Behavioral Decision Making
Lecture 1
Articles:
- Brooks, D. (2011). "Who You Are," The New York Times, October 20th, 2011.
- Barberis, N. (2013). Thirty Years of Prospect Theory in Economics: A Review and
Assessment. Journal of Economic Perspectives. 27(1), 173-196. (NOTE: focus on the
endowment effect in the application section of the paper)
- Heyman, J. & Ariely, D. (2004). Effort for Payment: A Tale of Two Markets. Psychological
Science, 15, 787-793.
Standard models of economics
1. People are rational and aim to maximize their utility.
2. People are driven by monetary incentives.
3. Optimal decisions are made at the margin. People will continue an activity until the benefits
exceed the costs. Once the costs exceed the benefits people will quit.
Expected utility theory (normative theory of behavior)
Expected utility theory is used as a tool for analyzing situations in which individuals must make a
decision without knowing the outcomes that may result from that decision. It assumes that individuals
will choose the outcome which gives maximum utility given the probability of outcomes
People should make decisions based on these 3 paradigms:
● A rational decision maker is able to maximize their utility by selecting among superior
alternatives.
● When alternatives have similar outcomes, a decision maker should be indifferent to these
alternatives.
● Utility is dependent of final wealth (for example, deviations from current state wealth are
inconsequential)
What matters to a person is the amount of money people have at the current moment, not where they
financially originate from.
A utility maximizer calculates the expected value, but most people don’t choose this because they don’t
calculate the expected value. The framing of a question determines how people choose their gamble.
Psychologists and economists don’t care about rationality, they care about the environment and
upbringing of the person.
Issue with the expected utility theory:
● The theory doesn’t reflect real life choices.
,Prospect theory (Descriptive theory of behavior)
The prospect theory talks about how people value future outcomes or ‘prospects’.
Descriptive theory of behavior = experimentally how people decide based on the context.
Understandings of human behavior (LCDR, lazy dream):
1. Losses: Losses loom larger for people than gains do. Losses are felt more. So people are risk
aversive. People want to minimize their loss and maximize their game.
2. Certainty:We look at all the options and if something feels certain only then people will go
ahead with it. Your decision is based on how options are framed.
3. Reference: Gain or loss comes from a reference point. People compare options from a reference
point (individuals status quo)
4. Diminished sensitivity: People experience diminished sensitivity to losses and gains. The curve
for sensitives flatten when going up further. For example, if you already lost 500, 600 won’t
matter much more.
There are gain frames (risk aversion) and loss frames (risk seeking).
People can be risk averse and risk seeking based on how options are framed and because losses are felt
more than gains.
Based on the frame reference you become risk seeking or risk aversing.
People don’t make decisions based on realism but based on how they feel.
Risk aversive: You fear being disappointed if your luck does not hold and you land in that 10% chance
that would get nothing. This leads you to take the sure gamble.
Risk seeking: Fear of loss leads most people to reject sure loss and gamble on the chance of losing for
example $1000 instead.
Reference dependence: It does matter what people have right now, but they pick the beginning point as
reference point, so that determines if people are happy or not.
Endowment effect: People tend to value items they own more highly than they would if they did not
belong to them.
Status Quo Bias: We like the default way of things set in motion. We have a lack of desire to change.
!The equations of the prospect theory won’t be questioned at the exam and therefore don’t matter!
People do not have conventional (economic) wisdom:
● We are not exclusively motivated by financial self-interst
● We do not engage in cost-benefit analysis
● And do not make conscious decisions.
Our rationality is bounded so we don’t make rational decisions. We rather rely on shortcuts to make
decisions.
,Experimental research
Experimental research is key to understanding human behavior as it enables researchers to isolate cause
and effects.
There is a difference between correlation and causality.
Correlation = A mutual connection, they are related.
Causality = Cause and effect.
The key features are control over variables, careful measurement, and establishing cause and effect
relationships (causal relationships).
Random allocations are necessary for unbiased outcomes.
The standard model of labor is one where motivation = payment. That is, individuals trade their effort for
monetary rewards. That is how the system operates.
People are driven by monetary incentives, but there are specific incentives that cause for an exception of
course.
Heyman et al. (2004) !Artikel!
Reason for research: In real life we see people doing a lot of work being motivated to put in a lot of effort
to put in a single task, however they are not paid a dime. Why does this happen?
Hypothesis:
There are 2 types of markets:
- The monetary market: The more money you get the more effort you will put in your task.
- The social market: Whether you paid nothing or little compensation in a social market, your
level of effort will remain the same.
Our compensation for effort is highly dependent on how the market and the individual is.
The market relationship represents the moderator of the effect between compensation and effort.
Human behavior does not necessarily follow certain axes but also other factors such as markets.
Brooks (2011) !Artikel!
Main key points:
● People rely on unconscious biases and rules of thumb to navigate the world, for good and ill.
● We are dual process thinkers: conscious reasoning and unconscious pattern recognition
● Most of our thinking is below awareness
, Barberis (2013) !Artikel!
Main key points:
● The term “endowment effect” actually refers to two distinct findings that may or may not be
related. The first is sometimes known as “exchange asymmetries,” and the second, as
“WTA/WTP gaps,” the gaps between willingness to accept and willingness to pay.
● Endowment effect begrijpen
Oefenvragen Lecture 1:
1. What are the 3 standard models of economics?
2. What is the difference between the expected utility theory and real life choice situations?
3. What is the prospect theory?
4. Describe what a diminished sensitivity to losses and gains is
5. Do you take more or less risk in a loss frame, why is this?
6. What are the 2 types of markets?
7. In which of these markets won’t a person put more effort into a task when he or receives more
money?
8. What does the endowment effect mean?
9. What is meant with status quo bias?
