This document discusses behavioral economics and game theory. It explains that behavioral economics explores irrational human decision-making, bounded rationality, inconsistencies like framing effects, and judgments of fairness. Game theory analyzes strategic interaction using concepts like the prisoner's dilemma, dominant strategies, and Nash equilibria. The prisoner's dilemma shows how rational decisions can lead to suboptimal outcomes. Cooperation is difficult in short-run interactions but strategies like tit-for-tat can promote cooperation in long-run relationships where parties are invested in each other.

1. CHERRY B. LECIAS
BEHAVIORAL ECONOMICS
AND GAME THEORY

2. Big Questions:
 How can economists explain irrational behavior?
 What is the role of risk in decision-making?
 How does game theory explain strategic behavior?

3. Behavioral Economics is the field
of economics that draws on insights
from experimental psychology to
explore how people make economic
decisions.

4. Bounded Rationality proposes
that although decision- makers want
a good outcome, either they aren’t
capable of performing the problem-
solving that traditional theory
assumes, or they aren’t inclined to do
so.

5. Bounded Rationality
Bounded rationality can be explained in
three ways:
1. The information that the individual
uses to make the decision may be
limited or incomplete.
2. The human brain has a limited capacity
to process information.
3. There is often a limited amount of time
in which to make a decision.

6. Behaviors that do not fit assumptions
about fully rational behavior:
1. Inconsistencies in decision- making
2. Judgments about fairness when making
decisions

7. Inconsistencies in Decision- Making:
Framing Effects occur when people change
their answer (or action) depending on how
the question is asked or how the alternatives
are presented.
Priming Effects occur when the ordering of
the questions influences the answers.
Status Quo Bias exists when people want to
maintain their current choices

8. Inconsistencies in Decision- Making:
Loss Aversion occurs when individuals
place more weight on avoiding losses than
on attempting to realize gains.
Intertemporal Decision-Making involves
planning to do something over a period of
time; this decision- making process
requires valuing the present and the
future consistently.

9. Judgments about Fairness:
Proponents of fairness believe in
progressive taxation, whereby the rich
pay a higher tax rate on their income than
those in lower income brackets. Likewise,
some people object to the high pay of
chief executive officers because they
believe there should be an upper limit to
what constitutes fair compensation.

10. The Ultimate Game is an economic
experiment in which two players decide
how to divide sum of money.

11. The Decision Tree for
the Ultimatum Game
The decision tree for the
ultimatum game has four
branches. If Player 1
makes a fair proposal,
Player 2 will accept the
distribution and both
players will earn $500.
However, if Player 1 makes
an unfair proposal, Player
2 may reject the
distribution even though
this decision means
receiving nothing.
Player 1
Player 2 Player 2
Fair proposal Unfair proposal
RejectAccept Accept Reject
($999, $1)
Unfair
distribution:
Player 2 earns
$1. Both players
are better off.
($0, $0)
This outcome
is never
observed.
($500, $500)
Fair distribution:
Player 2 accepts
($0, $0)
Player 2 almost
always chooses to
reject.

12. Preference Reversals
Expected Value is the predicted value of an event.
It is calculated by multiplying each possible
outcome by its respective probability and then
summing all of these amounts.
Preference reversal occurs when risk tolerance is
not consistent.
Positive time preferences indicate that people
prefer to have what they want sooner rather than
later.

13. Preference Reversals
Imagine that you’re on
a game show and could either
win the monetary prize
behind one of three doors or
take a sure thing. Behind the
door number 1 is $1. Behind
door number 2 is $100.
Behind door number 3 is
$1000. There is an equal
chance that you would win
any of these amounts since
you get to choose which door.
Expected Value
1/3($1) + 1/3($100)
+ 1/3($1000)
= $367

14. Risk-averse people prefer a sure thing
over a gamble with a higher expected
value.
Risk –neutral people choose the highest
expected value regardless of the risk.
Risk takers prefer gambles with lower
expected values, and potentially higher
winnings, over a sure thing.

