Chapter 7: Basic Behavioral Economics

The model of economic behavior we have

considered in this course is restrictive in a number
of ways
• Economic agents are assumed to be perfectly rational
• Agents are assumed to perfectly understand risk and
uncertainty
• Agents are assumed to be “self-interested”
In reality, people exhibit a number of departures
from this “rational agent” model of decision making
Behavioral economics – Branch of economics that
incorporates insights from human psychology into models
of economic behavior.
 Cont’d
Behavioral economics is concerned with
systematic departures from rational choice
• Behavioral economists attempt to identify
systematic “biases”
• Departures from rational choice can inform the
development of more general, descriptive models
of economic behavior
• Models can be used to develop testable hypotheses
and predict economic behavior
The two main motivations for behavioral
economics concern apparent weaknesses in
standard economic theory:
– People sometimes make choices that are difficult to
explain with standard economic theory
– Standard economic theory can lead to seemingly
unreasonable conclusions about consumer welfare
Behavioral economics grew out of research in
psychology
The objective is to modify, supplement, and enrich
economic theory by adding insights from
psychology
– Suggesting that people care about things standard
theory typically ignores, like fairness or status
– Allowing for the possibility of mistakes
 Cont’d

• A branch of economics that studies the psychology of

decision-making to explain consumer behavior.
• Similarities with standard economics:
• Individuals are assumed to have well-defined agendas
• Rely on mathematical models of behavior
• Test theories empirically
• Differences from standard economics:
• Focus on how consumers make decisions
• Inclusion of attitudes towards fairness and status
• Greater use of experiments
• Focus on when behavior deviates from the standard theory
• No single unifying theory
 [Link] of Behavioral Economics
Behavioral economics uses many of the same tools
and frameworks as standard economics
– Assumes individuals have well-defined objectives, that
objectives and actions are connected, and actions affect
well-being
– Relies on mathematical models
– Subjects theories to careful empirical testing
Important difference is use of experiments using
human subjects.
Behavioral economists tend to use experimental
data to test their theories rather than drawing data
from the real world.
 Cont’d
 The evidence from psychology and behavioral economics has
placed an even greater emphasis on the importance of testing
economic models with real data.
 However, analyzing economic decisions in the real world is
very difficult.
 In response, two subfields of economics have emerged as
leaders in the evaluation of economic models: econometrics
and experimental economics
• Econometrics: Field that develops and uses statistical and analytical
techniques to test economic theory.
• Experimental economics: Branch of economics that relies on
experiments to illuminate economic behavior.
 These two fields have helped turn economics into a more
evidence-based science.
Advantages of Experiments
 Easier to determine whether people’s choices are
consistent with standard economic theory by
ruling out alternative explanations.
 Often easier to establish causality.
 Researchers can double-check their assumptions
and conclusions by testing and debriefing subjects.
 Often possible to obtain information that isn’t
available in the real world
 Disadvantages of Experiments
• Decisions made in the lab differ from decisions made in
the real world.
• Introduce influences on decision-making that are hard to
measure or control.
– Strong evidence that subjects often try to conform to what they
think are the experimenter’s expectations
• Most subjects are students, thus not representative of the
general population.
– Also inexperienced at making economic decisions
• Scale of any given experiment is limited by the available
resources.
 [Link] Behavioral Evidence
 The first part is in line with the assumption which
considers that the consumer has full knowledge of
all the information relevant to his/her decision.
 The second part relaxes this assumption and tries
to involve the possibility of the existence of
uncertainties in the market.
 In short, the first part deals with the behavior of
the consumer under the condition of certain
information (Choice under certainty), while the
second part is concerned with choice under
uncertainty.
 7.3.1. Individual Decision Making (Choice under certainty)
 Certainty: refers to a situation where there is only one
possible outcome to a decision and this outcome is known
precisely. For example, investing on treasury bills leads to
only one outcome (i.e. the amount of the yield), and this is
known with certain.
 Under the theory of consumer choice behavior, the following
important assumptions are made:
 1. The consumer is assumed to be rational. This is the
axiom/postulate of utility maximization.
 2. It is also assumed that the consumer has all relevant
information important for his/her decision.
 This means that the consumer has perfect knowledge about
his/her income, complete knowledge of the available
commodities in the market, and exact knowledge of the prices
of all available commodities in the market.
 Cont’d
 Utility is defined as the level of satisfaction/pleasure
that the consumer can derive from consumption of
