you consume more of a good, you enjoy
additional units less than the initial units.
- Risk aversion: you don’t want to take the risk of loss
The expected utility hypothesis ~ Gary Becker:
Fines are preferable to imprisonment because more efficient with a fine, the punishment to
offenders is also revenue to the state
e.g. for a junkie, the win for now is more important than the loss later
The theory of decision making ~ Edwards (1954)
1) The theory of riskless choices: the decision maker is considered to be an economic man:
- He is completely informed: he is assumed to know not only what all the courses of action
open to him are, but also what the outcome of any action will be
- He is infinitely sensitive: the available alternatives are continuous
- He is rational
o Can weakly order states: if you like A more than B and B more than C, you must like
A more than C = transitivity of preference (if not, it’s not good because of money
pump)
o Can choose to maximise something: typically assumed to maximise utility (always
chooses the best alternative from among those open to him, as he sees it)
, Psychologists find the economic man very unlike real men, so they tend to reject the theories
that result form the assumptions. But, the most useful thing to do with the theory, is not to
criticise its assumptions but rather to test its theorems. If the theorems fit the data, then the
theory has at least heuristic merit.
Early utility maximising theory: ~ Bentham/Mill: goal of human action is seeking pleasure and
avoiding pain (maximum utility)
- The assumption of independent utilities can be rejected, because of several reasons such as
the existence of competing goods and completing goods.
- Edgeworth introduced the notion of indifference curves to deal with the utilities of non-
independent goods. An indifference curve is a constant-utility curve: there is an infinite
number of points on this curve, which all show an amount of utility (structure of theory of
riskless choices)
- Lange pointed out that utility was cardinally (on interval scale) measurable. This notion got
abandoned, because the indifference curve analysis could do everything that cardinal utility
could do, with fewer assumptions.
2) Application of the theory of riskless choices to welfare economics:
Utilities would be useful for policy evaluation when they ca be compared between people, but they
cannot.
- Pareto’s principle: solution – a change should be considered desirable if it left everyone at
least as well off as he was before and made at least one person better off
- Compensation principle ~ Kaldor: if it’s possible for those who gain from an economic
change to compensate the losers for their losses and still have something over from their gains,
then the change is desirable
Psychological comment: it seems utopian to hope that any experimental procedure will ever
give information about individual utilities that could be of any practical use in guiding large-
scale economic policy.
3) The theory of risky choices: economists make a distinction between risk and uncertainty
- Risk: known probabilities (If I flip a coin, what is the likelihood of heads)
- Uncertainty: unknown probabilities (what is the likelihood you work as a psychologist in 3
years)
Expected utility maximising: expected value of a bet is found by multiplying the value of each
possible outcome by its probability of occurrence and summing these products across all possible
outcomes.
Problem with this assumption because of St. Petersburg paradox and the fact that people are
willing to buy insurance even though the person who sells the insurance makes a profit
Solution Daniel Bernoulli: could be resolved by assuming that people act so as to maximise
expected utility rather than expected value
Assumptions utility theory: rational choices: ~ Von Neumann & Morgenstern
- Risky propositions can be ordered in desirability (just as riskless ones can)
- The concept of expected utility is behaviourally meaningful
- Choices among risky alternatives are made in such a way that they maximise expected utility
Economic implications of maximizing expected utility theory ~ Friedman & Savage:
Concerned with the question of why the same person who buys insurance (with a negative expected
money value), and therefore is willing to pay in order not to take risks, will also buy lottery tickets
(also with negative expected money value) in which he pays in order to take risk.
Double inflected curve for money: accept insurance because the loss against which he is
insuring would have a lower expected utility than the certain loss of the insurance premium.
Willing to buy the lottery tickets, since the expected utility of the lottery ticket is greater than
the certain loss of the cost of the ticket.
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