behavioral economics - may 2025

bounded rationality

By Herbert Simon…coined it as “satisficing” decision-making
Describes the limits of optimal decision making that result from imperfect intelligence and the scarcity of time and information.

bounded willpower

Willpower constrained by limits on the determination needed to do difficult things
- procrastinating, not doing homework
- not quitting because long-term benefits fall below short-term costs
- emotions

bounded self-interest

Self-interest that leaves room for concerns about the welfare of others
- charity
- those ultimatum & dictator games

(judgemental) heuristics

Energy savers, mental shortcuts, or “rules of thumb” that people use to simplify decisions when constrained by time, information, or cognitive ability.
- e.g. just doubling wholesale price for all products to get retail price

recognition heuristic

Assumes if one option is more easily recognized, it is probably more important or highly ranked.

prospect theory (all terms below are part of it)

1. People judge good things and bad things in relative terms. As gains and losses, or status quo

2. People experience both diminishing marginal utility for gains as well as diminishing marginal disutility for losses

3. People experience loss aversion

loss aversion

People tend to weigh losses (or perceived losses) more than gains (or perceived gains) when making decisions.
- results in people taking sunk costs into decision-making

framing

Creation of context for a product or idea
- not washing towel = good for hotels to save money
but they frame it as saving the environment to receive consumer support
- brand names, celebrities
- odd, or just-below pricing ($4.99) - ending with even numbers for brand image of luxury

anchoring effect

Tendency to rely significantly on the first piece of information that is given or available when making a decision

relativity trap

Consumers think about prices relative to a benchmark and retailers are aware of this
avoid by knowing the value the good has to YOU

endowment effect

• People overvalue things they own

• People become attached to the item they have and so are less likely to trade it away

status quo/default bias

People tend to stick with the initial option that is presented when making decisions

cognitive biases (all terms below are part of them)

Misperceptions or misunderstandings that cause systemic errors

confirmation bias

Human tendency to pay attention only to information that agrees with one’s perception

self-serving bias

Human tendency to attribute success to personal effort or character traits while at the same time attributing any failures to factors that were out of their control

overconfidence effect

Human tendency to be overly confident about how likely judgments and opinions are to be correct

hindsight bias

Retroactively believe that they were able to predict past events (“I knew it all along”)

availability heuristic

Human tendency to base estimates about the likelihood of an event based on whether or not similar events come to mind quickly and are readily available in their minds

planning fallacy

Human tendency to massively underestimate the time needed to complete a task

myopia

• Brains have a hard time conceptualizing the future

• Consequence: Given the choice between something that will generate benefits quickly versus for a long time, people will have a very strong tendency to favor the more immediate option.

time inconsistency

Tendency to systematically misjudge at the present time what you will want to do at some future time

self-control problems

Fought with pre-commitments

The Ultimatum Game

• The mean split is 60% of the total reward for the proposer and 40% for the responder

• A 50/50 split is the most common offer

• About 20% of low offers (any offer below 50%) are rejected.

Experimental evidence for fairness

Field evidence for fairness

• giving to charity

• obeying the law

• fixing prices

• purchasing fair-trade products

rational choice theory

decision makers are able to compare all of their alternatives with full information about their choices

blink: the power of thinking without thinking by malcolm gladwell

• most decisions made based on first impressions / snap judgements

bounded rationality: excessive optimism

some criminals are unrealistically confident things will always go their way - most violent offenders lack information on their punishments
- underestimate risks of common events like crashing a car and overestimate risks of crashing an airplane
- more than half of all new businesses fail within 4 years, entrepreneurs are too optimistic (prone to overinvest)

- majority of Americans believe they are smarter than average and have better-than-average chances of winning the lottery, being successful, more capable
- lawsuits go to trial because both sides have unrealistic optimism about winning the case