goods and services or by undertaking a certain
activity.
 It is the power of a good or service to satisfy a
certain human need.
 There are two basic approaches to the problem of
comparison of utilities. These approaches are:
 1. The Cardinalist Approach, and
 2. The Ordinalist Approach.
 From these approaches equilibrium of the consumer,
we will be determined.
1. The Cardinal Utility Theory: There are some
theories of utility that attach significance to the
magnitude of utility.
 These are known as Cardinal Utility Theories.
 The cardinalist school postulates that utility can be
measured.
 The advocates of this school have given various
suggestions for the measurement of utility.
 With the assumption of complete knowledge of market
conditions and income levels over the planning period
i.e. under certainty, some economists have suggested
that utility can be measured in monetary units, say, by
the amount of money the consumer is willing to
sacrifice for another unit of a commodity.
 Equilibrium of the Consumer under the Cardinal Utility
Theory
 Let’s begin our analysis of the equilibrium of the consumer
with a simple model of a single commodity, X. The
consumer has two alternatives for the use of his/her income:
either to buy X or retain the money income, Y.
 Under this condition, the consumer is in equilibrium (at the
highest possible level of satisfaction) when the marginal
utility of X is equal to its market price (Px).
 Marginal utility of a commodity is the extra satisfaction that
one can derive from one additional unit of the commodity.
 Symbolically, the equilibrium of the consumer can be
represented as: MUx = Px.
 Therefore, the consumer attains the maximum level of
satisfaction (utility) when MUx = Px.
2. The Ordinal Utility Theory
 The ordinalist school postulates that utility is not
measurable, but is an ordinal magnitude.
 The consumer need not know in specific the utility of
various commodities to make his/her choice.
 Under this approach, it suffices for the consumer to be able
to rank the various baskets of goods and services according
to the satisfaction that each bundle gives him/her.
 The indifference curves theory is one of the theories which
argues that utility is not cardinally measured rather it is
ordinally measured.
 This theory tries to show the equilibrium of the consumer
using the concept of indifference curves as the name
suggests
Equilibrium of the Consumer under the
Indifference Curves Theory
 To define the equilibrium of the consumer (that is
his/her choice of the bundle that maximises his/her
utility) we must introduce two concepts:
 i. the indifference curve and its slope which is the
marginal rate of substitution, and
 ii. the budget line.
 The consumer is at equilibrium when he/she
maximizes his/her utility, given his/her income and the
market prices of the commodities.
 Under the indifference curves theory, two conditions
must be fulfilled for the consumer to be in equilibrium.
Cont’d
 7.3.2. Choice under Risk and Uncertainty
 The traditional theory of consumer choice behavior
examined so far implicitly assumed a risk free world.
 It assumed that consumers face complete certainty as
to the results of the choices they make.
 Clearly, this is not the case in most instances.
 In contrary to our earlier assumptions of price,
income and other variables to be known with
certainty, many of the choices that people make
involve considerable degree of uncertainty.
 Although risk and uncertainty are usually used
interchangeably, some people distinguish between the
two.
 Cont’d
 (I) Uncertainty: refers to a situation when there are more than one
possible outcomes to a decision-maker and where the probability of
each specific outcome is not known.
 This may be due to insufficient past information or instability in the
structure of the variables.
 (II) Risk: refers to a situation where there are more than one possible
outcomes to a decision maker and the probability of each specific
outcome is known or can be estimated.
 Expected Value and Variation of Risky Choices
 We usually need two measures to describe and compare risky choices.
These measures are: expected value and variation.
 1. Expected value: is the weighted average of all possible
payoffs/outcomes that can result from a decision under the various
states of nature, with the probability of those payoffs used as weights.
 It measures the value that we would expect on average.
 If we multiply each possible outcome or payoff by its
probability of occurrence and add up these products, we get
the expected value.
 If, for instance, there are two possible outcomes having
payoffs X1 and X2 and if the probability of each outcome is
given by P1 and P2, then the expected value is:
 Example: If the probability that an oil exploration project will
be successful is ¼ and the probability that it will be
unsuccessful is ¾, and if success yields a payoff of 40 Birr per
share while failure yields a payoff of 20 Birr per share, the
expected value is:
 E(X) = P(success)(yield from success) + P(failure)(yield from
failure)
 = ¼ (40 Birr/share) + ¾ (20 Birr/share)
 = (10 + 15) Birr/share = 25 Birr/share
 2. Variability: is the extent to which the possible outcomes
of an uncertain event may differ.
 We measure variability by recognizing that large differences
between the actual and expected value imply greater risk.
 Standard deviation is the often used measure of variability.
 Standard deviation measures the dispersion of the possible
outcomes from the expected value.

