Behavioural Economics Overview

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Behavioural economics overview presented at the Malta Association of Risk Management (MARM) Conference of 15 March 2013 by Marie Briguglio

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Behavioural Economics Overview

  1. 1. Behavioural EconomicsAn overviewMarie Briguglio
  2. 2. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  3. 3. Economics...Any aspect of human behaviour that involves the allocation of scarceresources …the study of choiceLike all science, economics develops and applies theories, applies assumptions.The standard, or neo-classical, economic model is the dominantframework for thinking about consumer welfare and consumer choice. FOUNDATIONS
  4. 4. Practical men, who believe themselves to be quiteexempt from any intellectual influences, are usuallythe slaves of some defunct economist.”John Maynard Keynes FOUNDATIONS
  5. 5. ExampleImplicit assumption about how people make decisions1. They perceive a situation.2. They think of possible courses of action3. They calculate which course is in their best interest.4. They take action accordingly STANDARD ECONOMIC MODEL
  6. 6. More specifically •Is a Bayesian Information Processor •With well-defined and stable preferences •Who maximises expected utility •Who applies exponential discounting rules •Who is self-interested (narrowly defined) •Who has preferences over outcomes not changes relative to a reference point •Who has only instrumental tastes for beliefs and information (Rabin: The “Dead Parrot” of Economics) In short... Individuals are assumed to be like computers Can effortlessly process data and compute their optimal choice STANDARD ECONOMIC MODEL
  7. 7. If we assume decisions are made this way, we can believe in..- Informing decisions to achieve behavioural change- Using economic incentives to achieve behavioural change- Limiting the scope for government STANDARD ECONOMIC MODEL
  8. 8. Example:How do we assume that people make decisions about savings?They weigh up their consumption in the current and future periods.They use all relevant information in making their savings choices;They choose a level of consumption and saving that maximises theirlifetime utility. STANDARD ECONOMIC MODEL
  9. 9. But we often observe people....Paying for a gym they will never use....Investing in lotteries rather than saving...Leaving credit card bills outstanding ...Taking up smoking...Taking out a mobile phone contract with large upfront payments...Buying cars they cannot afford to maintain...Donating blood...Reacting negatively to performance bonuses…. BEHAVIOURAL ECONOMICS
  10. 10. From initial doubts...1. People are generally rational BUT2. Emotions such as fear, affection, hatred explain mostdepartures from rationality....to the idea of “Satisfising” (Simon)Information consumes the attention of its recipients...to ”heuristics” (Tversky & Kahneman)Rules of thumb that can lead to systematic biases…and behavioural economicsRelaxing the standard economic assumption thateveryone in the economy is rational and selfish.SEM as a special case. BEHAVIOURAL ECONOMICS
  11. 11. Behavioural economics increases the explanatory power ofeconomics by providing it with more realistic psychologicalfoundationsCamerer and Loewenstein 2004 BEHAVIOURAL ECONOMICS
  12. 12. Methodologically Multiple Regression Models Lab Experiments (e.g. Ariely) Field Experiments (e.g. della Vigna) Natural Experiments (Freakonomics) Imaging Studies (e.g. Laibson) BEHAVIOURAL ECONOMICS
  13. 13. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  14. 14. Loss aversionThe phenomenon that people dislike losses more than theylike gains. LOSS AVERSION
  15. 15. The endowment effectoccurs when a person’s preferences depend upon what theyalready possess.implies that a person’s preferences depend upon a certainreference point, perhaps determined by the person’spossessions. ENDOWMENT EFFECT
  16. 16. Kahneman and Tversky (1979) PROSPECT THEORYembodies both The endowment effect Loss aversionis more complex than utility theoryhas sharp implications for how markets functionIs useful when prospects (most) are mixed eg. starting a company running for elections PROSPECT THEORY
  17. 17. PROSPECT THEORY
