Chapter-Two: Introduction to Behavioural

Economics
❑ Definition: The study of actual choices made by
economic decision-makers to evaluate the strengths and
weaknesses of the rational choice model in modern
economics.
❑ Focus: Examines how psychological, cognitive,
emotional, cultural, and social factors influence the
decisions of individuals and institutions.
❑ Purpose: To understand how real-world decisions differ
from predictions of classical economic theory.
❑ Key Concern: The limits (bounds) of rationality in
human decision-making.
❑ Approach: Behavioural models combine insights from
psychology, neuroscience, and microeconomic theory.
❑ Scope: Studies market decisions and the mechanisms
behind public choice.
 Behavioural Economics – Development and Scope
❑A new branch of economics that developed
mainly since the 1950s and has gained growing
interest among specialists.
❑Seeks to understand economic decisions and
behaviours using tools from psychology and other
social sciences such as sociology, politics,
anthropology, philosophy, biology, and
neuroscience.
❑Behavioural economics entered the mainstream
due to paradoxes in rational choice theory, even
though psychological theories have existed long
before (Davis, 2008).
 Cont…
Summary of Behavioral Economics (BE)
❑ Core Idea: BE uses psychological experimentation to
understand how people actually make decisions.
❑ Findings: Identifies various biases caused by how
people think and feel.
❑ Challenges traditional economics by rethinking
perceptions of value and expressed preferences.
❑ Assumptions (vs. Classical Economics):People are not
always rational, self-interested, or utility-maximizing.
❑ Decision-making is influenced by limited knowledge,
imperfect feedback, and bounded processing ability.
❑ Choices are often made under uncertainty and affected
by context.
 2.1 Individual Decision Making (Choice under certainty,
Judgement and Choice under Risk and Uncertainty and –
Inter-temporal Choice)
❖ Choice under Certainty: occurs when the decision-
maker knows all alternatives, their associated conditions,
and the outcomes of each choice.
❖ Key features:
✓ outcomes are known and predictable.
✓ Information is accurate, measurable, and reliable.
✓ Decisions can be made with confidence due to complete
knowledge.
❖ Judgment and Choice under Risk and Uncertainty:
When outcomes are unknown or probabilistic. Future
results are unpredictable, and probabilities of outcomes
are unknown or unclear.
❖ Inter-temporal Choice: Decisions involving trade-offs
over time (e.g., saving vs. spending).
 Cont…
❖Choice under uncertainty:
❖Exists when the future environment is unpredictable
and constantly changing.
❖Most major decisions in today’s complex world are
made under uncertainty.
❖The decision-maker:
✓ Lacks knowledge of all possible alternatives.
✓ Is unaware of the risks and consequences of each
choice.
✓ Cannot determine the probabilities of outcomes.
✓ The environment is in a state of flux, making future
events highly unpredictable.
 Cont…
Choice under Risk:
❑ Exists when the outcomes of decisions are uncertain, but
the probabilities of different outcomes are known or can
be estimated.
❑ The decision-maker knows:
✓ The possible alternatives.
✓ The probable outcomes of each alternative.
✓ The degree of risk involved (often measurable).
✓ Decisions are based on probability analysis or expected
value calculations.
✓ Common in investment, insurance, and business
forecasting.
✓ Example: An investor choosing between projects with
known probabilities of profit or loss.
 Cont…
❑Final risk is the outcome or consequence of
uncertainty.
✓ It arises when there is imperfect information or
information asymmetry.
✓ The decision-maker has incomplete information
about alternatives.
✓ However, they can estimate the probabilities of
possible outcomes.
✓ Decisions are made by evaluating risks and
assigning probabilities based on available data
and managerial experience.
✓ Under risk, the future is not fully certain, but
probabilities are known, allowing for informed
decision-making.
Modern Approaches to Decision-making
under Uncertainty
❑There are several modern techniques to improve
the quality of decision-making under conditions
of uncertainty.
❑The most important among these are:
1. Risk analysis,
2. Decision trees and
3. preference theory.
 Risk Analysis
❖Involves identifying possible risks, estimating
their likelihood, and assessing their potential
impact.
❖Helps managers quantify uncertainty and make
more informed choices.
❖Example: A company planning to launch a
new product may assess market risk, supply
chain disruptions, and competitor reactions
to decide whether to proceed.
 Decision Trees
❖ A graphical method showing different decision
alternatives, possible outcomes, and their probabilities.
❖ Useful for visualizing complex decisions and
evaluating expected values.
❖ Example: An investor deciding between two projects
can use a decision tree to evaluate:
✓ Project A: 70% chance of $100,000 profit, 30% chance
of $20,000 loss
✓ Project B: 50% chance of $150,000 profit, 50% chance
of $50,000 loss
❖ The tree helps compare expected returns and make a
structured choice.
