1.7 Behavioural Economics

Question 1

What is behavioural economics?

Answer 1

“A method of economic analysis that applies psychological insights
into human behaviour to explain economic decision-making”

Question 2

What are we going to look at today?

Answer 2

When people do not behave in their best interests?
Decision vs experience utility; affective forecasting
government intervention.

Question 3

What is decision utility?

Answer 3

Is the consumer’s perceived utility at the time of decision-making. It is the forecast of what the consumer thinks experience utility will be when
consumption takes place. ( buying the good)

Question 4

When you are in decision utility what state is usually referred and explain it?

Answer 4

You are in the Hot state. - high level of emotions, can impact rational decision making.

Question 5

What is a reason for decision utlitiy? ( HINT ABOUT PREDICTIONS)

Answer 5

Affective forecasting - is predicting how you will feel in the future.people are generally inaccurate in predicting their future emotional states s (see Kahneman and Thaler, 2006) see more in the reading.

Question 6

What is experience utility?

Answer 6

Experience utility is the actual utility at the time the good is consumed ( consuming the good, you regret decision in hot state)

Question 7

What state are you in experience utlitiy?

Answer 7

Cold state - is one that is not being influenced by emotion and is usually more rational and logical.

Question 8

What is the uncompensated demand here don’t necessarily tell us the old fashioned compensated demand but just draw the graph(s)?

Answer 8

The sign infront of X1 is an index of how much the person values an extra unit of good x1.
Non-satiation holds but convexity doesn’t ( the second derative with respect to x1 = 0.
So corner solution depending on the MRS in relation to price ratio.
If MRS> price ratio = THE MU of good 1> good 2, since equally priced, the person only buys good 1.
If MRS< price ratio. Then MU2> MU1, since equally priced, the person only buys good 1.
If MRS = 1, they are indifferent so can spend anywhere.

Question 9

How can we use Decision and experience utlitiy to illustrate this example?
So imagine that the consumer in decision utility buys good 1, what does this mean?
In experience utility the consumer buys good 2, what does this mean?
USE HOT AND COLD STATE !!!!

Answer 9

in Experience Utility the MU is decreasing for each bite of good 1.( regret)

Question 10

What is are 3 thing that can cause you to be in a hot state?

Answer 10

Being distracted by payoff-irrelevant cues ( marketing)
• you associate the colour of an object with something nice

Acting on instinct
• using intuitions rather than thinking things through

Time lag ( between making decision and when you experience consequence of decision)

Question 11

Dan kahnerman(1933) wrote a book thinking fast and slow 
He asked the question 
A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much is the ball? 
A. 5 cents 
B. 10 cents
C. 15 cents 
D. 20 cents. 
What is the fast answer and slow answer?

Answer 11

Fast answer ( when fast we don't make rational decisions - 10 cents... but its wrong. ball at $0.1 + bat $1.10  = $1.20
Slow answer ( when slow we make rational decisions - 5 cents. A ball at $0.05 + $1.05 = $1.10

Question 12

To summarise if the decision utility is in hot state and consumption is in cold state then what?

Answer 12

The consumer is maximising the wrong function

Question 13

In experience utlitiy of theta 1 x1 + x2, were theta is less than 1 so they should of consumed all of x2, but what did they actually consume?

Answer 13

so x1 = m
x2 = 0
leading to them to experience a ultity of theta lm < m

If they had spent money on good 2, there utility x2 = m/p2 = m gets them to utlitiy m,
meaning they welfare optimise at the consumption bundle (x1,x2) = (0,m), but don’t the utility is lower.

Question 14

What do advertisements and companies do to enhance our decision utility?

Answer 14

Advertisers understand how to frame-decisions to make us like products
• creating “imagery” to enhance our decision utility

• And some businesses use high-pressure sales tactics to get us to buy
something before we have thought it through

Question 15

What is the effects of people making wrong decisions( decision utility? )

Answer 15

There is welfare loss from making wrong decisions.

Question 16

What are some government solutions to solve the welfare loss in society?

Answer 16

1)banning/taxing some products
2) regulating ‘choice architecture’ ( how items are laid out in shops)
3)“cooling-off” clauses which allow you to change your decision
e.g. cancelling motor insurance, a mobile phone contract or a loan
without penalty within 14 days
4) Even apps ( that track)

Question 17

What is another way to think of hot state to cold state?

Answer 17

Internality, ( present self imposing a negative externality on your future self hence regret and lower utility in future.)

Question 18

• Back to our example, where in the hot state the consumer buys only good 1
while future self would like to consume only good 2. Is tax an extreme solution and what would the good have to be? What is some of the problems imposing tax on good 1?

Answer 18

Extreme solution… it would have to be really bad for you.

• Requires the state to know best and act in the interests of citizens
• What about consumers who are not prone to bias?

Question 19

How might behavioural biases be linked to poverty?

