L10 - Behavioural Economics

Question 1

How is Behavioural Economics defined?

Answer 1

“Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications” (International Encyclopedia of the Social and Behavioral Sciences)

Applied behavioral sciences study human behavior –> Do people act ‘rationally’? Deviations consistent across time and populations

Rationality is important from a micro policy angle

Question 2

What is the standard approach when looking at consumer choice in economic models?

Answer 2

Standard approach: for any level of information, income andprices, consumer behavior is determined by consumers’ preferences

• Consumers suffer no cognitive limitations, and no systematic bias

Consumer policies should focus on providing accurate information (or education and advice) ot ‘educate, enable, encourage and empower consumers

• Regulation, subsidies, taxes should be used with caution

Question 3

What ‘irrelevant’ factors are ignored by standard economic theory when looking at consumer behaviour?

Answer 3

1. Small changes can make big differences
2. Policies run against human nature may be ineffective
3. Behavioural biases may be exploited by firms - should we stop this?
4. Behavioural biases may be used by governments (e.g. nudges)
5. Behaviourally Inspired Policies or Behavioural Public Policies
   
   1. Cost-effective –> changing one line in a tax letter is cheap but could lead to millions more in tax revenue
   2. Liberty preserving (freedom of choice is not affected)
   3. Widely supported

Question 4

What are irrelevant biases?

Answer 4

• Availability Bias
• Status Quo bias
• Sunk Cost Fallacy
• Endowment Effect
• Choice Overload

Question 5

What is the Availability Bias?

Answer 5

• consumers are sensitive to perceived availability, or ease of retrieval (e.g. time limited offers)
• therefore companies exploit this my charging a higher price originally then offer the actual price as a limited time offer

Question 6

What is the Status Quo bias?

Answer 6

consumers consider deviations from reference points as a loss (e.g. the preferred good)

Question 7

What is the Sunk Cost Fallacy?

Answer 7

consumers cannot disregard expenditures that have already occurred (e.g. ski on a rainy day because of a prepaid lift ticket)

Question 8

What is the Endowment Effect?

Answer 8

• consumers value more the goods if they feel entitled to them, or engaged with
• Consumer tend to value (and pay) more for an item in one’s possession (feel attached to it so give it an artifically high value)
  
  • Example - Richard Thaler’s experiment: Econ student at Cornell University in a market
    
    • on alternating seats were given a Cornell coffe mug or the chance of buying it
  • economic theory predicts that those that dont want the mug will sell them to mug lovers, same average value
  • What was obverserved:
    
    • Mugs NOT traded
    • Median value for seller - $5.25
    • Median value for buyer - $2.5

Question 9

What is Choice Overload?

Answer 9

more information can be worse than less information

• Individuals’ decisions should not be influenced by the introduction of additional options that would not otherwise have been selected
• Evidence suggests that large increases in the number of alternatives can induce individuals to…
  
  • …refrain from selecting an option at all,
  • …prompt individuals to make a sub optimal decision,
  • …induce individuals to be more likely to pick default options.
• These phenomena are often referred to as ‘choice overload’ (or ‘deferred choice’, ‘choice avoidance’ and ‘paradox of choice’)

Question 10

What is Anchoring?

Answer 10

• Consumers make decision by ‘anchoring on an aribtrary reference value in the decision context’
  e. g. the economist.com subscription - $59, print subscription $125, but you could get both for $125, you reference this against the last offer, as you believe you are actually getting a deal even though you have created an aribtrary anchor point with no real meaning, alot of people bought the last option - paid more just because they had a reference point

Question 11

What is Framing?

Answer 11

The framing effect is a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.

• In September 2001, President Bush signed the ‘‘Economic Growth and Tax Relief Reconciliation Act’’, and returned $38 billion to taxpayers in the form of $300–$600 ‘‘tax rebates,’’
• But, only 22% of households planned to spend their rebate check
• Behavioral hypothesis: people may be more (less) likely to spend income framed as a gain or a bonus (returned loss, or a rebate) from a state

Question 12

How does changing the reference point (contextual factor) influence people decisions?

Answer 12

• people make different decisions based on a reference point:
• people bought more french wine when french music was plaiyng and more german wine when german music is playing
• if you could save £50 on a cheap item (£100), or a really expensive item(£1000), more people would do something for the cheaper it as it seems like a relatively bigger saving compared the more expensive item even though the absolute value is identical