Concepts lecture 1 Flashcards
Explain: Economic psychology
the science of economic mental life and behaviour
Differences economic psychology and behavioural economics
BE is more narrow and looks at judgement/decision making, BE takes a behavioural data/experimental approach.
EP tries to model full mental life of economic thinking, EP uses self-report on hypothetical situations
Differences Economics & psychology (ethics & policy wise)
Ethics: economist don’t allow deceiving participants, whereas psychologist are ok with e.g. not saying the whole truth in order to get reliable results.
Policy: economist are in favour of nudging as it can help people to make better choices whereas psychologists are against as they worry it’s too subconscious.
Explain: Homo economicus (John Stuart Mill, 1836)
economic model of an individual that is: 1. 100% rational. 2. doesn’t show emotions 3. is self-interested 4. maximizes utility 5. capable of learning 6. has stable/consistent preferences.
The model is still respected among economists, but it often fails to predict actual human behaviour as the model doesn’t take human emotions into account.
Explain: expected value & utility
Expected value = outcome’s (monetary) amount x outcome’s probability
Utility = the amount of happiness and/or satisfaction an outcome/option offers. Utility is often considered as subjective value as it differs across people (prospect theory builds on utility).
Explain: prospect theory
Prospect theory splits decisions into 2 phases: 1. editing phase (assigning outcomes a subjective value + translating probabilities into decision weights) 2. choosing the prospect with the highest evaluation.
ASSIGNING SUBJECTIVE VALUES/UTILITY
gains and losses are evaluated differently as people react more strongly on losses than on gains (utility curve is steeper for losses than for gains):
- For gains a concave above reference point, graph slowly becomes stable/flattens due to diminished sensitivity (after a certain point, even more gains aren’t cared for)
- For losses a convex below the reference point, graph thickens towards the middle but keeps declining as we keep caring about losses (explains loss aversion)
TRANSLATING PROBABILITIES INTO DECISIONS
People use subjective probability (= believed probability of an outcome, is irrespective of objective probability). This affects decision weights as we tend to put too much weight on low probabilities and too little weight on high probabilities. Might be due to cognitive categories of frequencies (40%-60% feels similar but 0%-15% feels as a big range)
Explain: loss aversion
People are more sensitive to losses than to gains (can be explained by prospect theory)
Explain: endowment effect
The tendency to over-value a possessed object. The things we own are worth more to us than to other people.
Explain: status-quo effect
The tendency to prefer the current state of affairs, even when the current situation isn’t in one’s best interest as one doesn’t want to lose what he/she has now.
Explain: framing
highlighting different features of a decision context that can influence one’s decision, but doesn’t actually change the context.
Explain: Intertemporal choice
Choices between outcomes that differ in their timing, quality and quantity. Usually has a “smaller sooner” and a “lager later” option.
Explain: delay (or temporal) discounting & hyperbolic discounting
People tend to value immediate rewards more than larger delayed rewards (related to intertemporal choice). This is because of uncertainty about what the future might look like.
Hyperbolic discounting refers to the fact that the human discounting function is too extreme.
How can hyperbolic/delay (or temporal) discounting be diminished? Give 3 ways
- Common difference effect: adding a delay to both outcomes of the intertemporal choice ($100 in one year or $110 in 2 years).
- Subadditive discounting: adding a higher discounting rate over shorter intervals by making the ‘larger later’ option bigger ($100 now or $133 in 3 years)
- Magnitude effect: people have a lower delay. discounting rate for larger amounts –> thus make the amounts bigger ($1000 now or $1100 in 1 year). Might be because of (proportionally) higher waiting costs for smaller amounts (and effort reduces amount of gain).
Explain: common difference effect, subadditive discounting and magnitude effect
- Common difference effect: adding a delay to both outcomes of a intertemporal choice ($100 in one year or $110 in 2 years).
- Subadditive discounting: adding a higher discounting rate over shorter intervals by making the ‘larger later’ option bigger ($100 now or $133 in 3 years)
- Magnitude effect: people have a lower delay. discounting rate for larger amounts –> thus make the amounts bigger ($1000 now or $1100 in 1 year). Might be because of (proportionally) higher waiting costs for smaller amounts (and effort reduces amount of gain).
Explain: bounded rationality
Humans are rational creatures with capabilities like intelligence/rational but there are some limitations (boundaries) to their rationality like context, environment, uncertainty & satisficing.
