Chapter 10 Behavioral economics

Behavioral economics = Branch of economics that provides insight and understanding of how people make
decisions by acknowledging the role of emotions, biases and cognitive limitations in shaping economic choices.
These choices often leads to outcomes that deviate from economic predictions.

People do not always behave as rational utility maximizers but are instead irrational or suboptimal.

Daniel Kahneman, Amos Tversky, Herbert Simon, and Richard Thaler = Challenged traditional economic
assumptions.

Dual process thinking = Model showing how human cognition operates through two systems:

- System 1
o Fast, intuitive, and automatic, relying on heuristics, emotional responses, impulsive, and past
experiences to make quick judgments.
o Efficient for handling routine tasks and responding to immediate threats but prone to biases
and errors, as it often operates without consideration.
o Dominates – less energy
- System 2
o slower, more considerate, analytical, conscious reasoning, logical, evaluation, complex
calculation.
o Requires effort and cognitive resources, often inactive.
- The interactions between these explains why people don’t always make perfectly rational choices due to
system 1 making faulty and biased judgements based on heuristic and emotions while system 2 might
not step in to correct these biases because they are not activated or too lazy to care. As a result people
make irrational decisions even with potential for more logical reasoning.
- Irrational = Making harmful choices despite having info or ability to make better decisions. Lack of
reasoning and logic.

- Satisficers = People are not maximizers but satisfiers instead, they want to be good enough, don’t have
to do cost benefit analysis. Maximizing costs more. The benefit of getting more of a costly information
to make a very good decision won’t justify the cost.
- People are not stupid but the world is hard to navigate, hard to make decisions such as privilege
people. Either have too few or to many which are hard.
- People use rule to make decisions faster since its time and cost consuming however leads to errors since
they think with system 1.

Repeatedly consistent evidence:

Bounded rationality

- Bounded rationality: People make decisions within cognitive limits and constraints, relying on
simplifying heuristics and rules of thumb like the availability heuristic, representativeness heuristic, and
anchoring effect, which lead to predictable biases.
- Availability Heuristic: Suggests that individuals tend to judge the likelihood of an event based on how
easily they can recall similar examples. E.g. quickly recall news about plane crashes - overestimate the
probability thinking it is always dangerous. Error: Recalled easily do not mean more frequent.
- The Representativeness Heuristic = Judging how likely something is to belong to a category based on
perceived similarities or stereotypes, often ignoring statistical realities. E.g assume someone who enjoys
physics is an engineer, despite many may be lawyers, not engineers. This leads to biased decisions and
inefficient resource allocation. Error: Relying too much on stereotype, ignoring other important
factors.
 - The Anchoring Effect = Making estimates based on the initial info (anchor) we get, then adjusting
based on that even if it is irrelevant. Error: First number u hear is 500000, then base your estimate
around that when its far from actual population. Tendency for initial information to influence
subsequent judgments, even if that information is irrelevant. For example, the first house a person sees
may set an anchor that affects how they perceive the prices of other houses, leading to biased
comparisons.
- Framing Effects = how information is presented can significantly impact decision-making. Even when
the underlying choices are the same, different presentations can lead to different decisions. A classic
example is the treatment of a disease: framing the same outcomes as saving lives versus preventing
deaths can shift people’s preferences, even if the actual result is the same.
- Regression to the mean = refers to the tendency for extreme or unusual events to be followed by more
typical or average outcomes. For example, if someone performs exceptionally well on a test due to luck,
their next performance is likely to be closer to their average ability, not as extreme. People often
misinterpret this natural statistical pattern, attributing the change to specific actions or interventions,
when it is simply a return to the average. Error: Thinking the the luck or the extreme outcome will
continue.

Bounded willpower = Individuals make short sighted choices that conflict with long term interest since they
prioritize immediate rewards over future benefits. Which is limited self control and hyperbolic discounting.

Bounded self-interest = People only motivated by material gain. Research shows that people are also influenced
by concerns for fairness, reciprocity, and altruism, often acting against their own financial interests to help others
or maintain social norms. People do not always act out of self interest since it makes them feel good e.g. vote
when it won’t change outcome.

Loss aversion: individuals are more likely to act to avoid loss than to pursue gain. Individuals feel the pain of a
loss more intensely than the pleasure of a similar gain. This bias leads to risk-averse behavior, exemplified by the
endowment effect (valuing owned items more) and status quo bias (preferring the current state over change).

