Behavioral Economics Flashcards
Richard Thaler
We often ask our theories to do two tasks at the same: 1. to solve for optimal solutions to problem 2. to describe how humans actually choose. if we live in a world only of economists, there would be no need for two different model.
in reality, we need two different models. Expected utility theory remains the gold standard for how decisions should be made in the face of risk. Prospect theory is meant to be a complement to expected utility theory, which tell us how people actually make such choices.
Behavioral economics doesn’t emerge to replace the neoclassical paradigm and it’s just a set of practical enhancements that lead to better predicational about behaviors. the enhancements focus on two broad topics: preferences and beliefs.
Daniel Kahnerman and Amos Tversky’s Prospect theory is a good illustration of a model based on assumptions that preferences that differ from the ones used to derive expected utility theory. most of prospect theory’s predictive power comes from 3 crucial assumptions about preferences:
- utility is derived from changes in wealth relative to some reference point, rather than levels of wealth.
- the value function which translate perceived changes in wealth into utility, has a kink at the origin, with losses weighed more heavily than gains
- decision weights are a function of probabilities.
Two other research streams have been based on models of preferences.
The first topic is intertemporal (跨时期的）choice.economists have long worried that people
display what we now call “present biased” preferences, meaning that the discount rate between “now” and “later” is much higher than between “later” and “even
later.” Such preferences can lead to time-inconsistent behavior since we expect to be patient in choosing between a smaller reward in a year and a larger reward in a year plus a week, but when the year passes and the smaller reward is available “now,” we submit to temptation. If people realize they have such preferences, they may choose to commit themselves now to choosing the larger delayed reward, a strategy they will later regret (at least for a week or so).
Two kinds of models have been proposed to deal with these aberrant preferences.
- One is based on a two-self (or “two-system”) approach that is meant to capture the inherent conflict that defines self-control problems - a long-sighted “planner” and myopic “doer”
- second model is model “beta-delta” where delta is the standard exponential discount rate and beta measures short-term impatience.
Another aspect of preferences- “other-regarding preferences”. these models show http humans are not completely selfish “humans’ fist instinct is to cooperate as long as they expect others to do likewise”.
Behavioral beliefs:
Overconfidence and excessive extrapolation of recent trends are just two examples of a biased beliefs that have been documented by psychologists studying human judgement.
there is a long list of biases based on empirical finding but this is both a blessing and a curse. blessing is that each of the bias has possibility of providing insight to economic behaviors but curse is that this gives theorists a dangerously largely number of degrees of freedom.
Some examples of good uses of biases that do influence choices (“supposedly irrelevant factors):
401K retirement saving plan for example:
- instead of increasing the % of pay from defaulted %, putting off the increase in saving to the future helps those who are present biased
- linking % increases of saving to the increase in salary mitigates loss aversion
- making staying in 401k plan the default plan puts status quo bias to good use
By Richard Thaler: it’s time to fully embrace evidence-based economics. behavioral economics is one part of the growing importance of empirical work in economics. it’s a evidenced-based discipline.
“Choices, Values and Frames” Preface:
Prospect theory is a theory of choice under risk.
This book talks about the nonlinearity of decision weights, the reference-dependent characteristics of the value function and the significance of framing effects.
Nonlinearity of decision weights: the expectation principle of utility theory required a linear response to variations of probability. but intuition suggests and experiments readily confirms that raising the probability of an outcome from 0.39 to 0.40 has much less impact on preferences than increasing the probability of the same outcome from 0 to 0.01 or from 0.99 to 1.00.
Reference-dependence and Loss aversion
compared with standard application utility theory that the outcomes of risky prospects are evaluated as states of wealth, the observation shows that financial outcomes are almost always described as gains or losses - the effective carriers of utility are gains and losses (the changes), not the state of wealth (own or not own the wealth). giving up is weighted more than getting, by loss aversion - “losses loom larger than gains”.
Framing effects and mental accounting
People sometimes make choices depending on the description and interpretation of decision problems. here “framing” describes both the formulation to which the decision makers are exposed to as well as the interpretation that they construct for themselves. the activities here involve what the decision makers do and what is done to them: their activities of editing and mental accounting on their own and their susceptibility to framing effects that they are exposed to. Mental accounting by Richard Thaler offered a treatment of how people organize decision and outcomes by lumping some together and segregating others. people’s behaviors, violation of invariance, provide a compelling reason to separate descriptive from normative models of choices.
“Choices, Values and Frames” Chapter 1
The study of decisions addresses both normative and
descriptive questions. The normative analysis is concerned with the nature of rationality and the logic of decision making. The descriptive analysis, in contrast, is concerned with people’s beliefs and preferences as they are, not as they should be. The tension between normative and descriptive considerations characterizes much of the study of judgment and choice.