 Preference Theory
❑ Focuses on how individuals rank or choose among
uncertain alternatives based on their risk attitudes and
subjective preferences.
❑ Recognizes that people value outcomes differently
under uncertainty.
❑ Example: Two managers face the same investment
option:
✓ Manager 1 is risk-averse and prefers a safe moderate
return.
✓ Manager 2 is risk-seeking and prefers high-risk, high-
reward projects.
❑ Preference theory explains why different people make
different decisions even under the same conditions.
 Inter-temporal Choice
❖ Decisions that involve trade-offs between present and
future outcomes.
✓ Examples for individuals: deciding how much money
to spend now versus save for the future.
✓ Choices related to retirement planning, education, or
long-term investments.
❖ Examples for companies: investment decisions that
require allocating resources now for future returns.
❖ Decisions about research & development,
infrastructure, or expansion projects.
❖ Inter-temporal choices consider the impact of present
decisions on future well-being or profitability.
 Cont…
❖Trade-off between Present and Future Utility:
✓ Saving today → less current consumption →
lower present utility.
✓ Savings grow over time → more future
consumption → higher future utility.
❖Constraints: most individuals face budget
limitations, restricting their ability to consume or
save as desired.
❖Behavioural insight (Present Bias):People often
overvalue immediate rewards and undervalue
future benefits.
❖Leads to a tendency to spend now, even if it
reduces future well-being or financial security.
 2.2 Strategic Decision Making
❑The study of strategic decision-making integrates
multiple disciplines such as mathematics,
psychology, and philosophy.
❑Game Theory: Invented by John von Neumann
and Oskar Morgenstern in 1944.
❑Provides a framework to analyse strategic
interactions among decision-makers.
❑Significance: Vital to modern economic and
managerial analysis. Since 1970, 12 leading
economists and scientists have received the
Nobel Prize for contributions to game theory.
 Cont…
❑Game theory is applied in a number of fields,
including business, finance, economics,
political science, and psychology.
❑Helps analyze strategic interactions and
anticipate the actions of others.
❑Understanding both popular and lesser-known
strategies improves reasoning and decision-
making skills.
❑Essential for navigating complex, competitive
environments.
 Prisoner’s Dilemma
❖ A classic game theory scenario illustrating that rational individual
decisions can lead to worse collective outcomes than if players had
cooperated.
❖ Scenario:
▪ Two suspects are arrested and held separately.
▪ Each is told:
✓ If you confess and the other does not, you go free.
✓ If both confess, each gets 2 years in prison.
✓ If neither confesses, each gets 1 year in prison.
✓ If you don’t confess and the other does, you get 3 years.
❖ Individual rationality → both confess → 2 years each.
❖ Cooperation → both stay silent → only 1 year each.
❖ Demonstrates the conflict between individual incentives and
collective benefit.
❑ Applications: Economics, business strategy, political negotiations,
and social dilemmas.
 Cont…
Behavioural Insight:
❖Although mutual cooperation is the best
collective outcome, most rational individuals
tend to confess.
❖They aim to minimize personal risk, fearing
that the other suspect might betray them.
❖Key Lesson: Illustrates how self-interest can
conflict with collective benefit, a core concept
in strategic decision-making.
 Classical Game Theory, Behavioural Game Theory
and Social Preferences
Stages of Game Theory Development
1. Classical Game Theory
❖ Introduced by John von Neumann and Oskar Morgenstern.
❖ Focuses on the rational individual player who:
✓ Makes consistent decisions under certainty and uncertainty.
✓ Does not necessarily assume other players are rational.
2. Modern Game Theory (Nash)
❖ Defined by the Nash player.
❖ Assumes all players are rational.
❖ Players can coordinate strategies, leading to a Nash equilibrium.
3. New Game Theory (Harsanyi)
❖ Focuses on players with social preferences and behavioural
considerations.
❖ Expands analysis beyond strict rationality to include interactions
influenced by fairness, cooperation, and other social factors.
 Cont…
New Game Theory (Harsanyi Player):
✓ Rational player with limited knowledge about other players’ payoffs
or beliefs.
✓ Recognizes uncertainty about how others form beliefs.
Research Implications:
1. Epistemic Games (Traditional Approach):
✓ Analyzes belief formation through interactive thought experiments.
2. Evolutionary Approach:
✓ Agents imitate successful behaviors observed in others.
✓ Reflects bounded rationality and cognitive limitations.
❖ This approach combines rationality with realistic cognitive
constraints.
❖ Aligns with empirical research challenging classical rational choice
models (Frohn et al., 2001).
 Behavioral game theory
❖ Examines how social preferences, social utility, and
psychological factors influence strategic decision-
making.
