With this summary for the IBEB course Introduction to Behavioral Economics, you have everything you need to succeed! It includes both content from the book, as well as from lecture slides. Also, the summary provides handy tricks you can use on the exam. (FEB12015X / FEB12015)
Behavioural finance Nederlandse samenvatting (cijfer: 9,4)
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Erasmus Universiteit Rotterdam (EUR)
Economie en Bedrijfseconomie
Inleiding gedragseconomie (FEB12015X)
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Content preview
Chapter 1:
Theories of decision: given a set of goals, how should/will people pursue those goals
- Descriptive theory: how people in fact make decisions
- Normative: how people should make decisions
Standard economic theories: assume they are both descriptively and normatively correct
Behavioral economics: clear distinction between descriptive vs normative
- People often don’t act in the way that they should
Theory of rational choice: normatively correct theories of decision
- Rational decision: a decision which is in line with the theory
- Irrational: decisions that are not
Neoclassical economics vs behavioral economics
- Neoclassical: people may not act rational all the time, but deviations are small and
unsystematic → do not matter
- Hedonic psychology: individuals maximize pleasure and minimize pain
- Behavioral econ: deviations from rationality are large enough and systematic
- Cognitive science: beh. econ is comfortable talking about things ‘in the head’,
while neoclassicals only want to talk about observable things (preferences).
Methods:
- In the beginning: surveys with hypothetical scenarios
- Now:
- lab experiments, making real decisions about real money
- Field experiments: assign participants to random groups and see how
behavior differs if they are in different situations (have dif. info etc)
process methods: methods that provide hints about cognitive and emotional processes
underlying decision-making.
process-tracing: software to assess what information people use when making decisions in
games.
Chapter 2: Rational Choice under
Certainty
choice under certainty: there is no doubt as to which outcome will result from a given act
- E.g. you get a vanilla ice cream if you order a vanilla ice cream
Axiomatic theory: theory consists of set of axioms
- Axioms: basic propositions that cannot be proven using resources offered by the
theory (just have to take as given)
, - Choice under certainty is an axiomatic theory
preferences: are relations
Relations:
- Binary relations: relations between two entities
- E.g. Bob is older than Alf
- Notation: ‘R’ denotes the relation ‘is older than’
- bRa → Bob is older than Alf
- Rab → Alf is older than Bob
- Order matters!
- Ternary relations: between three entities
- E.g. Mom stands between Bill and Bob
Weak preference relation: ‘at least as good as’
- If coffee is at least as good as tea → c ≥ t
- For different individuals:
- Alf: c ≥Alf t
- Betsy: t ≥Betsy c
Universe (U): set of all things that can be related to one another.
- {Kwik, Kwek, Kwak}
- Order does not matter
- Universe may have infinite members (for example time)
- Set of alternatives: when talking about preferences relations
- Three apples, two bananas → 〈3,2〉
- Three apples, two bananas, six coconuts: 〈3,2,6〉
- Choice of universe might determine whether relation is transative/intransative,
complete/incomplete.
Weak order preference: preference relation that is transitive and complete
- Transitive: if A > B and B>C then A > C (for all A, B, C)
- Intransitive: if A is in love with B, and B in love with C, does NOT mean A is in
love with C → intransitive relation
- Complete: Either A bears relation R to B or B bears relation R to A (e.g. there must
be at least on relation connecting them)
- Either x ≥ y or y ≥ x (or both) (for all x, y)
- Example: Two people: Alf and Bob, either Alf is at least as tall as Bob or the
other way around
- Incomplete relation: if you take two random people out of the universe, one of
them is not necessarily in love with the other → incomplete
IF SOMETHING IS WEAK ORDER, IT IS ALSO REFLEXIVE
- ANY SET THAT IS COMPLETE IS ALSO REFLEXIVE
- → b/c there must be a relation between x and x (otherwise not complete)
,Logical symbols:
- x&y x and y
- xvy x or y
- x→y if x then y; x only if y
- x ←→ x if and only if y; x just in case y
- streepje down p not p
Indifference: x ~ y if and only if x ≥ y and y ≥ x
- Or: x ~ y ←→ x ≥ y & y ≥ x
- Symmetric: if x is as good as y, then y is as good as x.
- Incomplete: there probably is a preference relation in the universe between which
the agent is not indifferent between all options
Strict preference: x > y if and only if x ≥ y and it is not the case that y ≥ x
- Weak preference: “is at least as good as”.
- Properties:
- Transitive
- Anti- symmetric
- Irreflexive
Indirect proofs:
- Proof by contradiction: proving a proposition by first assuming that the opposite
proposition is true and then showing that this leads to a contradiction
How to do proofs:
- Proof: Sequence of propositions, presented on separate lines of the page (each
numbered), last line is the conclusion.
- Hints: if you want to prove…
- x → y, you must first assuming x, then derive y
- x ←→ y, first prove x → y, then y → x
- not p, first assume the opposite and then show it leads to a contradiction
Completeness: relation must hold in at least one
direction for all possible combinations
Reflexivity: relation ‘is not married to’
you cannot marry yourself
Irreflexivity: relation ‘is married to’
As you cannot marry yourself
Symmetry: ‘is married to’
If A married to B → B married to A
- So xRy means yRx
Anti-symmetric: if xRy means that IT IS NOT POSSIBLE that yRx
- E.g.: x > y → y cannot be bigger than x
Preference ordering: order all alternatives in a list, with the best at the top and the worst at
the bottom.
, - Completeness ensures each person will have exactly one list
- Transitivity ensures that the list will be linear (e.g. no cycling)
- Indifference curve: each bundle on one of these curves is as good as every other
bundle on the same curve
Menu / budget set: set of options, but you can choose only one option.
- Budget line: set of combinations of goods that you can afford
- Rational decision:
- You have rational preference ordering
- You choose (one of the) the most preferred item
Utility function: gives a number to each member of the set of alternatives
- Higher utilities correspond to more preferred items
- The actual numbers themselves don’t really matter (it is ordinal, only allows
you to order things)
- Rational: to maximize utility (choose highest IC curve)
Representation theorem: If the set of alternatives is finite, then ≥ is a rational preference
relation just in case there exists a utility function representing ≥.
- Given a rational preference relation, there is always a utility function that represents it
(if choice set is finite).
ordinal utility: We can replace u by v with v(x) = f(u(x)) for all x, as long as f is an increasing
function.
- Examples: f(u) = 4u + 10 f(u) = eu
- We don’t care about the actual numbers, just if one is bigger than the other
cardinal utility: We can replace u by v with v(x) = f(u(x)) for all x, as long as f is a linear
increasing function.
- Examples: f(u) = 4u + 10 But NOT f(u) = eu
- f(u) = 4u + 10 and f(u) = 8u + 20 reflect the same preferences
- f(u) =eu and f(u) = eu + 20 reflect the same preferences
- Preferences: we care not about the absolute number, but about the differences
between two states
- As long as the differences between two states are the same → reflect the
same preferences (--> larger difference means stronger preference)
- → any linear transformation preserves the differences between two
states
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