Behavioural Economics II

Question 1

What is behavioural economics?

Answer 1

The economics of real humans. It provides a way of bringing economics and psychology closer together.

Question 2

Is the assumption of maximising utility right?

Answer 2

consumers do not always do stuff that maxmise their utility, they tend to do activities that present a negative internality on oneself.

Question 3

What is the problem of dealing with biases in decision making?

Answer 3

It really depends on the poor decision, because if people are eating a little bit of unhealthy food, do you stop this.

Question 4

In general equilibrium what did we assume about consumers choices?

Answer 4

consumer sovergithy -the consumer has some controlling power over goods that are produced, and the idea that the consumer is the best judge of their own welfare.

Question 5

Answer 5

Question 6

Now we are going to draw an edgeworth box with possibility of behavioural biases, which will yield a pareto inefficient allocation. Firstly what did the edgeworth box in week the general equilibrium show?

Answer 6

It modelled decision utility which generates consumption bundles.

Question 7

Now we are going to draw an edgeworth box with possibility of behavioural biases, which will yield a pareto inefficient allocation. Suppose there are 2 individuals, and 2 goods and each individual has endownments of each good, so now show the denotation the 2 goods, but not showing whether its individual A or B so hint you will write J E {A,B}
Then show that individuals can have endownments of both goods, but they have a share of them and use j.

Answer 7

Question 8

How we going denote utility function for the decision utility and experience utility ( Also use J)

Answer 8

Question 9

If consumer A is behavioural how will we show this?

Answer 9

Question 10

Do we know a priori which in which direction a market will be distorted by behavioural biases?

Answer 10

No we cannot say what the implied distortion might be (there may be things that are good 4u in experience utility sense that you don’t buy or could be the opposite)

Question 11

Now draw a basic edgeworth box where individual A and B trade, through the prices determined in equilibrium which clear the market and are trading at a pareto efficient point ( this is showing decision utility). Show the original endownments where individual A as more of good 1 then individual b and individual b has more of good 2 than individual A>

Answer 11

Question 12

Now suppose there is a diveregence between decision utility and experience utility, can we make a pareto improvement now?

Answer 12

Its possible now if we use experience utility from equilibrium point using decision utility to move in a north west direction ( according to experience utility) and generate a pareto efficient improvement. There the old equilibrium point is no longer pareto efficient, as its based on decision utility.

Question 13

How do we know that the old equilibrium was not pareto efficient?

Answer 13

The old point there is now pareto inefficient because pareto improvement is possible, we don’t need both agents better off! we only need 1 to be bettter off ( A) and B to not be worse off ( B indifference curve stays the same). SO THEREFORE EQUILBRIUM PRICES AND CONSUMPTION DECISIONS BASED ON DECISION UTLITY ARE NO LONGER PARETO EFFICIENT.

Question 14

What have we lost because of the divergence between experience and decision utility?

Answer 14

The first fundamental welfare thereom, as markets work on the basis of decision utility but we are measuring individuals welfare based on experience utility.

Question 15

Does the divergence between experience and decision ultiy as shown on edgeworth box have equity implications

Answer 15

If there are groups of people ( individual A) who are making bad decisions means that individual A is not as well off as she expects given decision utility.

Question 16

What is a culumative disturbtion function and what is uniform distrubtion?

Answer 16

Are used to calculate area under the curve to the left from the point of interest
Uniform distrubtion = every result is equally likely.

Question 17

Now we are going to create a model to explore government intervention, suppose there are 2 goods food (good 1) and gym membership(good 2)
food is normalise at one and gym membership costs p. gym membership is a discrete good, so you either by or not ( we are going to study who buys gym membership with or without behavioural biases, if they do not buy gym membership all their income is spent on food but firstly what are peoples preferences?

Answer 17

If delta = 0 you don’t buy gym membership, if its =1 you buy membership, u is the value of gym membership and x = food.
u is a range of valuations of gym membership in the population

Question 18

What is the budget constraint of consumer who has endowment m of food which they can consume or trade for gym membership? what are we assuming about m

Answer 18

M is large enough so everyone can buy food and a membership.

Question 19

What is the utility of buying a gym membership and what is utltiy of not?
When will you buy a gym membership?

Answer 19

Utility of buying a gym membership = u - p + m ( you get ultity for going but you have to reduce income -p. )
Ultity of not going gym = m ( consume all income on food .
You buy gym membership when your valuation is higher than price.

Question 20

We want to show a cumulative distribution of valuations of gym membership which is what?

Answer 20

G(u) = is tells how many people have a

valuation less than or equal to u

Question 21

What is the demand for gym membership? remember those who buy gym membership have a valuation greater than price, how does it look on graph?What does it mean if price goes up

Answer 21

1 - G(p) ( where G(p) is the proportion who don’t want to go gym whos valuation are less than p. As G(p) is an increasing function, its a downward sloping function ( if price goes up there will be people who go and buy a gym membership, as there will be more people who have a valuation of gym membership less than high p)

Question 22

What are we are going to assume about supply of gym membership?

