1. Cognitive Limitations and Consumer Behavior
In a previous class session, give out handout about doing the “choice under uncertainty” experiment with two subjects.
Just before starting the lecture, ask everyone to record on the board their subjects’ responses. Tabulate the responses and calculate %s.
We’ve discussed ways in which the predictions of rational choice-based theory are consistent with much economic behavior: for example, the law of demand and different degrees of price elasticity, etc.
We’ve also noted:
Complexities of rational choice that are not quickly learned
That rational choice is not in general intended as a literal description of thought processes, but as an “as if” predictive framework
There are pitfalls of non-rational choices that people more or less frequently fall into
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2. Drawing on Chapter 8
Drawing on Frank’s chapter 8 and other readings, we will …
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3. Overview Choice Under Uncertainty Bounded Rationality
Reasons for Non-Utility-Maximizing Behavior
Loss Aversion
Acting on Sunk Costs
Explicit vs. Implicit Opportunity Costs
Affective Forecasting Errors
Judgmental Heuristics And Biases
The Psychophysics Of Perception
The Difficulty Of Actually Deciding
The Self-control Pitfall
… examine more closely the evidence about
How often and
Under what circumstances
people tend to behave non-rationally,
Look for predictable patterns of those non-rational choices, and
Learn about alternative theories of economic choices consistent with the experimental evidence.
Within ten years after Von Neuman & Morgenstern’s 1944 EU theory, a few economists started emphasizing limitations of our cognitive abilities (“bounded rationality”) in making economic choices.
In the 1970s, psychologists studying choice began to amass a growing body of experimental evidence of non-rational choices that began to show patterns and suggest alternative theories (refer to the list of “Reasons” and the rest of the list).
Let’s review these bodies of evidence and theory, drawing first on our experiment and Frank’s summary, then writings of one of the most important psychological researchers of choice and reviewers of his recent book.
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4. Choice Under Uncertainty
(Experimental results)
Problem 1: choose between
A: A sure gain of $240 (84%)
B: A 25% chance of getting $1000 and a 75% chance of getting $0. (16%)
The simple experiment we have conducted (following Kahneman and Tversky’s) is a good starting point for exploring these issues and theories.
Q: What is the rational choice? What is the EV of B? What about EU? See graph on next slide. A: It depends on your degree of risk aversion, but is likely to be the sure gain, A. EVB= $250, not much more than MA.
Compare previous experimental results to ours. So far, so good?
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5. Figure 8.5: A Risk-Averse Person Will Usually Prefer a Sure Gain to a Lottery with Slightly Higher Expected Value
To be consistent, it should show U(M), not U(W), and M0, not M.
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6. Choice Under Uncertainty
Problem 2: choose between
C: A sure loss of $750 (13%)
D: A 75% chance of losing $1000 and a 25% chance of losing $0. (87%)
Now MC = EVD, so
Q: What is the rational choice of a person who is at least slightly risk-averse? A: A (show with modified graph on board).
Puzzling. Another problem may help to explain.
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7. Choice Under Uncertainty
Problem 3: choose between
E: A 25% chance of getting $240 and a 75% chance of losing $760 (0%)
F: A 25% chance of getting $250 and a 75% chance of losing $750. (100%)
Q: Now what is the rational choice? A: In F the gain is bigger and the loss is smaller than in E with the same probabilities, so F.
This makes sense rationally … when considering these choices in isolation.
But E combines A and D (chosen by most) and F combines B and C (chosen by few).
[Say and outline what is below, and graph on board the value function analysis of the experimental example (see hand-drawn graph) BEFORE showing the next few graphs:]
Kahneman and Tversky proposed this explanation: people usually evaluate alternatives not with the conventional utility function, but instead with …
… a value function that is
defined over changes in wealth, and
much steeper in losses than in gains.
applied separately to each item of a collection of events before summing.
This:
gives potential perceived losses much heavier weight than perceived gains in decisions. (This does not necessarily imply irrational behavior.)
Separation -- Is it irrational? Where the distinct outcomes are mutually exclusive (each with some probability), perhaps not.
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8. Figure 8.1: Utility of a Pair of Events that Increases Total Wealth
However, the irrationality of the separate valuation of distinct outcomes before combining values is more apparent in this case.
Suppose that a person compares:
A & B: experiencing two events, a gain of $100 (unexpected gift) and a loss of $80 (bill for repair of broken water line) that together increase his or her wealth by $20, and
C: keeping current wealth M0.
According to rational choice theory, if they have utility function U(M) [again, not U(W)], they should prefer the two events (A & B), which together provide greater utility.