 The smaller the value of the standard deviation (σ), the

tighter or less dispersed the distribution is and thus the lower
would be the risk attached to it, and vice versa.
 Standard deviation If two alternatives to choose from have
the same expected value, the one with the lower/smaller
standard deviation is less risky and is hence the preferred
one.
• Impact of Risk and Uncertainty on Choices
During Decision Making
• Lower risk and uncertainty are preferable
situations: If the management of a firm fail to
think about risk and uncertainty, it may end in
quandary.
• As risk and uncertainty increases, some strategic
choices become more valuable than others: At
high levels of risk and uncertainty, the best
strategic choices are those that boost an
organization's flexibility and sustain open options.
 Cont’d

• Sources of 2. Supply Structure •

• New Products
Uncertainty • New Processes
[Link] Structure • New Technology
• Customer Preferences Competitors
• Market Size • Nature of Competitors
• Price Responsiveness • Strategies of Competitors
• Segmentation Externalities • Behaviours of Competitors
• Industry Structure 3. Internal Forces
• Government Regulation • Alignment of Ownership
• Influence of Non • Behaviour of Management
Governmental • Behaviour of Employees
Organizations Time
• Social Norms • The Rapidity of a
Phenomenon
 Cont’d

• “Whetherit is uncertainty, risk, or somewhere in-

between there is one strategy that always improves the
manager’s ability to make sound management
decisions and that is information.
• The more information a manager has on the potential
uncertainties and risks that they face, then
 the more they can establish probabilities of likely
outcomes,
 evaluate the impact on the business, and
 evaluate risk management strategies accordingly.” -
Kevin Bernhardt
 Cont’d

• Bernoulli’s Model of Different Risk

• i. Risk-Averse: This involves preference for a certain outcome
instead of a gamble with expected value of wealth.
• When a Risk-Averse decision-maker acts, a risky opportunity would
be exchanged for one that has a definite outcome.
• This is characterized by diminishing marginal utility of wealth.
• ii. Risk Neutral: This is indifferent between the certain outcome and
gamble.
• The Risk Neutral attitude to decision- making focuses on expected
value.
• iii. Risk-Seeking: This involves preference for the gamble instead of
the certain outcome.
• Risk-Seeking decision- maker would want to be paid an amount
higher than the expected value, so as to exchange the risky decision
for the certain one.
• This is characterized by increasing marginal utility of wealth.
• Strategic Decision Making
• 1. Classical Game Theory:
• Game theory was developed by an Economist John Von
Neumann and Oscar Morgenstern in 1944
• Game theory is a way of looking at whole range of human
behaviors as a game.
• Games have the following characteristics
 Players
 Rules
 Payoffs
 Strategies
• We classify games into several types
 By the number of players
 By the rules
 By the payoff structure
 Cont’d

• Games by number of players

• 1-person (game against nature)
• 2-person
• N-person
• Games as defined by the rules:
• These determines the number of options/alternatives in the play of
the game.
• The payoff matrix has the structure (independent of value) that is
the function of the rules of the game.
• Thus many games have a 2x2 structure due to 2 alternatives for
each player
• Games as defined by the payoff structure:
• Zero-sum game
• Non-zero sum game
• Occasionally constant sum
 • Strategies
• It can also be classified as strategies that we employ
• It is natural to suppose that one player will attempt to anticipate
what the other player will do. Hence
• Minimax: to minimize the maximum loss – a defensive
strategy.
• From rows
• Minimax Criteria: The minimizing player lists his maximum
loss from each strategy and selects the strategy which gives him
the minimum loss out of these maximum losses.
• Maximin : to maximize the minimum gain - an offensive
strategy
• From column.
• Maximin Criteria: The maximizing player lists his minimum
gains from each strategy and selects the strategy which gives
the maximum out of these minimum gains.
 Cont’d

Player B

B1 B2 Row minima
Player A A1 9 2 2
A2 8 6 6 * Maximin
A3 6 4 4
Column Maxima 9 6 * Minimax
Since Maximin = Minimax
V=6
• Maxi [Min.] = Mini [Max]
• The strategies followed by both
the players are called
‘optimum strategy’
• 2. Behavioral Game Theory
• BGT: looks at how people actually behave
• experiment by setting up real economic situations
• account for people's economic decisions
• don't break game theory when it works
• Fit a model to observations; not rationality
• Eg., in market structure…
• Cournot Duopoly: Firm 1 chooses optimal production
quantity, given the quantity chosen by Firm 2
• Bertrand Duopoly: Firm 1 chooses optimal product price,
given the price chosen by Firm 2.
• Stackleberg Leader-Follower Duopoly: Leader chooses
optimal production quantity, understanding Firm 2 will choose
an optimal production quantity based upon the quantity
chosen by firm 1.
 Cont’d

• Social Preferences
• Social Preferences relax the self-interest hypothesis
and allow for interdependent preferences.
• As a result models of social preferences often
account that an individual’s utility function
depends on the utility of others.
• Examples
• Altruism (Self scarifies), Spite
• Reciprocity (mutuality, interchange)
• Fairness
• Beliefs, Intentions
 Cont’d

• Types of social preferences

• Distributive Preferences: Preferences over
the final distribution,
• E.g., Equity, efficiency, altruism; related to
consequences or outcomes
• Reciprocal Preferences: Desire to reward or
punish other beyond mere consequences, e.g.,
being “more than fair” to someone who has
been fair to you; related to intentions or types
of agents.