College 1
Chapter 1
Behavioral economics studies the ways in which behavior differs from the standard economic model
in order to improve the explanation of economic behavior.
Standard economic model: people are rational. Behavioral economics: people are often not rational
Some assumptions of rationality
- Correct assessment of information
- Calculation
- Self-control
- Self-interest
Two ways in which people depart from rationality
- Judgement (beliefs, evaluations)
o Optimism
o Context dependence
o Etc.
- Choice (behavior, decisions)
o Self-control
o Decisions over time
o Charity
Development of rational behavior
- Do market forces make people more rational?
o They only provide incentives, not enforcement (punishment may even drive out
intrinsic motivation to behave oneself)
o Real life frequently provides no arbitrage opportunities for irrational choices (even in
finance ‘smart money’ should follow ‘dumb money’)
o Life is not an experiment (je kunt dingen maar 1x doen, je kunt niet je eigen leven
vergelijken met een ander leven van jezelf als je een iets anders zou hebben gedaan)
- Does evolution make people more rational?
o Evolution may weed out both rational (cf. game theory) and irrational behavior (cf.
overconfidence)
o Evolutie zorgt er niet dat we meer rationeel worden
- Does learning make people more rational?
o Much behavior takes a long time to be learned or learning is not possible at all (e.g.,
retirement decisions)
o Opportunity costs of learning or experimenting may be too high (e.g., study or work
decisions)
Bounded human nature, three unrealistic traits
- Unbounded rationality
o Loss aversion, decision heuristics, satisficing (e.g., overconfidence in financial
markets, taxi cab drivers)
- Unbounded willpower
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, o Self-control problems
- Unbounded selfishness
o Free rider problem, charity, volunteer work, dictator game, ultimatum game
Some examples of bounded human nature
- Finance
o Frequent traders obtain less net return than non-frequent traders
o 1/n heuristic (naïve diversification) (evenredig verdelen)
o Predictability of stock prices
January effect
Friday effect
Overreaction (long run) (aandelen waar het goed mee gaat, worden
overschat)
Underreaction (short run) (aandelen waar het slecht mee gaat, worden
onderschat)
Disposition effect (mensen verkopen aandelen die winst maken en verkopen
aandelen die verlies maken) (mensen willen de negatieve waarde niet waar
maken, maar hopen dat de waarde gaat stijgen terwijl de kans groot is dat
deze verder daalt waardoor ze meer verlies hebben)
- Saving
o Economic life cycle model assumptions of rationality and willpower are unlikely to
hold
o Consumption tracks income
- Self-control
o Christmas saving clubs
o IRAs, 401(k) saving plans in US, forced pension saving in the Netherlands
o Changing default option in saving plans
o SMART saving plan
Conclusions
- Phycological effects seem to undermine rational behaviour in decision making:
o Habits, self-control, valuation of gains and losses, consumer confidence, motivations
and emotions
Two false statements
1. All behavior is rational
2. Rational models are useless
Why choose an activity X?
- People have scarce resources (money, time, energy, health, etc. is limited)
- Therefore, they have to (implicitly) calculate the value of each alternative activity
- Value = Benefits minus cost
- Reservation price = price at which one is indifferent between doing X and not doing X
(benefits = costs)
A doen betekent ook dat je B NIET kan doen (dat zijn dus kosten -> opportunity costs)
Opportunity baten
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,Sunk cost: (ook wel verzonken kosten) zijn kosten die al gemaakt zijn en niet meer ongedaan te
maken zijn.
Homo economicus
- Stereotypical decision maker in the self-interest model:
o Guided by material benefits associated with selfish behaviour
- Behavioural economics:
o bounded selfishness, bounded rationality, bounded will-power
Positive vs. normative questions
- Positive: a question about the consequences of specific policies or institutional arrangements
(e.g., what happens to fish price, employment, consumption, if fish catch is limited?)
- Normative: a question about what policies or institutional arrangements lead to the best
outcomes (e.g., how important is fish preservation?)
Book
Cost benefit approach:
Benefits of x > costs of x. Then you should do x.
Benefits: The maximum monetary amount you would be
willing to pay. Costs: The value of all the resources you
must give up to do x.
Reservation price: The price at which a person would be indifferent
between doing or not doing x. (The minimum amount it would take to get
you out of a chair to turn down music)
Opportunity costs: the opportunity cost of an activity is the value of all
that must be sacrificed in order to do the activity.
Criticism:
Unrealistic assumptions about how people behave.
Response to criticism: people do not calculate explicitly, but it is useful
to make predictions. Useful insight into our behaviour can be gained by
assuming that we act as if governed by the rules of rational decision
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, making. By trial and error we eventually absorb these rules, just as pool
players absorb the laws of physics.
Common pitfalls in decision making:
1. Overlooking opportunity costs.
Opportunity costs: if doing x means you are not able to do Y. The value of
Y is the opportunity cost. (the value of the most attractive alternative you
will forgo.)
2. Failing to ignore sunk costs
Sunk costs: a cost that is beyond recovery when a decision is made.
Ex. 1.1: if the expected gain would have been 7000, this would have
been lower than the costs to finish the job. Therefore your answer would
be not to move.
Ex 1.2: Mike will be more likely to go, since he has paid 18 euros for the ticket.
3. Measuring costs and benefits as proportions rather than
absolute monetary amounts.
You can save ten euros for a 20 euro clock by walking 15 minutes →
people will do this. You can save ten euros for a 1010 euro television →
people will not do this.
When using the cost-benefit test, you should express costs and benefits
in absolute terms. Comparing percentages is not a fruitful way to think
about decisions like these. Ex 1.3: Use the coupon to get 120 euro off
the normal 2400 euro airfare to New Delhi, since 120 is more than 100.
4. Failure to understand the average-marginal distinction
Marginal cost: The increase in total cost that results in performing one additional
activity.
Marginal benefit: The increase in total benefit that results in performing
one additional activity.
Average cost: the average cost of undertaking n units of an activity is
the total cost of the activity divided by n.
Average benefit: the average benefit of undertaking n units of an activity
is the total benefit of the activity divided by n.
Ex 1.4: Tom should launch two more boats. Since the daily marginal
benefit of 180 > the marginal cost of 150.
Ex 1.5: If the call rate would drop until 2 cents per minute, she would
spend 600 minutes on the phone.
Homo economicus: personal material costs and benefits are the only thing
they care about.
Positive vs. normative questions:
Positive question:
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