A Primer in Behavioral Economics

Behavioral Economics

The attempt to increase the explanatory and predictive power of economics by providing more psychologically plausible foundations.

Descriptive Theories

Theories that describe how people actually make decisions.

Normative Theories

Theories that describe how people should make decisions.

Rational-Choice Theories

Theories that define what it means to make rational choices.

Laboratory experiments

Involve real choices, real money, and real subjects (students)

Field experiments

Randomly assigning participants to test or control group and observe

Process measures

Combine restos with brain scans and other data to provide a model

System 1

Fast, automatic, intuitive thinking requiring little effort.

System 2

Slow, deliberate, analytical thinking requiring conscious effort.

Cognitive Reflection Test (CRT)

Test designed to measure the tendency to override an intuitive but incorrect response and engage in reflection.

Weak Preference (≽)

Relationship meaning "at least as good as."

Strong Preference (≻)

Relationship meaning "strictly better than."

Indifference (∼)

Relationship meaning two alternatives are equally preferred.

Completeness

A property of rational preferences where any two alternatives can be compared.

Transitivity

A property of rational preferences where if x is preferred to y and y to z, then x is preferred to z.

Rational Preference

A preference relation that is complete and transitive.

Properties of indifference

Reflexivity, symmetry and transivity

Properties of strong preference

Transitivity, anti-symmetry, irreflexivity

Reflexivity

The property that every alternative is indifferent to itself.

Symmetry

The property that if x is indifferent to y, then y is indifferent to x.

Anti-symmetry

The property that if x is strictly preferred to y, then y cannot be strictly preferred to x.

Irreflexivity

The property that no alternative is strictly preferred to itself.

Utility

A numerical representation of preference.

Utility Function

A function assigning numbers to alternatives such that higher values represent preferred outcomes.

Explicit Cost

The direct monetary cost of obtaining something.

Opportunity Cost

The value of the best alternative forgone when making a choice.

Economic Profit

Benefit of a choice minus its opportunity cost.

Rational Choice

A choice whose utility is at least as great as its opportunity cost.

Sunk Cost

A cost that has already been incurred and cannot be recovered.

Sunk-Cost Fallacy

The mistake of allowing unrecoverable past costs to influence current decisions.

Menu Dependence

The phenomenon where preferences are influenced by the available set of options.

Decoy Effect

The tendency for preferences to change when an inferior option is introduced.

Before the introduction of the decoy effect

After the introduction of the decoy effect

Asymmetrically Dominated Option

An option dominated by the target alternative but not by the competitor.

Reason-Based Choice

Choosing an option because it provides a justification for the decision.

Bandwagon Effect

The tendency to do something because many other people are doing it.

Endowment Effect

The tendency to value something more once it is owned.

Loss Aversion

The tendency for losses to have a greater psychological impact than equivalent gains.

Without loss aversion

With loss aversion

Reference Point

The benchmark against which gains and losses are evaluated.

Anchoring

The tendency to rely heavily on an initial value when making judgments.

Anchor

The initial value or reference used in estimation and decision making.

Independence

Two events are independent if one does not affect the probability of the other.

Gambler's Fallacy

The mistaken belief that independent random events influence one another.

Law of Small Numbers

The mistaken belief that small samples closely resemble the populations from which they are drawn.

Conjunction Fallacy

The error of judging a conjunction of events as more probable than a single event.

Disjunction Fallacy

The error of judging a broader category as less probable than one of its subsets.

Confirmation Bias

The tendency to interpret information in ways that confirm existing beliefs.

Availability

The ease with which information comes to mind.

Availability Heuristic

The tendency to judge probability based on how easily examples can be recalled.

Framing Effect

The tendency for decisions to change depending on how information is presented.

Gain Frame

A presentation emphasizing positive outcomes.

Loss Frame

A presentation emphasizing negative outcomes.

Integrating Outcomes

Evaluating multiple gains and losses as a single net outcome.

Segregating Outcomes

Evaluating each gain and loss separately.

Cancellation

Combining a small loss with a large gain into a single outcome.

Silver Lining

Separating a small gain from a larger loss to make the gain more noticeable.

Allais Problem

A decision problem demonstrating violations of expected utility theory.

Sure-Thing Principle

The principle that choices should not be affected by outcomes that are common to all options.

Certainty Effect

The tendency to overweight outcomes that are certain.

Ellsberg Paradox

A paradox showing people's preference for known risks over ambiguous risks.

Regret aversion

Individuals know they might regret the risky choice over the sure thing

Ambiguity Aversion

The tendency to avoid options with unknown probabilities.

Probability Weighting Function

A function describing how people subjectively distort probabilities.

Prospect Theory

A theory stating that people evaluate outcomes relative to a reference point and weight probabilities nonlinearly.

Value Function

In prospect theory, a function defined over gains and losses relative to a reference point.

Concave for Gains

A characteristic implying diminishing sensitivity to gains.

Convex for Losses

A characteristic implying diminishing sensitivity to losses.

Game Theory

The study of strategic interactions among decision makers.

Game

A decision problem where outcomes depend on the actions of multiple players.

Strategy

A complete plan of action specifying what a player will do in every circumstance.

Payoff

The outcome or reward associated with a particular strategy combination.

Payoff Matrix

A table showing payoffs for all possible combinations of strategies.

Nash Equilibrium

A strategy profile where each player's strategy is a best response to others.

Nash's Theorem

The theorem stating that every finite game has at least one Nash equilibrium.

Pure Coordination Game

A game in which players have perfectly aligned interests.

Battle of the Sexes

An impure coordination game where players prefer different coordinated outcomes.

Zero-Sum Game

A game in which one player's gain is exactly another player's loss.

Prisoner's Dilemma

A game where individually rational actions lead to a collectively worse outcome.

Pareto Dominance

One outcome is better for at least one person and no worse for anyone else.

Pareto Optimality

A situation where no one can be made better off without making someone else worse off.

Cheap Talk

Non-binding communication between players.

Backward Induction

A method for solving sequential games by reasoning from the end backward.

Trembling-Hand-Perfect Equilibrium

A Nash equilibrium robust to small probabilities of mistakes.

Sequential Game

A game in which players move one after another.

Subgame

A portion of a larger game that itself constitutes a game.

Subgame-Perfect Equilibrium

A strategy profile that is a Nash equilibrium in every subgame.

Ultimatum Game

A game where one player proposes a division of resources and the other can accept or reject it.

Dictator Game

A game where one player unilaterally decides how to divide resources.

Trust Game

A game where one player sends resources that are multiplied and another decides how much to return.

Public Goods Game

A game involving voluntary contributions to a shared resource.

Beauty Contest Game

A game where players choose numbers aiming to be closest to a fraction of the average choice.

Social Preferences

Preferences that depend on both one's own outcome and others' outcomes.

Altruistic Preferences

Preferences where a person's utility increases with another person's welfare.

Envious Preferences

Preferences where a person's utility decreases when others do better.

Rawlsian Preferences

Preferences focused on maximizing the welfare of the worst-off individual.