Summary The Psychology of Economics
Class 1
Behavioral economics: Reunifying psychology and economics
Camerer, 1999
Psychology and economics need to be reunified, since early thinking of
economics had much psychological insight. However, psychology and
economics went along different paths later on. Two trends caused this:
1. Both areas where inspired by natural sciences. The economist
concluded that a theory is a body of mathematical tools and
theorems. The psychologist concluded that a theory is a verbal
construct or theme that organizes experimental regularity.
2. Economic theories assumed that individual agents are highly rational
and willful, judge probabilities accurately, and maximize their own
wealth might prove useful. Psychologist had shown those
assumptions are false, causing economist to ignore psychological
theories.
In order to reunifying both areas, behavioral economics try to
incorporate psychological theories into economics. In order to do so,
psychologists have modeled bounded rationality in terms familiar to
economists. Also economist try to attach economic theory to psychological
foundations.
Therefore, the rational principal needs to be included as a
mathematical special case so that easy statistic measurements can show
that general behavior can converge to rationality. There are four principles
of economic behavior:
1. Expected utility theory.
Utility is a measure of the person’s preferences amongst different
things. People value risky gambles by weighing the utility of an
outcome Xi by its probability Pi denoted ΣiPiu(Xi), where u is a
function that measures the value of an outcome. With this rational
principle, outcomes are integrated in the overall wealth of the
person, and when two gambles with a common probability of a
common outcome the outcome is cancelled out deciding between
the two gambles.
The behavioral principle of this theory is prospect theory where
possible outcomes are weight by a “decision weight”, which is non-
lineair. People adapt to their experiences and thus utilities are
determined by gains and losses from a reference point r. Therefore
the function is Σiπ(Pi)u(Xi-r). People mentally account for money in
separate categories and dislike losses more than they like gains. The
latter explains why people are risk seeking when a gamble involves
losses (better to break even). Also it explains the endowment effect.
People overweight low probabilities.
2. Exponential discounting.
, In order to make choices people weigh the utilities of future costs
and benefits. Rational evaluation comes with “exponential
discounting”, which means future utilities u(xt) are discounted by
weight δt which is an exponentially declining function of t, Σtδtu(xt). It
makes the strong prediction that the evaluation of two payments
only depend on the delay between the two payments. People have
an exaggerated preference for immediate reward and explains
addiction and procrastination (=uitstel).
However, it does not explain the savor of delaying good outcomes or
liking increasing wage profiles. The behavioral principle of
“hyperbolic discounting” does take delayed reward into account by
βδt. β is the preference for immediate reward, δ expresses the
preference for reward delayed t periods, relative to a delay of t+1
periods, u(X0) + Σt=1βδtu(Xt).
3. Social utilities.
Economists assume people only care about their own health and are
not willing to sacrifice anything to help or hurt others. Though, these
sacrifices are common in the form of altruism and vengeance. This is
called “social utilities”, u1x2(X1, X2) ≠ 0, in the behavioral principle.
Mathematical theories explain these kind of utilities by assuming
people dislike allocations in which they earn different amounts than
the other or that people like to reciprocate. The principle laying
behind the rational principle is the own-payoff maximization,
u1x2(X1,X2) = 0.
4. Equilibrium.
Economists see systems as in equilibrium. This means that supply
meets demands, or all agents are choosing optimal strategies. So
people choose the mutual best response.
The behavioral principle explains that people learn by reinforcement,
meaning they use strategies that would have performed well had it
been chosen the previous time (experience weighted attraction).
Though, this kind of leaning rules were also studied by game
theorists with belief learning.
It is clear that the rational principle describes ideal behavior. However, the
behavioral principle shows how people actually think, instead of the
normative prescription of economists. Economics should shift from how
people should behave to how people actually behave.
Other rational principles were criticized, but did not yet have a behavioral
principle.
1. Utility maximization.
People rank objects consistently enough to permit assignment of a
unique number u(X) to object X. However, there are many ways in
which utilities depend on how objects are described or how choices
are made (constructed preferences).
2. Bayesian probability judgment.
, It prescribes a precise way of altering judged probabilities in the light
of new information. P(A│D)=P(D│A)P(A)/P(D), A is hypothesis, D is
new evidence, P(A│D) posterior probability of A after observing D.
This is impossible, since this rule insists that the order of information
arrival does not affect judgment. With that, it says belief and
evaluation of data are independent, which is not true when the belief
influences the encoding of evidence (top-down processing in
perception and confirmation bias).
An alternative to this rule are some heuristics as availability and
representativeness, but these are not mathematical.
Behavioral economics explain multiple field phenomena and provides for
a more realistic and thoughtful basis for making economic policies.
The Psychological perspective on Economics
Kahneman, 2003
There is a gap between Psychology and Economics. Three
assumptions that explain the narrowing of the gap:
1. Selfishness
Research has shown that people’s behavior due to economic
decisions is based on motives instead of profits. So unequal divisions
of money by a stranger will be rejected, but will be accepted when
this division is allocated by a computer.
People start out trusting and benevolent and reciprocate good and
bad behavior. However, research has shown that a misbehavior of a
stranger is punished even when it costs themselves something.
When there are multiple people in a population with these kind of
motives, people with a different motive are turned into apparent
cooperators.
Economic theory has also conducted some research that is in
line with social science. For instance, Fehr says some agents are
‘opportunistic with guile’, but behave fair since they have to interact
with people who care about being treated fairly and willing to do
something about it.
2. Rationality
Economic theory is based on people being rational. However,
nowadays it is understood to be a approximation, since stakes may
be significant and it will disappear under the discipline of the
market.
Rationality in economics is the maximization of subjective
expected utility. Though, this is not true. The concept of satisficing
and bounded rationality is introduced (realistic normative standard
for organisms with a finite mind). Other research showed that
rationality itself does not exist. People are influenced by the framing
of decisions, which violates the assumption of invariance
(=onveranderlijkheid) and so is not normative. This is also known as
extentionality and consequentialism. As a consequence, economic
theories are developed departing from economic rationality in