Answer 22

gym places can be created at mc = c, you can create as much capacity as possible, gyms are homogeneous goods, so we are going to assume betrand compeititon between gyms. So we know that p = mc

Question 23

So what is the market equilibrium of gym membership show this on the diagram?

Answer 23

Gym membership only for those who value the good more than mc ( U>p=c)
Everyone knows their valuation of gym membership so trade can happen and we are at a pareto efficient equilibrium.

Question 24

Now we are going to use this model of gym membership at adapt it a bit with behavioural consumers, suppose that there is a fraction ( greek u called Meuu) that are behavioural and 1-meuu are rational( they know what there u(valuation is), u is ‘true’ experience utility, what are we going to assume behavioural consumers do (HINT 2 TYPES OF CONSUMERS)?

Answer 24

Behavioural consumers are going to misperceive their valuation, where their valuation is.
Their valutation is Bu but experience utltiy is u.

Question 25

Now that we have added behavioural consumers what is the people who buy a gym membership who are rational and what about behavioural consumers What is the demand function?

Answer 25

Demand function is 1 - those who have a behavioural consumers who have valuation less than p/b - rational consumers who have a valuation less than p ( 1- people who don’t go gym)

Question 26

Is the supply side altered with the introduction of behavioural consumers? how does this affect demand function? How will consumption change over the 2 types of behavioural consumers ( the pessmitistc and optimistic) ?

Answer 26

No p = c ( still Bertrand competition), there will either be a over consumption or under consumption now

Question 27

When beta is bigger than one ( e.g. people convinced they will spend lots of time in the gym but reality do not go( hence more gym memberships), how does it look on diagram with price and quantity and what about those who are pessimistic who do not buy the good but should of brought it.

Answer 27

Both red lines are decision utility demand curves

Question 28

How does our model here with behavioural biases with gym membership compare to that off general equilibrium?

Answer 28

in the gym membership model, prices are not distorted by behavioural biases , only consumption decisions, prices are the same no matter how many consumers there are.

Question 29

So what question do we want to answer now after looking at gym membership model?

Answer 29

How do we make a pareto improvement such that those rational consumers are not worse off those who are worse off can become better off. ( we don’t want to touch prices, as it will affect those who are rational)

Question 30

When beta is > 1 who are the people who buy the good who would not buy it if they were not over optimistic ( so regret decision), why might it be interesting from a policy POV?

Answer 30

Those who have a valuation between p/B and p. We might want look at these consumers and see if there is a way we can stop them from buying the good, as they would be better off in terms of experience utility.

Question 31

When beta is < 1 who are the people who do not buy the good who would buy it if they were not pessemtic ( so regret decision), why might it be interesting from a policy POV?

Answer 31

Those who have a valuation between p,p/B.

If they had brought the good, they would be better off in terms of experience utltiy.

Question 32

So what would be an ideal way to get a pareto improvement ?

Answer 32

if we could get to those consumers who are optimistic or pessimstic we can create pareto improvement, as they would be better off buying good at p=c/not buying good. Without changing price

Question 33

Depending on the divergence away from 1 ( no behavioural bias) beta is in either direction? what will happen to maximum ultitarian welfare in comparison to market welfare ( when we let people make on consumption decisions)

Answer 33

There will be a welfare loss as people making decisions based on decision utltiy rather than experience in comparison to the utilitarian welfare function which Beta = 1 no divergence. Its bigger when B is bigger than 1, the more behavioural consumers there are.

Question 34

If there was an omniscient planner who knew everyone’s valuations what would they do so u instead of Bu?

Answer 34

They would ban over optimistic people and pass a law to people who are pessimistic

Question 35

So what are the 2 main government interventions which are realistic ?

Answer 35

devices that act directly on Beta

2) taxes/subsidies which change p( but only if we really think there a lot of pessimistic people so make cheaper)

Question 36

What is libertarian paternalism? ( ACTING ON BEHAVIOURAL BIASES)

Answer 36

you want people to choose for themselves, but want to do it in a paternalistic framework, where people are reminded of the things they might do wrong, once they are reminded, they are on their own

Question 37

What are some other ways of prompting people to change decision making?

Answer 37

1) Getting people to sample a good before buying ( more so decision ultity = experience utltiy)
2) changing defaults ( opt in versus opt out )

Question 38

What else have we beframe decision making?

Answer 38

Nudges e.g. Putting the fruit at eye level counts as a nudge.

Question 39

Answer 39

Question 40

In perfect competition what will producers do to increase profits? how does it compare to our model where firms make 0 profits?

Answer 40

They will increase behavioural biases ( doing a lot of nudging and schemes that entice behavioural biases such as advertising)
As firms in our market make 0 profits, markets might have an incentive to reduce B ( although they might raise C, making gym memberships expensive for everyone.

