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.