Complete and concise notes for the entire course in Behavioural Economics at UCL. Helpful for economics students as well as students choosing to undertake this introductory course as an optional module. Includes lecture notes for all topics like decision-making under risk and uncertainty, reference...
Topic 1: An Introduction to Behavioural Economics
Asynchronous:
Introduction
o Understanding human behaviour and the consequences of human decisions is the
core focus of social sciences, including economics
Human behaviour depends on internal and external factors
Internal: preferences, beliefs, cognitive ability, personality, emotion
External: factors that shape the environment for decision-making
such as available information, budget constraints, social norms,
rules and regulations
How do these factors interact with one another?
How can they be altered via policy?
How do they vary over time?
Neoclassical economic approach
Individual choices are ‘rational’.
Individual preferences are complete and transitive.
o Agents know the ordering of their preferences and this
doesn’t change
Individuals maximise their utility subject to constraints they face.
o Able to perceive all different options and compute cost-
benefit analysis
o Perfect information about own preferences, the current
environment and how both of these might change in the
future
Markets exist, when firms have incentives to participate, and
individuals make rational choices to maximise their own utility.
Governments may intervene in case of market failure due to
asymmetric information, externalities, or failure in public good
provision.
o Don’t intervene to correct for internal issues such as
irrationalities
Behavioural economics allows us to relax some of these assumptions
o Behavioural economics
Is a field of economics that draws on knowledge in psychology to capture
important aspects of human behaviour and social interactions that standard
economic models cannot explain.
It seeks to increase the explanatory power of traditional economic
models by incorporating more realistic psychological and
sociological foundations.
And predictive power
, The goal is not to reject the traditional approach but to improve in
order to generate better theoretical insights, improve predictions
and policy making.
Three waves according to Rabin
First wave – Identify anomalies: BE was concerned with describing
anomalies in human behaviour that does not fit into standard
economic models
Second wave – Formalise alternatives and test empirically: Extensive
empirical research on biases, social and time preferences, among
other BE concepts.
3. Third wave – Full integration: BE has become fully integrated into
the field of economics, where BE now improve upon existing
neoclassical economic models.
o This allows us to improve theory and reconnect theory to
empirical economics, which also results in better policy
making.
Previous history
Adam Smith “The Theory of Moral Sentiments” (1759) explaining
the role of emotions in decision-making
Jeremy Bentham introduced utility theory, but also wrote
extensively about psychology of consumers and happiness
Standard Model vs BE
o Standard model
Individual I at time t=0 maximises expected utility subject to beliefs about
the probability distribution p(s) about the states of the world s is a member
of S
t
The utility function U(x|s) is defined over the payoff x i of individual I
and future utility is discounted with a (time-consistent) discount
factor
Agents maximise expected utility consequences with full self-
interest, rationality and self control
Preferences and probabilities
Risk preferences are linear in probability and risk attitudes are
captured by the curvature of the utility function u(.)
Time preferences: there is constant discounting by factor δ and time
consistency, which implies that there is no problem of self control
Social preferences: utility depends only on own consumption but
not on others’ consumption or wellbeing
Probability judgement: Bayesian model with rational beliefs
o Correct assessment of probabilities
o Correct Bayesian updating
Optimisation and implications
Optimisation: utility maximisation
, o Full ability to make decisions (cognitive and non-cognitive)
o Full attention
o Neutrality to the changes in context and environment
Therefore heterogeneity in behaviour in the standard model is
explained by heterogeneity in preferences, constraints, information
and beliefs
o What could go wrong in the standard model?
Non-standard preferences
Risk preferences: Utility depends on a reference point, probability
weighting, loss aversion, ambiguity aversion
Time preferences: Individuals do not exhibit a constant discount
factor (hyperbolic discounting), time inconsistency (problems of self-
control)
o Present bias and awareness of present bias
Social preferences: Utility depends on the utility of others, fairness
matters, trust and reciprocity is important
o E.g. some people are inequality averse
o But some kinds of preferences are perfectly rational e.g.
parents caring about the utility of their children more than
their own – could be included in the standard model
Non-standard beliefs
Individuals may be overconfident
o You might know the statistics and understand them but
think it doesn’t apply to you. E.g. 70% of drivers think
they’re better than average
They may not understand probabilities or be subject to biases such
as:
o Hindsight bias
o Law of small numbers
o Gambler’s fallacy
They may be affected by the context or the presentation of the
problem (framing)
Non-standard decision making
Individuals simplify complex decisions and environments
They employ heuristics
o Probability judgement may depend on heuristics such as
availability and representativeness
They are emotional
They have limited attention – only pay attention to salient
characteristics of something
They may have a limit in cognitive ability, lack of proper set of skills,
e.g. financial literacy
o Rationality
Full rationality refers to
Unlimited calculative powers
Perfect self-knowledge – complete preferences (completeness
axiom)
, Fully coherent preferences (transitivity axiom)
Mathew Rabin:
BE does not argue against ‘rationality’; rather it is arguing against
the stereotype of the self-interested ‘homo economicus’ and the
unrealistic assumptions that accompany this stereotype.
BE is not about people systematically making ‘errors’ because they
exert bounded rationality. On the contrary, it allows for
‘rationalisable behaviour’.
People may be perfectly rational in not acting in a purely self-
interested manner. If they have, for example, social preferences
then they actually act rational by being altruistic, fair etc. because
they derive pleasure from doing so.
Ariely: we are predictably irrational
BE does not rule out rationality per se. It shows that people behave ‘rational’
most of the time when accounting properly for their preferences and other
factors.
o Bounded rationality
BR was developed by Simon in the 1940-50s due to dissatisfaction with the
‘comprehensively rational’ economic and decision theory models of choice
and as a challenge to its usage in economics
The model first appeared in print in Administrative Behavior (1947), was
officially introduced by Simon (1957) and explicitly recognised by Kahneman
(2003).
BR asserts that decision makers are ‘intendedly’ rational; that is, they are
goal-oriented and adaptive, but because of human cognitive and emotional
architecture, they sometimes fail.
Bounded rationality relates to:
Limited attention and salience
Decision making ability and quality research
Incomplete contracting
From ECON0013 notes:
o Completeness: Either qA >~ qB or qB >~ qA
Ensures that choice is possible in any budget set – rules out indecision
Consumer preferences are incomplete if there are two goods q 1 and q2 and
A B A B
qA >~ qB if and only if both q 1 ≥ q 1 and q 2 ≥ q 2
With these preferences the consumer simple can’t decide between
two bundles if each bundle has more of one of the two goods as
shown
o Transivity: q >~ qB and qB >~ qC implies qA >~ qC
A
This ensure that there are no cycles in preferences within any budget set
Graphically this requires nesting of weakly preferred sets
If one bundle qB is in the weakly preferred set of qA then its own
weakly preferred R(qB) set must lie entirely within R(qA)
Consumer preferences are intransitive if there are two goods q 1 and q2 and
A B A B
qA >~ qB if and only if either q 1 ≥ q 1 or q 2 ≥ q 2
A C A C
Take bundles qA and qC such that both q 1 ≥ q 1 and q 2 ≥ q 2 – clearly,
qA >~ qC
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