- E.g. reluctant to sell something they already own. The minimum price they sell for is higher than what
you bought it for. Sell 50 for a ticket if u have it but buy it for 30 when you don’t have it.
- Lower value items difference in price is 2 to 1 meaning sell twice as much,
- Higher value items such as homes, health, safety have larger difference.
o Lead to Status quo bias = Prefer current state of things rather than changes since it feels like
potential loss when it can be beneficial e.g. public policy decisions thinking the losses from the
change will be really bad and affect how they might adapt to the situation, they resist changes
that can improve the situation.
o Use default options to reduce the status quo bias.
o Default options: pre-set courses of action that take effect if nothing is specified by the
decision maker. These are pre-selected choices that take effect unless actively changed. People
tend to accept defaults, even if they’re not the best option. This is seen in organ donation
policies, where opt-out systems (default donation) lead to higher donation rates than opt-in
systems.

Present aim model = People act unselfish because they get positive feelings from it. Error: Do not make clear
predictions since it explains the reason for every behavior is because they get satisfaction from it.

Traditional rationality = People make decisions with perfect efficiency based on their goals and available
information and aim to maximize their own well being through self interest.

Adaptive rationality = Recognize that people adjust their goals and decision making strategies based on the
environment and not act with perfect information or in self interested ways. Choose goals that is efficient for
them in the long run than in the short run. E.g. value trust and cooperation in relationships, which influences
decisions even if cooperating sacrifice short term gains. Act in unselfish ways to solve problems if it helps
mutual cooperations or surviving in competitive environments. People seek efficiency to achieve their goals
Social norms and relative position: People often compare themselves to others, influencing their decisions.
This can lead to suboptimal societal outcomes, such as competition for positional goods (prestigious schools,
luxury items), which may create collective action problems. People care about their relative position – how their
consumption, wealth, status compared to other around them.

- Traditional models suggest that consumers spend based on their well being (only care of their own
consumption, absolute consumption) however it is shown that others spending patterns affect an
individual's consumption (relative consumption) and that they do not consume for their well being but
instead to keep up with others – feels better.
- Sell safety and leisure for higher wages and status to get ahead of other – do not improve well being
- Taking riskier jobs for higher wages

Habitual behaviors: many choices are not true decisions but automatic responses

Bounded willpower means people sometimes make short-term choices that go against their long-term goals, like
procrastinating or smoking, because they lack self-control. The effects of these choices over time can be hard to
notice.

Discounting refers to how people value the future. While traditional economics says we discount the future at a
steady rate, in reality, people tend to value the present more and discount the future more heavily, a tendency
called hyperbolic discounting. This means people often prefer immediate rewards over future benefits.

Altruism refers to the willingness to help others, even at a personal cost. In the Dictator Game, a proposer is
given money and decides how much to give to a receiver

Weber-Fechner law = People focus in the relative changes rather than absolute changes leading to inconsistent
judgements because they do not consider all factors of the context (misinterpret it). E.g. save $10 on a $20 radio
but not on a $1000 computer even when the cost and benefit is the same.

Decoy effect = Having trouble choosing between two options if one is better, but introducing a more worse
option will make the better option more appealing. Economic model says a worse option should not change
preferences when it actually happens.

Traditional economic models assume people make rational decisions without regretting it even if they know the
outcomes in advance – fail because it do not account for self-control issues thinking they act in long term when
they make choices based on immediate desires.. Reality: They do regret by choosing immediate rewards than
larger and more beneficial rewards in the future such as junk food and improved health. People have difficulty
waiting.

Development in economics by revising models:

- Loss aversion = People feel losses more painful than the gains.
- People do not always make decisions bevause they are self interested. Sometimes act selfish and
sometimes consider others needs.
- People are concerned by their relative position to others which affects their decisions e.g. spending
patterns.

Positional good:

Non positional good.

Concerns about relative position can have significant implications. For nations, this leads to spending more on
military arms rather than addressing issues like CO2 emissions. For individuals, it can result in saving money to
send children to better schools, but the collective effect of everyone trying to do the same ends up driving up
housing prices in those areas. Ultimately, half of all children still attend lower-performing schools.
This is an example of a collective action problem, where individuals would all benefit from cooperation, but fail
to do so because their personal efforts lead to suboptimal outcomes for the group as a whole.