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9. Figure 8.2: The Kahneman-Tversky Value Function
The asymmetric value function approach predicts differently: separately evaluate the two events, then combine values, with a net value that is shown as negative -- with finger spans, subtract V(-80) from V(100), pointing to the result on the vertical axis halfway between the two value levels -- due to the asymmetry.
Where the two events are not chosen, this just predicts a negative net emotional impact.
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10. Figure 8.3: Rejection of a Dominant Insurance Plan
Where there is a choice involved, the value function model may predict a choice that differs from the utility-maximization-based choice. This has to do with the way events are framed (perceived):
as combined or separate?
as changes in relation to what base level of wealth?
In Frank’s example, employees choose between
D: old medical insurance plan with $500 premium and 100% coverage with $0 deductible
E &F: new plan with $250 premium and $200 deductible before 100% coverage
If they focus on the net effect of the premium and deductible, even in the worst-case scenario with bills >= $200, U(M0-$ )>U(M0-500) [and the same for V(-$ )>V(-$500)], so choose the new plan.
If they perceive (frame) the premium and deductible as separate events deviating from the old plan’s certain financial result, V(250)+V(-200)<V(0), so choose the old plan.
Which is rational?
Provide another example for students to think over and respond to.
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11. Sunk Costs
Thought Experiment: you bought a used car for $2,000, but found out it was a lemon, and have no warranty coverage. You will have to continue paying for repairs that cost more than you would be willing to pay for another car to drive.
Do you continue operating and repairing it, or junk it and get another?
Would your response be any different if you had not bought the car, but instead had been given it as a gift?
Rational choice theory says to junk it. It is common for people to keep repairing it.
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12. Judgmental Heuristics And Biases
Three simple heuristics that people use to make judgments and inferences about the environment:
Availability - much easier to recall events that are more “available” in memory.
Representativeness – estimate likelihood that an event belongs in a class by its “representativeness” of the class.
Anchoring and Adjustment - first choose a preliminary estimate and then adjust it in accordance with whatever additional information that appears relevant.
The psychological evidence has revealed ways our brains have evolved to facilitate quick low-effort decision-making by drawing on several thinking short-cuts (heuristics). Much of the time they work well, but there are many ways they make our perceptions prone to biases. Let’s look at some of the most common examples, among several others.
[Ask each question before bringing up the related text.]
We are particularly prone to biases in estimating probabilities:
For example, how common are university and college mass shootings: what % of campuses per year? If the Oregon shooting had happened last weekend, would your perception be different? In general, events are more available – and that type of event perceived as more probable -- when more recent and vivid.
Suppose that a RC student named Travis is very strong. Is he more likely to be a football player, or not?
… and monetary valuations:
Why does Amazon.com show the list price of books (such as Thinking Fast and Slow, linked to “estimate”) along with the price at which it sells the book? (So you anchor your valuation of the book in the list price before comparing that to the sale price.) This may make seem rational to you, but even in experiments where the “anchor” is obviously random, it still biases people’s choices.
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13. The Psychophysics Of Perception
Weber-Fechner law: the property of perception whereby the just noticeable difference in a stimulus tends to be proportioned to the value of the stimulus.
This helps to explain why we respond more to % sales discounts than to $s off.
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14. The Difficulty Of Actually Deciding
For many pairs of alternatives utility functions just don’t seem to assign clear, unambiguous preference rankings.
Difficulty is most pronounced when the alternatives differ along dimensions that are hard to compare.
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15. Figure 8.7: Choosing between Two Apartments
Our choices between alternatives are often based on such dissimilar characteristics of those alternatives that it’s hard to weigh their relative importance. We may have some idea of which of these two alternatives we prefer, but it’s a weak sense of preference (ranking).
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16. Figure 8.8: Adding an Irrelevant Alternative
If the choice is framed instead as between not only those alternatives, but also another that is clearly inferior to B, people will shift substantially toward choosing B. The framing influences its perceived preference ranking. (Hey, it’s definitely better than C. So why not better than A?) If a person has complete preference orderings, should the inclusion of C affect their choice?
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17. The Self-control Pitfall
People often have difficulty carrying out plans they believe to be in their own interests.
Examples of commitment devices:
“Christmas clubs” - special accounts that prohibit withdrawals until late autumn
Whole-life insurance policies
In each case, a withdrawal or cancelation penalty helps us do what we know is better for us -- save for gift-giving and retirement – but we have trouble sticking with.
This has begun to explore the predictable patterns of non-rational economic choices and alternative theory. We’ll dig more into the fundamental theory with the next set of readings.
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