Behavioral Economics Notes

Irrational Exuberance and Behavioral Economics

• "Irrational exuberance" led people to believe housing and stock prices would continuously rise.
• They felt compelled to "get in the game," even if it meant borrowing money.
• Behavioral Economics studies the accumulation of human errors in economic transactions.
• The 2008 downturn was caused by human error, which Behavioral Economics aims to understand and prevent.

Traditional Economics vs. Behavioral Economics

• Traditional economics is based on two fundamental assumptions:
  • People are rational.
    • They can accurately assess the utility (pleasure or pain) of different outcomes.
    • They can estimate the likelihood of outcomes with available information.
  • People are selfish.
• Economists have traditionally viewed financial markets and individual actions through the lens of these assumptions.
• Behavioral Economics challenges these assumptions.
• It posits that judgments are often distorted by predictable biases.
• People are concerned about more than just their own selfish interests.

Shortcomings of Traditional Economics

• Traditional economic theory does not address important shortcomings in individual judgments and decision-making.
• These shortcomings can combine to influence the performance of the economy as a whole.
• Behavioral Economics uses insights from psychology to create more realistic and accurate models of economic behavior.
• People often behave irrationally when making economic decisions.
• Richard H. Thaler is a key figure in Behavioral Economics.

Irrelevant Factors Influencing Decisions

• People's buy and sell decisions should not be influenced by factors irrelevant to the intrinsic value of the item.
• However, transitory and irrelevant mood states can influence financial transactions.
  • The amount of sunshine on a given day is positively correlated with market performance.
  • A country’s stock market tends to decline when their national soccer team is eliminated from important tournaments.
  • Example: Computer Literacy Inc. rebranded as fatbrain.com to sound more edgy and hip.

Consistent Irrationality and the Endowment Effect

• People depart from rationality in consistent ways, allowing their behavior to be anticipated and modeled.
• Standard economic theory predicts that people will use savings from declining gas prices for their most pressing needs, not necessarily more gasoline.
• People place a higher value on their own possessions – "endowment effect".
• When deciding which stocks to sell, people are more inclined to sell winners than losers.
• Loss Aversion: The tendency for a loss of a given magnitude to have more psychological impact than an equivalent gain.

Framing Effects and Constructivism

• Choices people make are systematically altered by the language used in the formulation of options (framing effects).
• The same stimulus can be interpreted in different ways (constructivism).
• How something is construed profoundly affects behavior.
• The same outcome can be construed as a loss or a gain depending on how it is framed.
• Whether we pursue an outcome is determined by whether we frame it as a loss or gain.
• We often fail to realize that underlying structures of problems are similar because we are distracted by how problems are presented.
• Decision framing refers to how a problem is presented.

Framing Effects: Gains vs. Losses

• Does the decision describe the gains or losses that might occur?
  • People become cautious when alternatives are presented in terms of losses.
  • They are more likely to take chances when alternatives are framed in terms of gains.
• "The disease problem" (Tversky & Kahneman, 1981) illustrates framing effects.

The Disease Problem Example

• Imagine the U.S. preparing for an outbreak expected to kill 600 people.
• Two programs are proposed:
  • Positive Frame:
    • Program A: Exactly 200 people will be saved.
    • Program B: 1/3 probability all 600 saved, 2/3 probability no one saved.
  • Negative Frame:
    • Program C: Exactly 400 people will die.
    • Program D: 1/3 probability nobody will die, 2/3 probability all 600 will die.
• Results:
  • Positive Frame: 72% choose Program A (sure gain), 22% choose Program B (risky gain).
  • Negative Frame: 28% choose Program C (sure loss), 78% choose Program D (risky loss).
• Risk Aversion: People tend to avoid risk when a positive frame is presented (lives saved).
• Risk Seeking: People tend to take risks when a negative frame is presented (lives lost).

Framing and Financial Decisions

• How economic outcomes are framed has a strong effect on whether people make risky or conservative financial decisions.
• Example 1:
  • Given $300 , choose between:
    • A sure gain of $100 .
    • A 50% chance to gain $200 or a 50% chance to gain nothing.
  • 75% would take the sure $100 (risk averse).
• Example 2:
  • Given $500 , choose between:
    • A sure loss of $100 .
    • A 50% chance to lose nothing and a 50% chance to lose $200 .
  • 75% would take the gamble (risk seekers).
• Final Outcome (Example 1): $400 for sure vs. 50% chance of $500 and 50% chance of $300 .

Diminishing Marginal Utility and Framing

• Risk aversion when it comes to gains is due to diminishing marginal utility.
• A gain of $100 is experienced as more than half as valuable as a gain of $200 .
• The more dollars you already own, the less utility you get from each additional dollar you receive.
• Diminishing marginal utility works for losses as well.
• People tend to be risk-seeking when choosing between a sure loss of $100 and a risky chance to lose nothing or lose $200 .
• A loss of $100 is more than half as painful as a loss of $200 .
• Framing is pervasive.
• Example: Credit card surcharges vs. cash discounts.
  • Losses (surcharges) have a greater psychological impact than foregone gains (discounts).

The Sunk Cost Fallacy

• People are more likely to take a trip if they paid for it than if they won it in a raffle.
• Whether the vacation was free or paid for makes no difference in whether it will be rewarding or not.
• Rationally, historical cost should not factor into your decision.
• Only future costs and benefits of different options should be weighed.
• Sunk Cost Fallacy: A reluctance to “waste” money that leads people to continue with an endeavor, whether it serves their future interests or not, because they have already invested money, time, or effort in it.
• People pay attention to historical costs (not rational).
• Example: People who pay for theater subscriptions attach more importance to seeing the play the more they paid for the tickets.

Mental Accounting

• Mental Accounting: The tendency to treat money differently depending on how it is acquired and the mental category to which it is attached.
• Many people report they would be more conservative initially when betting with their own money but bolder when betting with "house money."
• Example:
  • Losing $200 after buying a $200 ticket is mentally charged to the cost of the event (making it seem too steep at $400 ).
  • Losing $200 unrelated to the event is mentally charged to some other "accident" or "general expenses" account (keeping the cost of the ticket at $200 ).
• Economists advise that we integrate all our assets and liabilities into one overall account to make the best use of our money.