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Behavioral Economics

Behavioral Economics. Terry Hurley Department of Applied Economics University of Minnesota. Overview. What is it? What are its goals? Why is it fashionable? Will it remain fashionable?. What is it?.

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Behavioral Economics

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  1. Behavioral Economics Terry Hurley Department of Applied Economics University of Minnesota

  2. Overview What is it? What are its goals? Why is it fashionable? Will it remain fashionable?

  3. What is it? “Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations.” (Camerer & Loewenstein)

  4. What are its goals? Prediction Generalization Tractability

  5. Why is it in fashion? • New Methods For Testing Old Theories • Lab & Field Experiments • Neuroeconomics • Computer Simulation • Results Contrary To Old Theories • Realization That Psychology Can Provide Insight

  6. Contrary Results Discussed Last Year Relevance Of The Irrelevant Fairness Discounting Risky Choice

  7. Relevance Of The Irrelevant • Sunk Costs Influence Behavior • Framing Influences Behavior • Random Information Influences Behavior • Implications • Marketers Can Use Anchoring & Framing To Influence Choice • “Buyer Beware” Has Even More Meaning

  8. Fairness • People Are Not Purely Self-Interested • Implications • Charitable Giving More Common Than Expected • Tragedy Of The Commons May Not Be So Tragic • Private Provision Of Public Goods Possible

  9. Discounting • People Prefer Instant Gratification • Appears Partly Physiological • Implications • Commitment Devices Can Encourage Good Behavior

  10. Risky Choice • Reference Points Matter (Anchoring & Framing) • Risk Seeking Over Losses/Risk Avoiding Over Gains • Losses More Salient Than Gains • Overestimate Unlikely/Underestimate Likely Events • Appears Partly Physiological • Implications • Investment • Insurance • Health…

  11. Some Other Examples Of Contrary Results Entry Deterrence Game Centipede Game Investment Game Beauty Contest Game

  12. Entry Deterrence Game Question: If you were Player 1, what would you choose? Question: If you were Player 2, what would you choose? Player 1 Out In Player 2 (70, 60) Left Right (90, 50) (60, 10) Payoffs: (Player 1, Player 2)

  13. Entry Deterrence Game Theory: Solve Backward Player 1 Player 1 Should Choose In & Player 2 Should Choose Right! Out In Player 2 (70, 60) Left Right (90, 50) (60, 10) Payoffs: (Player 1, Player 2)

  14. Entry Deterrence Game Evidence Player 1 So, what is the problem? Out In Player 2 (70, 60) 12% Left Right Goeree & Holt (2001) (90, 50) (60, 10) 0% 88% Payoffs: (Player 1, Player 2)

  15. Entry Deterrence Game Question: If you were Player 1, what would you choose? Question: If you were Player 2, what would you choose? Player 1 Out In Player 2 (70, 60) Left Right (90, 50) (60, 48) Payoffs: (Player 1, Player 2)

  16. Entry Deterrence Game Theory: Solve Backward Player 1 Again Player 1 Should Choose In & Player 2 Should Choose Right! Out In Player 2 (70, 60) Left Right (90, 50) (60, 48) Payoffs: (Player 1, Player 2)

  17. Entry Deterrence Game Evidence Player 1 Out In Player 2 (70, 60) 32% Left Right Goeree & Holt (2001) (90, 50) (60, 48) 32% 36% Payoffs: (Player 1, Player 2)

  18. Entry Deterrence Game • What can explain this behavior? • Spite • Revenge • Implications • Incredible Threats Are Credible When They Are Not Too Costly

  19. Centipede Game Player 2 1 2 P P P P P P 2 1 1 (25.60, 6.40) T T T T T T (0.80, 3.20) (6.40, 1.60) (3.20, 12.80) (0.20, 0.80) (1.60, 0.40) (0.40, 0.10) Question: If you were Player 2, would you ever choose T? If so, when? Question: If you were Player 1, would you ever choose T? If so, when? Payoffs: (Player 1, Player 2)

  20. Centipede Game Player 2 1 2 P P P P P P 2 1 1 (25.60, 6.40) T T T T T T (0.80, 3.20) (6.40, 1.60) (3.20, 12.80) (0.20, 0.80) (1.60, 0.40) (0.40, 0.10) Theory: Solve Backward Player 1 Should End the Game Immediately by Choosing T! Payoffs: (Player 1, Player 2)

  21. Centipede Game Player 2 1 2 2 1 1 P P P P P P (25.60, 6.40) 4% T T T T T T (0.80, 3.20) (6.40, 1.60) (3.20, 12.80) (0.20, 0.80) (1.60, 0.40) (0.40, 0.10) 1% 6% 20% 38% 25% 5% Evidence: Almost No One Ends the Game Immediately, But Inevitably Almost All End It Short Of The Maximum Total Payoff! McKelvey and Palfrey (1992)