  18. 18. Anchoring and adjustment:A process used when forming judgments: we first pick an initial estimate (ananchor), then adjust up or down as necessary.The estimate does not have to be related to the good.Nor does the anchor have to be consciously chosen by the consumer. ANCHORING AND ADJUSTMENT
  19. 19. Choice paradoxAlthough increased choice is perceived as desirable, in somecircumstances, the provision of choice either inhibits decisionmakers’ likelihood to make a choice or detrimentally affectstheir experienced well-being after the choice is made…. CHOICE PARADOX
  20. 20. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  21. 21. Gambler’s fallacyMistakenly believing two outcomes are dependent is the gambler’sfallacy. GAMBLER’S FALLACY
  22. 22. AvailabilityThe availability heuristic refers to the assessment ofprobability of an event by reference to its availability AVAILABILITY
  23. 23. Framing effectsPeople’s choices are often affected by irrelevantfactors of presentation FRAMING EFFECTS
  24. 24. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  25. 25. Time InconsistencyOne’s behavior is time consistent if their preferences over twooptions do not change just because time has passed.The standard model of exponential discounting fails to capture themanner in which people’s preferences appear to change over time. TIME INCONSISTENCY
  26. 26. Preferences over ProfilesPeople might also have preferences over shapes of utilityprofiles.They might prefer increasing profiles, and/or like to end ona high note. PREFERENCES OVER PROFILES
  27. 27. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  28. 28. Strategic interactions Limited strategic thinking Altruism – pure or impure Envy Fairness Betrayal aversion Reciprocity Trust Peer effects Group Processes
  29. 29. Successful investing is anticipating the anticipationsof others.John Maynard Keynes STRATEGIC INTERACTION
  30. 30. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  31. 31. Behavioural Economics hasfound its way to the heart ofgovernmentFT 2009. INTERVENTION
  32. 32. Example of problems…Savings too low to fund retirementObesity rates and chronic illness levelsConsumption patterns unsustainable….ripe for BE solutions simplified interventions changing “default options” mandating “cooling off periods” application of “nudges” “choice architecture” INTERVENTION
  33. 33. All errors which he is likely to commit against advice andwarning, are far outweighed by the evil of allowing others toconstrain him to what they deem his good.JS MillIt is impossible not to meddle. Given that we can’t avoidmeddling, let’s meddle in a good way.R Thaler. INTERVENTION
  34. 34. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  35. 35. Its not a case of: Read this book and then youll thinkdifferently. Ive written this book, and I dont thinkdifferently.Daniel Kahneman
  36. 36. Examples of empowering self- Avoiding decisions when S2 is depleted- Committing self to reach goals- Choosing the right peer groups- Changing default options- Availability beats cognition
  37. 37. The Automatic Millionaire: #1 selling business book of 2004Make savings automatic so that you don’t notice it (payrolldeductions, automatic withdraws from checking, mortgagepayment, etc.) PRE COMMITMENT
  38. 38. 1. Background2. How we really make choices3. How we handle risk4. Decisions about the future5. Choice and other people6. Influencing decisions7. Making better decisions8. Conclusion
  39. 39. Homo EconomicusIndividuals make choices to maximize utility under constraints they faceIn uncertainty, individuals maximize expected utility by assigningprobabilities to different states of the worldVs Homo SapiensPeople are complicated WAY FORWARD
  40. 40. “We are just at the beginning!” Daniel Kahneman WAY FORWARD
  41. 41. Resources marie.briguglio@um.edu.mt A Course in Behavioral Economics, by Erik Angner (Palgrave Macmillan, 2012). An Introduction to Behavioral Economics: A Guide for Students by Nick Wilkinson (2008). “Nudge” by Thaler and Sunstein; Ariely’s “Predictably Irrational”; "Exotic Preferences" by Lowenstein and Frey and Stutzer’s economics and psychology. Thaler, Richard and Cass Sunstein. Nudge: Improving Decisions about Health, Wealth and Happiness. New Haven: Yale University Press, 2008. Behavioural Economics YOUTUBE CHANNEL via www.mariebriguglio.comDue acknowledgement to Liam Delaney and Russell James for some of the slide contents.

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