Analyses of decision making commonly distinguish risky and riskless choices. Risky ones can be about gambles. A typical riskless decision concerns about transactions or trades.
a preference for a sure outcome over a gamble that has higher or equal expectation is called risk aversion, and the rejection of a sure thing in favor of a gamble of lower or equal expectation is called risk seeking.
in a gamble, the expected value of an item is not a linear function of the probability of winning this item. i.e. an increase from 0% to 5% has a larger effect than the one from 35% to 40%. these considerations suggest a category-boundary effect. A change from impossibility to possibility or from possibility to certainty has a bigger impact than a comparable change in the middle of
the scale. i.e. Insurance should appear more
attractive when it is framed as the elimination of risk than when it is described as a reduction of risk partially.
In prospect theory, the pseudocertainty effect is the tendency for people to perceive an outcome as certain while it is actually uncertain in multi-stage decision making. The evaluation of the certainty of the outcome in a previous stage of decisions is disregarded when selecting an option in subsequent stages.
Formulation Effects:
e.g. Surgery, unlike radiation therapy, entails a risk of death during treatment. As a consequence, the surgery option was relatively less attractive when the statistics of treatment outcomes were described in terms of mortality rather than in terms of survival.
Formulation effects can occur fortuitously, without anyone being aware of the impact of the frame on the ultimate decision. They can also be exploited deliberately to manipulate the relative attractiveness of
options.
The evaluation of outcomes is susceptible to formulation effects because of the nonlinearity of the value function and the tendency of people to evaluate options in relation to the reference point that is suggested or implied by the statement of the problem.
in order to evaluate a multiattribute option, a person sets
up a mental account that specifies the advantages and the disadvantages associated with the option, relative to a multiattribute reference state. The overall value of an option is given by the balance of its advantages and its
disadvantages in relation to the reference state. Thus, an option is acceptable if the value of its advantages exceeds the value of its disadvantages.
in a situation when you find you lost a 10-USD ticket or you lost 10 dollar right before you want to watch a 10USD film. most people are unwilling to buy another ticket but still will go to see the movie. Reason: Going to the theater is normally viewed as a transaction in which the cost of the ticket is exchanged for the experience of seeing the play. Buying a second ticket increases the cost of seeing the play to a level that
many respondents apparently find unacceptable. In contrast, the loss of the cash is not posted to the account of the play, and it affects the purchase of
a ticket only by making the individual feel slightly less affluent.
Regret, frustration, and self-satisfaction can also be affected by framing.
The satisfaction of saving $5 on a $15 item can be marred if the consumer discovers that she
would not have exerted the same effort to save $10 on a $200 purchase. We do not wish to recommend that any two decision problems that have the same primary consequences should be resolved in the same way. We
propose, however, that systematic examination of alternative framings offers a useful reflective device that can help decision makers assess the values that should be attached to the primary and secondary consequences of their choices.
Losses and costs
Many decision problems take the form of a choice between retaining the status quo and accepting an alternative to it, which is advantageous in some respects and disadvantageous in others. The analysis of value that
was applied earlier to unidimensional risky prospects can be extended to this case by assuming that the status quo defines the reference level for all attributes. The advantages of alternative options will then be evaluated as gains and their disadvantages as losses. Because losses loom larger than gains, the decision maker will be biased in favor of retaining the status quo.
Thaler (1980) coined the term “endowment effect” to describe the reluctance of people to part from assets that belong to their endowment.
When it is more painful to give up an asset than it is pleasurable to obtain it, buying prices will be significantly lower than selling prices. That is, the highest price that an individual will pay to acquire an asset will be smaller
than the minimal compensation that would induce the same individual to give up that asset, once acquired.
In general, loss aversion favors stability over change. the instability of preferences produces a preference for stability. In addition to favoring stability over change, the
combination of adaptation and loss aversion provides limited protection against regret and envy by reducing the attractiveness of foregone alternatives and of others’ endowments.
Thaler’s dead-loss effect:
a man who develops tennis elbow soon after paying the membership fee in a tennis club and continues to play in agony to avoid wasting his investment. Playing in pain, we suggest, maintains the evaluation of the membership
fee as a cost. If the individual were to stop playing, he would be forced to recognize the fee as a dead loss, which may be more aversive than playing in pain.
The concepts of utility and value are commonly used in two distinct senses: (a) experience value, the degree of pleasure or pain, satisfaction or anguish in the actual experience of an outcome; and (b) decision value, the
contribution of an anticipated outcome to the overall attractiveness or aversiveness of an option in a choice. The distinction is rarely explicit in decision theory because it is tacitly assumed that decision values and
experience values coincide.
