Lesson 7 Flashcards
1.1 Explain the premise of behavioral economics (5 points)
Subfield of economics that draws on the psychological, social and cultural foundations of human decision making.
Premise is that we are not always self interested, benefit maximizing and costs-minimizing individuals with stable preferences.
Most of our choices are not the result of careful deliberation. We are influences by memory, automatically generated affect and salient information in the environment.
We tend to resist change and are poor predicters of future behaviour.
Finally we are social and have social preferences such as trust, reciprocity, and fairness. We are susceptible to social norms and a need for self consistency.
1.2 Outline the basic premise of rational choice theory
Assumes that individuals have stable preferences and engage in maximizing behaviour.
Decisions are the result of careful weighing of costs and benefits and are informed by existing preferences
1.3 Outline the basic premise of prospect theory
Shows how we decide between alternatives that involve risk and uncertainty.
We make decisions based on a consideration of changes in values from a reference point rather than on absolute values.
This theory suggests we are risk averse and we dislike losses more than we like gains. Willingness to take a risk is influence by the framing of the option
1.4 Explain how reference dependence influences our perceptions of value among decision choices
In prospect theory the reference is the benchmark.
We ask comparison questions and classify gains and losses.
1.5 Explain the premise of bounded rationality (3)
The premise is that decision makers are working under 3 constraints:
1) Only limited information regarding alternatives is available
2) The human mind has a limited capacity to evaluate and process the information available.
3) Only a limited amount of time is available for decision making.
Therefore even if we intend to make rational choices we end up making satisficing choices
1.6 Explain how the nature of the feedback that we receive contributes to bounded rationality
Good information, experience and prompt feedback are key factors that enable individuals to make good decisions.
They can be hard to obtain though.
Feedback is often limited to broad based information which includes the economic costs of unhealthy behaviour.
Personal feedback of our own health decisions are often delayed and not reflected in decision making.
1.7 Explain how loss aversion can influence behaviour
Loss looms larger than gains. Twice as large generally.
Loss aversion has been used to explain the Endowment effect bias
1.7 Explain the Endowment effect bias
Occurs when we value what we own regardless of its objective market value. Especially goods that wouldn’t be normally bought or sold at market
1.7 Explain the sunk cost fallacy bias
We continue a behaviour or endeavor as a result of previously invested resources rather than current evaluation of it as beneficial.
1.8 Explain how mental accounting can influence behaviour
We think of the value in relative rather than absolute terms.
We treat money differently based on origin and intended use rather than as a truly fungible asset.
We frame or categorize assets as belonging to current wealth, current income or future income.
For example small windfalls will be treated as current income to be spent and larger windfalls are considered wealth.
1.9 Outline the basic premise of the dual system theory
System 1 - thinking processes that are intuitive, automatic, experience based and relatively unconscious
System 2 - more reflective, controlled, dynamic and deliberative
2.1 Outline the two most significant differences between the behavioral model of decision making and the standard economic model
The two factors not considered in the standard model are:
1) We may process only the most salient information. Salient information is novel, stands out or seems relevant. What we consider salient may cause us to overlook key information and can be influenced by how the information is presented.
2) There may be a mismatch between intention and action. Even if we understand the full consequences of our actions we may make decisions the favour the present at the expense of the future
2.2 List 6 characteristics and an example of Automatic System thinking
1) Considers what automatically comes to mind
2) Relatively unconscious
3) Effortless
4) Associative
5) Fast
6) Intuitive
eg: speaking in mother tongue, takings a daily commute, desiring cake
2.2 List 6 characteristics and an example of Deliberate System thinking
1) Considers a broad set of relevant factors
2) Controlled
3) Effortful
4) Based on reasoning/analysis
5) reflective
6) Slow
eg: learning a foreign language, planning an unfamiliar journey, counting calories
2.3 Explain why we tend to rely on automatic rather than deliberative thingking
Deliberative thinking requires self control, is cognitively taxing, and can be exhausting.
Or ability to engage with it is usually limited and when we are under cognitive strain it’s even worse.
On automatic mode thinking is fast and effortless
2.4 Differentiate between framing the way choices are described and framing as part of decision making
The term frame applies to decision making at two levels:
1) Description and presentation of choices to the decision maker
2) Interpretation and mental editing - what the decision maker does. The mental models that we bring to the problem influence how we pay attention and interpret what we percieve
2.5 Contrast the terms heuristics and cognitive biases
Heuristics are commonly defined as cognitive shortcuts or rules of thumb.
Cognitive biases are systematic errors in thinking that we may be left with when we make decisions.
A cognitive bias is a “systematic” error, in the sense that a judgment deviates from what would be considered desirable from the perspective of accepted norms or correct in terms of formal logic.
3.1 List 8 Heuristics
1) Affect
2) Anchoring
3) Availability
4) recognition
5) representativeness
6) 1/N
7) scarcity
8) take the best
3.1 Define and provide an example of the heuristic:Affect
A reliance on good or bad feelings experienced in relation to a stimulus.
More pronounced when we have little time or resources to reflect.
For example “lung cancer” produces an affect of dread.
3.1 Define and provide an example of the heuristic: Anchoring
Exposure to a number serves as a reference point influencing subsequent judgements about value.
For example the price of the first house shown by a real estate agent may serve as an anchor and influence perceptions of subsequent houses
3.1 Define and provide an example of the heuristic: Availability
We make judgements about the likelihood of an event based on how easily an example comes to mind.
For example as investors we may judge the quality of an investment based on information that was recently in the news. ignoring other relevant facts.
