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EC345: Weeks 1-5 notes
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Leture, seminar and reading notes for weeks 1-5 of behavioural economics
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W1: IntroductionWhat is behavioural economics?
● Economic analysis that applies psychological insights to behaviour to explain
economic decision making
○ Psychological underpinnings of economic analysis
● Objective: modify, supplement and enrich economic theory by adding insights
from psychology
○ Starting point: standard economic theory
○ Builds on economic theory to introduce concepts such as altruism,
envy, time-inconsistency
History
● Economics and psychology were not separate
● Adam Smith: Theory of Moral Sentiments “we suffer more… when we fall
from a better to a worse situation, than we enjoy when we rise from
a worse to a better” → loss aversion
● Jeremy Bentham: Principle of Utility → psychological underpinnings of
utility
● Francis Edgeworth: Theory of Mathematical Physics → envy in utility
● Neoclassical revolution separated psychology and economics
○ Economics is a natural (not social) science
○ Psychology has unstable foundations
● Rejection of the hedonistic assumptions of Benthamite Utility functions
● Neoclassical economists removed psychology from economics
● Criticism of the neoclassical economy in the early part of the 20th century
● Irving Fisher and Vilfredo Pareto speculated about how people feel and think
about economic choices
● Keynes appealed to psychological insights
● Katona, Leibenstein, Scitovsky and Simon looked at psychological measures
and bounds on rationality
○ Did not fundamentally alter the direction of economics at the time
● What changed → acceptance of models like expected and discounted utility
○ These normative and descriptive models highlighted their limitations
and drew criticism
● Allais (1953) looked at the anomalous implications of expected and subjective
utility
, ○ Strotz (1955) questioned experimental discounting
● Kahneman and Tversky (1979) developed a theory for simple lotteries and
state probabilities that expected utility theory did not support
● Thaler (1981) looked at dynamic inconsistency and discounted utility
How does it work
● Identify normative assumptions used, e.g. expected utility
● Identify anomalies that demonstrate violations, rule out alternative
assumptions (need to prove external validity)
● Use anomalies to create alternative theories that generalise existing models
● Construct economic models of behaviour using the behavioural assumptions
from step 3
○ Derive new implications and test them
● Experiments play a large role in the initial phase of behavioural economics
○ Helpful for distinguishing behavioural explanations from standard ones
● Experimental and behavioural economics are clearly linked
○ Experiments have produced empirical regularities that support
behavioural economics
○ Methodological field that can be widely applied → not part of
behavioural economics
Behavioural economics methods
● Most common method: experimental economics
○ Helps to distinguish behavioural explanations from standard ones
○ Field data (survey data)
○ Field experiments (artefactual, framed, natural)
■ Observe how individuals behave in the real world → decisions
have real consequences
● Observational studies use survey-based data
○ Can comment on general patterns of behaviour
● Computer simulation (agent-based modelling)
● Brain scans (neuroeconomics)
Summary
● Behavioural economics should enhance, not replace traditional economics
● Adding non-traditional assumptions doesn’t abandon traditional methods
● Implications of non-traditional assumptions should be studied using
mathematical methods, tested using standard stats and metrics and judged by
standard scientific criteria
, W2: Decision under uncertainty
Expected utility theory
● With uncertainty, an agent chooses between uncertain outcomes/lotteries
(probability distribution over possible outcomes)
○ Situation of risk: agent knows what could happen/how likely it is
○ Situation of uncertainty: don’t know the possible outcomes/probabilities
○ Prospect: probabilities things will happen/monetary payoffs if they do
● Expected utility theory: if an agent’s preferences can be represented by an
expected utility function, we need to know his preferences over uncertain
outcomes and payoffs from the outcomes
○ Proposed by Bernoulli (1738)
● Assumption: procedure invariance → preferences over prospects are
independent of the method used to elicit them
● Assumption: description invariance → preferences don’t depend on how
distributions are described
Required axioms
● Completeness: we can always compare preferences between two prospects
○ At least one of ^x ⪰ x or x ⪰ x^ holds
● Transitivity: if we prefer bundle 1 to 2, and 2 to 3, then we prefer 1 to 3
○ Individuals are consistent with preferences and avoid preference cycles
● A preference relation is rational if it is complete and transitive
● Continuity: if X > Y > Z, the agent is indifferent between Y and some weighted
average of X and Z
○ Given a good, medium and a bad good, there’s a weighted average of
the good and bad that's exactly as good as the middle
● Independence: for any lotteries X, Y and Z, X > Y if and only if any mixture of
X and Z is also preferred to the mixture of Y and Z with the same weights
○ Preference over 2 lotteries isn’t affected by a third
● Fulfilling these 4 axioms gives the expected utility theory
The Theory
● If your preferences satisfy those 4 axioms, it is
possible to assign a real number ui to outcomes so
X ⪰Y if and only if U ( X) ≥ U (Y )
● Convex indifference curves → concave utility
functions
● Risk aversion: someone prefers a certain amount of
money to a prospect with the same expected value
○ Concave utility function
−u ' '(w)
● Absolute risk aversion: Ra (w)=
u ' (w)
, ○ Positive for risk averse individuals
−u ' '( w)w
● Relative risk aversion: Rr =¿
u ' (w)
Anomalies/deviations from EUT
Shows inconsistency of choices with those predicted by expected
utility theory
Allais Paradox
● Most people choose A and D
○ Violates independence
○ Not consistent with EUT
● Most people chose A over B → u( A)>u (B)
● Most choose D over C → u(D)>u(C )
● A over B gives
○ 0.89 u(5 mil )+ 0.11u (5 mil)>0.89 u(5 mil)+0.1 u(15 mil)+0.01 u( 0)
○ Simplify to 0.11 u(5 mil)> 0.1u (15 mil) EQ1
● D over C gives
○ 0.1 u(15 mil )+ 0.89u (0)+ 0.01u (0)>0.11u (5 mil)+0.89 u(0)
● 0.1 u(15 mil )> 0.11u (5 mil) EQ2
● Equation 1 and 2 directly contradict each other
○ Individuals choose the certain amount in bargain 1 when there is a 1%
chance of getting 0
○ The the second lottery, they pick the gamble with the lower probability
but higher potential winnings
● Certainty effect: people favour outcomes that are seen as certain vs possible
○ Also known as the common consequence effect
● Reflection effect: choices are partly made by measuring relative deviations
from current wealth
● Substitution axiom shows common attitudes towards risk that are not
explained by EUT
● Allais paradox can be caused by people trying to avoid potential
disappointment
○ Disappointment causes indifference curves to fan out, rather than
being parallel
○ If disappointment increases sufficiently, they no longer fan out
■ Less chance of winning = less disappointment
Ellsberg Paradox
● Expected utility theory predicts: if individuals
choose A, they should choose C
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