The assumption that decision values and
experience values coincide is part of the conception of
an idealized decision maker who is able to predict future experiences with perfect accuracy and evaluate options accordingly. For ordinary decision makers, however, the correspondence of decision values between experience values is far from perfect (March, 1978). Some factors that affect experience are not easily anticipated, and some factors that affect decisions do not have a comparable impact on the experience of outcomes.
In contrast to the large amount of research on decision making, there has been relatively little systematic exploration of the psychophysics that relate hedonic experience to objective states. The most basic problem of hedonic psychophysics is the determination of the level of adaptation or aspiration that separates positive from negative outcomes. The hedonic reference point is largely determined by the objective status quo, but it is
also affected by expectations and social comparisons.
An objective improvement can be experienced as a loss, for example, when an employee receives a smaller raise than everyone else in the office. The experience of pleasure or pain associated with a change of state is also critically dependent on the dynamics of hedonic adaptation. Brickman & Campbell’s (1971) concept of the hedonic treadmill suggests the radical hypothesis that rapid adaptation will cause the effects of any objective
improvement to be short-lived.
The common mismatch of decision values and
experience values introduces an additional element of uncertainty in many decision problems.
The prevalence of framing effects and violations of invariance further complicates the relation between decision values and experience values. The framing of outcomes often induces decision values that have no
counterpart in actual experience. In other cases, however, the framing of decisions affects not only decision but experience as well. For example, the framing of an expenditure as an uncompensated loss or as the price of insurance can probably influence the
experience of that outcome. In such cases, the evaluation of outcomes in the context of decisions not only anticipates experiences but also molds it.
“choices, values and frames” chapter 16: this chapter provides some cases of prospect theory in wild.
Why equity premium is high than bonds?
In Thaler’s theory, investors are not averse to the variability of returns; they are averse to loss (the chance that returns are negative). Because annual stock returns are negative much more frequently than annual bond returns are, loss-averse investors will demand a large equity premium to compensate them for the much higher chance of losing money in a year.
Saving and consumption - insensitivity to bad news:
In the standard theory, if next year’s wage is surprisingly good, then the teachers should spend more now,
and if next year’s wage is disappointingly low, the teachers should cut back on their spending now. In fact, the teachers in Shea’s study did spend more when their future wages were expected to rise, but they did not cut
back when their future wages were cut. – this can be explain by: the marginal utility of consuming just enough to reach the reference point is always strictly larger than the marginal utility from exceeding it. if people are consuming below their reference point, the marginal utility of consumption rises as they get closer to it.
with bad news that their wages next year will be cut short the teachers still may not cut their current consumption at all. Consumption is “sticky downward” for two reasons: (1) Because they are loss averse, cutting current consumption means they will consume below their reference point this year, which feels awful. (2) Owing to reflection effects, they are willing to gamble that next year’s wages might not be so low; thus, they would rather take a gamble in which they either consume far below their reference point or consume right at it than accept consumption that is modestly below the reference point.
status quo biases to refer to an exaggerated preference for the status quo.
endowment effects: when an individual owns a thing, the prices of selling this thing is generally much larger
than the price he/she paid for this thing in the first place.
default biases: people tend to just go for default option compared to non-default option.
status quo biases, default preference, and endowment effects are consistent with aversion to losses relative to a reference point. Making one option the status quo or default or endowing a person with a good (even hypothetically) seems to establish a reference point people move away from only reluctantly, or if they are paid a large sum.
Racetrack Betting-the favorite long-shot bias: bettor tend to bet on long-shot horses and not on favorite horses. there are a few explanation: 1) a gambler’s fallacious belief that such horses are due for a win 2) even a small chance of losing on favorite is more disappointing than losing on a non-favorite long-shot horses
Racetrack Betting-the-end-of-the-day effect: bettors
tend to shift their bets toward longshots, and away from favorites, later in the racing day. Because the track takes a hefty bite out of each dollar, most bettors are behind by the last race of the day. These bettors really prefer longshots because a small longshot bet can generate a large enough profit to cover their earlier losses, enabling them to break even.
Within a state, lottery ticket sales each week are strongly correlated with the size of the rollover. this can be explained by cumulative prospect theory that there is a high demand for high jackpots and insensitivity toward low probability to win.
Reflection effects – gambling in the domain of a perceived loss – can explain holding losing stocks longer than winners and refusing to sell your house at a loss (disposition effects), insensitivity of consumption to bad income news, and the shift toward longshot betting at the end of a racetrack day.