15. Risk aversion: Risk taking Behavior
You have a choice between selecting heads or tails. If
your guess is correct, you earn $2,000. But you earn nothing if
your guess is incorrect. Alternatively, you can simply take $750
without the gamble. You decide to take the $750.
The expected value of a 50/50 outcome worth $2,000
is $1,000. Therefore, the decision to take the sure thing, which
is $250 less, is evidence
of risk aversion.
You have a choice between (a) predicting the roll of a
six- sided die, with a $3,000 prize for a correct answer, or (b)
taking a sure $750. You decide to roll the die.
The expected value of the roll of the die is 1>6 X $3,000, or
$500. Therefore, the $750 sure thing has an expected value
that is $250 more. By rolling the die, you are taking the option
with the lower expected value and also more risk. This indicates
that you are a risk taker.

16. Game Theory is a branch of mathematics
that economists use to analyze the
strategic behavior of decision- makers.

17. Strategic Behavior and the Dominant Strategy
The Prisoner’s Dilemma occurs when
decision makers face incentives that
make it difficult to achieve mutually
beneficial outcomes.

18. Strategic Behavior and the Dominant Strategy
10 years in jail
Walter White
25 years in jail
Jim Pinkman
The Prisoner’s Dilemma
The two suspects know that if they both keep quiet, they’ll spend
only one year in jail. The prisoner’s dilemma occurs because the
decision to testify results in no jail time for the one who testifies
if the other doesn’t testify. However, this outcome means that
both are likely to testify and get 10 years.
10 years in jail goes free
goes free
25 years in jail
1 year in jail
1 year in jail
Keep quietTestify
Testify
Keep quiet

19. Strategic Behavior and the Dominant Strategy
Dominant strategy exists when a player
will always prefer one strategy,
regardless of what his or her opponent
chooses.
Nash equilibrium occurs when decision-
makers cannot, on their own, change their
strategy and make themselves better off.

20. Duopoly and the Prisoner’s Dilemma
$27,000 revenue
AT-Phone
$30,000 revenue
Horizon
The Prisoner’s Dilemma in Duopoly
Each company has a dominant strategy to serve more customers because it
makes the most revenue even if its competitor also expands production. A high level
of production leads to a Nash equilibrium at which both firms make $24,000. By
colluding, AT- Phone and Horizon could agree to a low level of production and increase
their revenue to $27,000 each, but the likelihood of cheating makes this an unstable
equilibrium.
Collusion is an agreement among rival firms that specifies the price each firm
charges and the quantity it produces.
$27,000 revenue
$22,500 revenue
$30,000 revenue
$24,000 revenue
$24,000 revenue
$22,500 revenue
Low production:
300 customers
High production:
400 customers
Low production:
300 customers
High production:
400 customers

21. Advertising and Game Theory
$100 million profit
Coca-Cola
$75 million profit
Pepsi Co
$100 million profit
$150 million profit
$75 million profit
$125 million profit
$125 million profit
$150 million profit
Advertises Does not advertise
Advertises
Does not
advertise
The Prisoner’s Dilemma and Advertising
The two companies each have a dominant strategy to advertise. We can see
this by observing that Coca- Cola and PepsiCo each make $25 million more
profit by choosing to advertise, given the other company’s strategy. As a
result, they both end up in the upper- left box, earning $100 million profit
when they could have each made $125 million profit in the lower- right box if
they had agreed not to advertise.

22. Escaping the Prisoner’s Dilemma in the Long Run
Tit-for-Tat is a long-run strategy that
promotes cooperation among participants
by mimicking the opponent’s most recent
decision with repayment in kind. As the
name implies, a tit- for-tat strategy is
one in which you do whatever your
opponent does. If your opponent breaks
the agreement, you break the agreement
too. If the opponent behaves properly,
then you behave properly too.

23. The prisoner’s dilemma nicely captures why
cooperation is so difficult in the short run. But
most interactions in life occur over the long run.
For example, scam artists and sketchy companies
take advantage of short- run opportunities that
cannot last because relationships in the long run—
with businesses and with people— involve mutual
trust. In long- run relationships, cooperation is
the default because you know that the other side
is invested in the relationship. Under these
circumstances, the tit- for- tat strategy works
well.