  22. Centipede Game • What can explain this behavior? • Altruism • Reciprocity • Limited Cognition • Implications • It May Be Rational To Be At Least A Little Irrational (Or At Least To Assume Others Are Irrational)

  23. Investment Game A • Suppose I gave you, the Investor, $10 to allocate between two accounts: a private account & an investment account. • Each $1 put into the private account is yours to keep. • Each $1 put into the investment account is multiplied by 2 & given to a Trustee. The Trustee then gets to choose how much to return to you and how much to keep. Question: If you were the Investor, how much would you put in the investment account? Question: If you were the Trustee & you received $2, how much would you return? Question: If you were the Trustee & you received $10, how much would you return? Question: If you were the Trustee & you received $20, how much would you return?

  24. Investment Game A • What does economic theory say? • Investor Should Put Nothing In The Investment Account • Trustee Should Return Nothing Regardless OfWhat Is Put Into The Investment Account • What do people actually do? (Berg, Dickhaut & McCabe, 1995) • Most Investors Invest At Least Some Money • About Half The Trustees Return Initial Investment Or More • A Third Of Trustees Return Nothing Or Token Amount • Lots Of Variations On This Theme With Similar Results

  25. Investment Game A • What can explain this behavior? • Trust • Altruism • Reciprocity • Fairness

  26. Investment Game B • Suppose I gave you, the Investor, $10 to allocate between two accounts: a private account & an investment account. • Each $1 put into the private account is yours to keep. • Each $1 put into the investment account is multiplied by 2 & given to a Trustee. Question: If you were the Investor, how much would you put in the investment account?

  27. Investment Game B • Cox (2004) Found That Investors Invested Less On Average, But Still 2/3 Sent Something • What can explain this behavior? • Altruism • Fairness

  28. Investment Game C • Suppose I gave you, the Investor, $10 to allocate between two accounts: a private account & an investment account. • Each $1 put into the private account is yours to keep. • I then randomly choose an amount between $0 and $10 to give to the Trustee. The Trustee then gets to choose how much to give to you and how much to keep. Question: If you were the Investor, how much would you put in the investment account? Question: If you were the Trustee & you received $2, how much would you return? Question: If you were the Trustee & you received $10, how much would you return? Question: If you were the Trustee & you received $20, how much would you return?

  29. Investment Game C • Cox (2004) Found That Trustees Give Less On Average, But Still 40% Give Something • What can explain this behavior? • Altruism • Fairness

  30. Investment Games • Implications • People Care About The Wellbeing Of Others (e.g. Altruism & Fairness) • People Care About The Intentions Of Others (Trust & Reciprocity)

  31. Beauty Contest Game Suppose everyone in the room is given the opportunity to pick a number between 0 and 100 and the individual who picks the number that is closest to 70% of the average wins $100. Question: What number would you choose?

  32. Beauty Contest Game • What does theory say? • Everyone should choose 0! • If everyone chose 100, then you should choose less than 70. • But, if everyone realized this & chose less than 70, you should choose less than 49. • But, if everyone realized this & chose less than 49, you should choose less than 34.3. • …, until you should choose 0. • What do people actually do? Camerer (2003) • Initially, people tend to choose between 21 & 40. • But as they learn, their choices get closer to zero, though few ever actually pick 0.

  33. The Beauty Contest Game • What explains this behavior? • Limited Cognition & Learning • Implications • People Are Limited In Their Ability To Reason But Can Learn • “When I played this game at a CalTech board of trustees meeting, a very clever board member (a well-known Ph.D. in finance) chose 18.1. Later he explained his choice: He knew the Nash equilibrium was 0, but he figured the average Caltech board member was clever enough to do two steps of reasoning and pick 25. Then why not pick 17.5 (which is 70% of 25)? He added 0.6 so he wouldn’t tie will people who picked 17.5 or 18, and because he guessed that a few people would pick high numbers , which would push the average up.” Camerer (2003)

  34. Will it remain fashionable? • Yes, for the foreseeable future! • Generalization & Tractability Are Receiving Less Emphasis Than Prediction • Psychology Is Important For Prediction • Research Increasingly Interdisciplinary • Increased Interactions With More Than Just Psychologists

  35. Will it remain fashionable? • Interdisciplinary Interactions Leading To Enriched Theories • Preferences That Consider • Wellbeing Of Others • Intentions Of Others • Constraints That Consider • Cognitive Biases & Limitations • Physiological Responses Thank You For Your Time & Attention!

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