Module 12.7 The Principles of Brhavioral Economics Lecture

Rational Behavior and Optimization

• Rational behavior refers to making the best possible decisions based on available information.

• Individuals often strive for optimal choices but may deviate from rationality in predictable manners, as highlighted by behavioral economics.

Predictable Failures in Decision Making

• People with less experience, such as using credit cards, may incur avoidable fees due to lack of knowledge.

• Overconfidence and underestimating risks can lead to poor decision-making.

• The phenomenon called availability bias causes people to overestimate the likelihood of events that come readily to mind.

  • Example: Fear of flying vs. driving; more fatalities occur in car accidents than plane crashes, yet plane crashes garner more media attention.

Reference Points and Circumstances

• Reference points influence emotional responses and decision-making.

  • Individuals tend to gauge satisfaction based on expectations compared to outcomes.

  • Example: Earning $15/hr when expecting $18/hr leads to greater dissatisfaction compared to just being told a flat $15/hr.

• The concept of loss aversion suggests that losses impact feelings more than equivalent gains.

  • Example: A drop from $18/hr to $15/hr feels worse than a rise from $15/hr to $18/hr, even if the end values are the same.

  • Loss aversion can hinder investment decisions; investors may hold onto underperforming stocks to avoid realizing losses.

Anchoring Effect

• Anchoring occurs when individuals rely too heavily on the first piece of information they encounter, which serves as a mental reference point.

  • Example: Retail pricing strategies where original prices are shown next to sale prices, influencing buyer perception of value.

Sunk Costs

• Sunk costs represent expenses that have already been incurred and cannot be recovered.

• Individuals often fall into the trap of honoring sunk costs in decision-making, leading to suboptimal outcomes.

  • Example: Continuing to watch a boring movie simply because a ticket was purchased wastes time and doesn’t retrieve the sunk cost.

Self-Control Problems

• Traditional economic models often assume intentions align with actions, which doesn't account for self-control issues.

• Concepts like present bias or myopia illustrate how individuals may struggle with short-term temptations over long-term goals.

  • Example: Students may choose partying over studying even though they desire good grades.

• This behavior can contribute to insufficient retirement savings or lack of exercise despite clear personal goals.

Reducing Choices to Improve Outcomes

• Limiting options may help individuals achieve their goals, such as maintaining a healthy diet.

• Governments may intervene, like banning unhealthy foods, aiming to assist people in making better choices, although this remains a debated issue.

Nudge Theory in Behavioral Economics

• Some government agencies use behavioral economics principles to “nudge” people towards better decision-making.

  • Example: Organ donation rates differ significantly based on whether individuals must opt-out or opt-in, demonstrating default settings' impact on choice.

Conclusion

• While traditional economic models remain robust, behavioral economics provides additional insights into human behavior and decision-making.

• Rational choices do not equate to perfect decisions; they reflect individuals utilizing available resources and information to the best of their ability.