❖ Methods: Combines game theory, experimental
economics, and experimental psychology.
❖ Focus of Experiments: Tests deviations from classical
assumptions, such as:
✓ Independence axiom
✓ Neglect of altruism and fairness
✓ Framing effects
❖ Development: Emerged as a research program over the
last three decades.
❖ Key Insight: Provides a more realistic view of human
behaviour in strategic interactions than classical models.
 Classical vs. Behavioural Game Theory
Classical (Traditional) Game Theory:
✓ Assumes rationality, self-interest, and utility maximization.
✓ Focuses on mathematical equilibrium structures.
✓ Uses rational choice theory as the foundation of economic models.
Behavioural Game Theory:
✓ Examines deviations from classical predictions in actual human
behaviour.
✓ Incorporates psychological principles to explain social preferences,
fairness, framing effects, and other behavioural factors.
✓ Aims to build more realistic models of strategic decision-making.
❖ Behavioural game theory extends classical theory by integrating
human psychology, improving prediction of real-world behaviour.
 Cont…
Key Observat: Human choices are not always
rational and often deviate from utility-maximizing
behavior.
Research Methods:
❖Empirical and theoretical research to study
behavior.
❖Laboratory and field experiments.
❖Theoretical and computational modeling.
❖Machine learning applied to improve prediction
and understanding of behavior in strategic games.
❖Integrating psychology, economics, and computer
science allows for a more accurate and predictive
understanding of strategic decision-making.
 Cont…
Behavioral Game Theory: Historical Development
Foundational Work:
✓Allais (1953) → Allais Paradox: Choices may
violate expected utility theory.

✓Ellsberg (1961) → Ellsberg Paradox: Decisions

often do not reflect expected benefits due to
ambiguity or uncertainty.
 Cont…
Experimental Economics:
✓ Vernon Smith (1956): Demonstrated that economic
markets can be studied experimentally, reinforcing
rationality and self-interest in models.
Modern Behavioral Insights (1970s onwards):
✓ Tversky & Kahneman: Developed regret theory,
prospect theory, and hyperbolic discounting, showing
deviations from classical decision models.
Social Preferences:
✓ Can be positive or negative, depending on the type of
game and the level of cooperation between players.
❑ Behavioral game theory integrates experimental
evidence to refine our understanding of human
decision-making in strategic contexts.
 Summary
Behavioral Economics (BE)
❑ Studies actual economic decision-making,
incorporating psychological, cognitive, emotional,
cultural, and social factors.
❑ Challenges the classical assumption that individuals are
fully rational, self-interested, and utility-maximizing.
❑ Uses psychological experimentation to identify biases
and deviations from traditional economic theory.
❑ People’s decisions are shaped by limited knowledge,
processing capacity, context, and feedback, often
involving uncertainty.
 Summary
2. Individual Decision-Making
Under Certainty
❖ All alternatives, conditions, and outcomes are known and predictable.
❖ Common in routine and repetitive business operations.
Under Risk
➢ Outcomes are uncertain, but probabilities are known or can be estimated.
➢ Managers use experience and available information to assign probabilities.
Under Uncertainty
➢ Future environment unpredictable, alternatives and outcomes may be
unknown.
➢ Most real-world decisions fall under this category.
Inter-temporal Choice
➢ Decisions have future consequences, e.g., saving vs. spending today.
➢ Present bias often leads individuals to prioritize immediate rewards over
future benefits.
➢ For businesses, decisions include investments with long-term impacts.
 Summary
Modern Techniques for Decision-Making Under Uncertainty
1. Risk Analysis – Evaluate probability and impact of uncertain outcomes.
2. Decision Trees – Visualize options, outcomes, and probabilities to guide
decisions.
3. Preference Theory – Model individual preferences under uncertainty.
Strategic Decision-Making
Game Theory
❑ Studies strategic interactions where outcomes depend on others’ choices.
❑ Applied in business, finance, politics, economics, and psychology.
Prisoner’s Dilemma
❖ Demonstrates conflict between individual rationality and collective benefit.
❖ Typically, rational players confess, even though cooperation would yield better
outcomes.
 Summary
Stages of Game Theory
1. Classical (von Neumann & Morgenstern): Rational individual
player, may not assume others are rational.
2. Modern (Nash): Rational players assuming all others are rational
→ Nash equilibrium.
3. New (Harsanyi): Rational but limited knowledge, considers belief
formation and evolutionary strategies.
Behavioral Game Theory (BGT)
❑ Integrates psychology, social preferences, and experimental
methods.
❑ Explains deviations from classical predictions (e.g., fairness,
altruism, framing effects).
❑ Methods include laboratory/field experiments,
theoretical/computational modeling, and machine learning.
END OF CHAPTER TWO