Answer 19

poverty could lead to problematic decisions. e.g. you are homeless, with 3 children and book a hotel on credit, this is problematic in the LR or like pay day loans( large interest payments)
.

Question 20

If there is poverty is government intervention more necessary?

Answer 20

Yes to help those more deprived groups.

Question 21

lets say we have 2 individuals and we are trying to tax good 1
1 individual ‘hot self likes good 1 and cold self likes good 2.
2 individual hot and cold set likes good 1.
How do we know there are biases
Would the tax have to be for the consumer to consume all of good 2 if we assume theta is 1.2?
Remember that the relative prices = 1/1
What does it mean for individual 2?

Answer 21

We know there are biases through the theta its different for individual 1 so bias, whereas its different for individual 2.
We know that MRS> p1/p2 means they consume all of good 1
we want MRS< p1 + t/p2 so they consume all of good 2.
If the MRS = 1.2 we need a tax or an increase in price of at least 20%.
This reduces the utility of individual B, as they are worse off. ( they can afford less)
So taxing good 1 means pareto effieicency cannot happen, who cannot make someone better off without making them worse off.

Question 22

What is a indirect way of influencing A without distorting B

Answer 22

Nudges:
Create a default option of x1 = 0
• Allow A-types to opt out to choose x1 > 0 ( delay decision making)
• Requires effort/thought, so helps one make the choice in the cold state
e.g. you go shop. you are given carrots, but you say no can you give me cookies, this requires effort and allows you to eventually think no)

Question 23

What are some of the ways for studying to avoid decision utility of going on phone?

Answer 23

Leaving phone in another room ( but this requires commitment)

Question 24

Lets look at example of preferences of saving. When you are young you spend lots, meaning you have less when older. When people are older they which they had saved more in the current period rather than consumed lots ( and could potentially accumulate debts, we will not show that.), Now show the decision and experience utility using a utlitiy function a cobb-douglas one?

Answer 24

Question 25

When we had cobb-douglas function and we had budget constraint, what was the uncompensated demand?

Answer 25

Question 26

What is the intertemporal budget constraint for consumptions and find uncompensated demands using the general rule we know about cobb douglas functions.

Answer 26

Consumption today and tomorrow = income today and tomorrow.

Question 27

So when young what does he consume at c0 and c1 and what is his saving?
When old and looks back what should consumption of been, compare with young today.
What should consumption in the future and compare it to what it is now?
Remember use theta’s.

Answer 27

Question 28

Now draw the diagram with c1 as a function of c0, and illustrate 2 bundles, 1) showing decision utility 2) showing his experience utlitiy.
Here just identify bundles as Y for young and O for old, remember gradient and labels of the intercepts.

Answer 28

Question 29

(i) and (ii)

Answer 29

(i)Decision utility is the consumer’s perceived utility at the time of decision-making.
Experience utility is the actual utility at the time the good is consumed.
(ii) As perfect subistutes, convexity doesn’t hold as = 0, so there is a corner solution depending on preference.
Remember to compare MRS to price ratio, if MRS>price ratio, you consume all of good 1, here 2> 1, if the MRS< price ratio, you consume all of good 2, 1/2<1.

Question 30

iii

Answer 30

Those in the first group choose 10 units of good 1, but afterwards regret this decision. They would have preferred to have chosen 10 units of good 2! Experience utility is 10 although it could have been 20.

Those in the second group choose 10 units of good 2, but afterwards find they would have preferred to have chosen 10 units of good 1! Again, experience utility is 10 although it could have been 20.

Question 31

Could a tax on consumption of one of the goods correct the sub-optimal outcome?
Explain.

Answer 31

The main point is that a tax will not help correct both types of consumers’ mistakes as these are in opposing directions. For example, a tax (of at least 1, or 100% if ad valorem) on good 1 is sufficient to induce consumers in the first group to shift their decision from consuming all good 1 to Consuming all good 2. However, such a tax would not help induce the consumers in the other group to start consuming good 1!

Likewise, a tax on good 2 (of at least 1 or 100% if ad valorem) would induce those in the second group to switch to consuming all good 1, but would not be effective in correcting the error of those in the first group. Either tax (on good 1 or good 2) would be Pareto improving – it causes a gain but without anyone losing out – but is ineffective in fully correcting the sub-optimal outcome.

Question 32

What would taxing both products mean?

Answer 32

Note that taxing both goods would be entirely ineffective as it would not alter relative price – it would simply serve to lower the utility of both groups further!

Question 33

What does the tax have to be for good 1 and what does the tax have to be for good 2?

Answer 33

1) FOR FIRST GROUP MRS> P1/P2 = 2>1/1 THE TAX WOULD BE = ( DOUBLE PRICE TO MAKE CONSUMERS INDIFFERENT OR PRICE>2 MEANING MRS