Chapter 8 Behavioral Economics This chapter will define behavioral economics and explain how it contrasts with neoclassical economics. It will relate how prospect theory helps explain many consumer behaviors; and how time inconsistency and myopia cause people to make suboptimal long-run decisions. It will also define fairness and give examples of how it affects behavior in the economy. Behavioral Economics Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Comparing Behavioral Economics with Neoclassical Economics People have stable preferences that aren’t affected by context People are eager and accurate calculating machines People are good planners who possess plenty of willpower People are almost entirely selfish and self-interested Rationality is the most fundamental point of disagreement between behavioral economics and neoclassical economics. Neoclassical economics makes a number of highly unrealistic assumptions about human capabilities and motivations. LO1

Comparing Behavioral Economics with Neoclassical Economics Focusing on the mental process behind decisions Improving outcomes by improving decision-making Behavioral economics puts significant emphasis on the mental process driving behavior. Improving outcomes by improving decisions is one of the distinguishing characteristics of behavioral economics. LO1

Comparing Behavioral Economics with Neoclassical Economics Viewing behavioral economics and neoclassical economics as complements Neoclassical economics at the supermarket Behavioral economics at the supermarket Complementary explanations at the supermarket Many economists prefer to think of neoclassical and behavioral economics as complementary approaches that can be used in conjunction to help improve our understanding of human behavior. “Incentives matter!” Neoclassical economics believe that consumers care a great deal about prices. They cannot explain “impulse buying” very well, however. Behavioral economics explains impulse buying and other irrational behaviors as the result of a wide variety of underlying factors. LO1

Behavioral Economics vs. Neoclassical Economics This table summarizes how the two approaches differ in several areas. LO1

Our Efficient, Error-prone Brains Heuristics are energy savers Riding a bicycle with steering heuristics Guesstimating ranks with the recognition heuristics The implications of hardwired heuristics The brain evolved many low-energy mental shortcuts, called heuristics. These shortcuts are not the most accurate mental-processing options but used because the opportunity cost of perfection is high. LO2

Our Efficient, Error-prone Brains Brain Modularity System 1 and System 2 Cognitive Biases Confirmation Bias Overconfidence Effect Availability Heuristic Planning Fallacy Framing Effects The brain is modular - specific areas of our brain deal with specific sensations such as vision, breathing, and anger. The brain’s decision-making system falls into two categories: System 1 and System 2. System 1 uses a lot of heuristics in the older parts of the brain and System 2 uses newer parts of the brain to undertake slow, deliberate, and conscious calculations of costs and benefits. The unconscious mental processes suffer from a variety of cognitive biases, or misperceptions that cause systematic errors. Psychologists have identified scores of cognitive biases; here are a few that are relevant to economics and decision-making. LO2

Prospect Theory People judge good things and bad things in relative terms, as gains and losses, or status quo People experience both diminishing marginal utility for gains as well as diminishing marginal disutility for losses People experience loss aversion How people cope with negative possibilities is a central focus of behavioral economics. Many observations have been catalogued as to how people actually deal with the prospect of bad things as well as good things. Three very interesting facts summarize how people deal with good and bad. LO3

Prospect Theory Losses and shrinking packages Framing effects and advertising Anchoring and credit card bills Mental accounting and overpriced warranties The endowment effect and market transactions Status quo bias Businesses have to be very careful about increasing the price they charge for their products, because once consumers become used to a given price, they will view any increase as a loss relative to the status quo price they had been accustomed to. Framing affects have major consequences for consumer behavior because any frame that alters whether consumers consider a situation to be a gain or a loss will affect their consumption decisions. By showing each small minimum-payment amounts, credit card companies anchor many customers into the expensive habit of paying off their debts slowly rather than quickly. The endowment effect is the tendency that people have to put a higher valuation on anything that they concurrently possess than on identical items that they do not own but might purchase. Status quo bias is the tendency that people have to favor any opinion that is presented to them as being the default (status quo) opinion. LO3

Global Perspective This diagram shows, for a selection of European countries, the percentages of their respective populations that have indicated their willingness to participate in organ-donation programs. People tend to stick with whatever option is presented as the default option. Thus, the seven countries with high percentages consenting to be organ donors have organ-donation programs in which the default option is participation. By contrast, the four countries with low percentages consenting to be organ donors have organ-donation programs where the default option is not participating LO3

Myopia and Time Inconsistency Self-control problems Economists use the word myopia to describe the fact that brains have a hard time conceptualizing the future. The primary consequence of myopia is that when people are faced to choose between something that will generate benefits quickly and something that wont yield benefits for a long time, they will have a very strong tendency to favor the more immediate option. Time inconsistency is the tendency to systematically misjudge at the present time what you will want to do at some future time. It is a major cause of self-control problems. LO4

Myopia and Time Inconsistency Fighting self-control problems with pre-commitments Hiding the alarm clock Automatic payroll deductions Salary smoothing Early withdrawal penalties Weight-loss competitions The key to fighting time inconsistency and self-control problems is to have a good understanding of what your future self is likely to want. You can then make precommitments and take actions ahead of time to prevent your future self from doing much damage. LO4

Fairness and Self-Interest Field evidence for fairness Giving to charity Obeying the law Fixing prices Purchasing the “Fair-Trade” products Neoclassical models assume that people are purely self-interested. What behavioral economists have discovered is that the human propensity to care about others extends into every type of economic behavior. While self-interest is always present, most people care deeply about others and how they are interacting with others. As a result, economic transactions are heavily influenced by moral and ethical factors. Fairness is a person’s opinion as to whether a price, wage or allocation is considered morally or ethically acceptable. Many everyday economic behaviors indicate that people care substantially about fairness. LO5

Fairness and Self-Interest Experimental evidence for fairness The dictator game The ultimate game The rules How players Behave Why the threat of rejection increases cooperation Implications for market efficiency Our understanding of fairness and how it affects economic transactions has been reinforced and refined in recent decades by examining experimental games that were specifically designed to test people’s feelings about fairness. LO5

Nudging People Toward Better Decisions Behavioral economics sought to explain a number of behaviors Used to “nudge” people towards choices that are better for themselves and others Now that behavioral economics has made significant headway in explaining many behaviors, some economists are suggesting that its insights be used to nudge people toward choices that are better for themselves and others. A key feature of “nudges” is that they are subtle and can cause large changes in behavior without making people feel bullied or coerced—and also without imposing stringent new rules or having to offer people big monetary incentives or disincentives to get them to do what you want.