3.1 Define and provide an example of the heuristic: recognition
Recognition is an easily accessible cue that simplifies decision making and indicates that sometimes less knowledge can lead to more accurate inferences.
For example judging which is the larger of two cities based on our recognition of the city name.
3.1 Define and provide an example of the heuristic: Representativeness
We judge the probability that thing A belongs to class B by looking at how much A resembles B.
For example,
consider the following problem: Bob is an opera fan who enjoys touring art museums when on holidays. Growing up, he enjoyed playing chess with family members and friends.
Which situation is more likely?
- Bob plays trumpet for a major symphony orchestra.
- Bob is a farmer.
A large proportion of us will choose the first option in the above problem, because Bob’s description matches the stereotype we may hold about classical musicians rather than farmers.
When we use this heuristic, we neglect information about the general probability of the second option occurring.
In reality, the likelihood of Bob being a farmer is far greater, because farmers make up a much larger proportion of the population.
3.1 Define and provide an example of the heuristic: 1/N
Assigns equal weight to all cues or alternatives
Often we hedge money in investments by allocating equal amounts to different options. This is a form of naïve allocation of resources
3.1 Define and provide an example of the heuristic: Scarcity
When an object is less readily available we perceive it as more valuable.
For example limited edition products
3.1 Define and provide an example of the heuristic: take-the-best
One decision making rule. Judges based on a single good reason to discriminate between options.
For example, single issue voters.
3.2 Explain the impact of confirmation bias on judgement and decision making
We automatically interpret information if a way that will support our prior beliefs.
It contributes to overconfidence in personal beliefs.
We may fail to recognize that we don’t know what we claim to know and fail to learn from new information
3.3 Explain the impact of anchoring bias on judgement and decision making
Sometimes the anchor is obvious and appropriate but sometimes it is inappropriate.
Because this is part of automatic thinking the first thing that might help with the choice is grabbed onto even if it actually has no influence on the decision.
e.g. purchase quantity limits can increase purchase quantities
3.4 Explain how present bias can create an intention - action divide
We may overweight the present relative to the future in a way that results in inconsistencies over time. We tend to weigh current costs more heavily than future benefits
3.5 Explain the concept of the “peanuts effect” bias
We don’t consider the consequences of small dollar transactions because we view small amounts of money as peanuts
3.6 Explain the concept of the “money illusion” bias
We prefer things that are high in numerical terms even if net they aren’t the best
For example preferring a 6% raise when there’s 4% inflation over a 3% raise with no inflation
4.1 Explain the significance of intertemporal choice for savings behaviour
The study of how we make choices about what and how much to do at various points in time.
Choices at one time can influence choices at another and by the relative weight we assign to payoffs at different points in time.
Most choices require decision makers to trade off costs and benefits at different times
4.1 Explain the significance of the dual choice model for savings behaviour
Inconsistency between the patient long run self and the myopic short run self.
Practically oriented research tries to make us feel more connected to our future selves
4.2 Explain the significance of present bias to temporal discounting theories
In time discounting theories we weigh present events more heavily. This discounting is not linear and if rewards are very distant in time the cease to be valuable.
4.3 Explain how diversification bias and (hot-cold) empathy gap can contribute to time inconsistency in judgement and decision making
Time inconsistency occurs when our present self fails to predict the preferences of our future self.
The inability to appreciate fully the effect of emotional and physiological states on decision making is known as the (hot-cold) empathy gap.
4.4 Explain the significance of forecasting and memory to judgement and decision making
When we make plans for the future we are often too optimistic.
Similarly when we try to predict how we will feel in the future we overestimate the intensity of our own emotions.
5.1 Describe the underlying premise of the social dimension of behavioural economics
Does not assume that humans make choices in isolation or to serve their own interest.
Aside from cognitive and affective (emotional) dimensions, an important area of behavioral economics also considers social forces, in that decisions are made by individuals who are shaped by—and embedded in—social environments.
5.2 Explain the significance of trust for judgement and decision making
Trust is one of the explanations for discrepancies between actual behaviour and self interested models. Trust can reflect risk preferences but can also reflect social preferences. We take greater risks when faces with a given probability of risk vs the same probability of being cheated.
`5.2 Explain the significance of dishonesty for judgement and decision making
While in standard economics dishonesty can be seen as a byproduct of self interested motives in relationships its seen as a violation of trust.
Dishonesty is the product of situation’s as well as both internal and external reward mechanisms which often involve self deception to appear less dishonest.
5.3 Explain the significance of fairness and reciprocity for judgement and decision making.
Resistance to unfair outcomes is call inequity aversion.
This can be disadvantageous since we are willing to forgo a gain in order to prevent another person from receiving a superior reward.
Fairness is related to a human desire for reciprocity. This can be beneficial, a gift begets a greater gift, or lead to putative responses to negative actions.
5.4 Explain the significance of social norms for judgement and decision making
Social norms signal appropriate behaviour and are an important component of identity economics.
There are norms for exchanges and economic activities that influence economic decisions.
5.5 Explain the role of consistency and commitment for judgement and decision making
We are susceptible to feedback about social norms as part of our desire to maintain a positive view of ourselves as people.
When an outcome threatens this rather than change our behaviour we often change our attitudes or beliefs to reduce cognitive dissonance.
5.6 Explain the significance of cognitive dissonance in behavioural economics
The uncomfortable feeling between two simultaneous and conflicting ideas or feelings.
For example behaviour inconsistent with who we want ourselves to be.
We are motivated to resolve this by changing our beliefs as this is easier than changing our actions.