Question 41

We are now going to look at optimal tax, but why isn’t a tax an optimal thing in comparison to targeting individually at behavioural consumers?

Answer 41

Tax will distort those who didn’t have a behavioural bias and lower their utility, so taxation is the second best way.

Question 42

What should optimal tax always be in our model?

Answer 42

It should a tax that maximises utilitarian welfare, given that people have behavioural biases

Question 43

So again what is optimal solution to deal with welfare loss in society from behavioural consumers?

Answer 43

depends on whether the government can identify the people with a negative and positive bias and tax some and subsidize some. If this isn’t possible then we can set uniform tax/subsidy depending on the fraction of people with each of the bias and/or try to promote an informational campaign to reduce the bias instead of affecting prices.

Question 44

When do we want to tax and when do we want to subsidize people ?

Answer 44

we want to tax when people have a beta > 1 and we want to subsidize when people have a beta < 1

Question 45

If u( meu) was = 1 ( everyone is bias will a tax be an optimal think to do) If meu <1?

Answer 45

A tax will completely offset their bias
Then tax will be less than the tax that completely offsets bias because you would be distorting decisions of rational consumers

Question 46

Why might be focused on disturbtional effects rather than efficiency?

Answer 46

behavioural biases among vulnerable groups, means we might be focused on this, ( e.g. when electricity prices sky high, educated and higher income seem to get better energy supply deals than poorer groups). Thus we might want a welfare function which reflects distrubtion of beta and income. to balance efficiency and equity.

Question 47

What is the paper related to this topic?

Answer 47

Overconfident Consumers in the marketplace ( Grubb,2015)

Question 48

What is the paper about? Overconfident Consumers in the marketplace ( Grubb,2015)?

Answer 48

When people sign contracts they place a value of the future usage of the product or sevice matter e.g. gym membership. Consumers place weightage on how often he/she anticptates going to the gym. In our model we assume consumers are rational. But infact, there is a deviation from desicion and experience utility, where these two utilites are not the same. Consumers are either overoptimistic or overprecision.

Question 49

What do you understand by the term overconfident consumers? Overconfident Consumers in the marketplace ( Grubb,2015)?

Answer 49

This has 2 forms, Overoptimism and Overprecision
Overoptimism - overestimate their own abilities or prospects, either in absolute terms or in comparison to others.
Overprecise- infividuals place overly narrow confidence intervals around forecasts.
These biases can lead to consumers misforcasting their future product usage, hence leading to suboptimal allocations of resources.

Question 50

Give an example of a market where you believe that overconfidence is rife among consumers. Overconfident Consumers in the marketplace ( Grubb,2015)?

Answer 50

Gym membership - there is overoptimism about self control, hence explains why individuals overpay for gym membership that they underutlize. Overoptimism leads consumers to overestimate gym attendance and hence to overweight the membership benefit of avoiding per-visit gym fees.

Question 51

How do you expect overconfidence to affect prices and quantities traded in this market?Overconfident Consumers in the marketplace ( Grubb,2015)? ( firstly lets think about Overprecision?

Answer 51

A consumer who underestimates future usage underestimates the chance of paying marginal fees, and hence understimates the cost of any increases in marginal fees, hence firms have an incentive to inflate this. E.g. lets say you pay a fixed fee for phone contract, and there is extra charges for calling. overconfident consumers underestimate this. Hence firms can put this price as high as they possibly can, as they know consumers will have to pay this price, but not soo high so it deters consumers from coming into the market. This will increase those pessimistic consumers.
So therefore this lowers the price and sales of contracts to benefit firms and harm those of the infra-marginal consumers.

Question 52

How do you expect overconfidence to affect prices and quantities traded in this market?Overconfident Consumers in the marketplace ( Grubb,2015)? ( firstly lets think about Overoptimism?

Answer 52

Here if consumers overstimate the chance of paying marginal fees, they also overestimate the value of any discount to marginal prices, hence firms discount marginal fees. Hence increase quanitities demand.
So therefore this increases the price and sales of contracts to harms firms and benefit those of the infra-marginal consumers.

Question 53

Does overconfidence always reduce societal welfare? Overconfidence Consumers in the marketplace ( Grubb,2015)? ( firstly lets think about Overconfidence?

Answer 53

Overconfidence doesnt always reduce societal welfare, usually overconfidence lowers social welfare, but it can be welfare improving. If distortions due to overconfidence could be welfare improving if the distortions due to overconfidence are countervailing to other distortions in the marketplace. ( so e.g. if there is overprecision and prices really low because of market power, then contract expansion due to overvaluation can increase social welfare, allbeit at consumer expense. )

Question 54

What concept of welfare loss/gain are you applying to answer this?Overconfidence Consumers in the marketplace ( Grubb,2015)?From previous

Answer 54

From previous slide we are referring to consumer surplus and producer surplus.