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Behavioral economics-principles with examples
This document discusses several concepts from behavioral economics including perverse incentives, prospect theory, and the tragedy of the commons. Perverse incentives are incentives that result in unintended negative consequences. Prospect theory suggests that people value gains and losses differently and make decisions based on perceived gains rather than losses. The tragedy of the commons describes how individuals acting in their own self-interest can ultimately deplete a shared limited resource, even when it is clear that it is not in anyone's long-term interest for this to happen. Examples are given for each concept.
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Behavioral economics-principles with examples
- 2. What is it? Itstudies the effects of psychological, social, cognitive and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns and resource allocation It is primarily concerned with the bounds of rationality of economic agents and integrates sightings from psychology and microeconomics theory
- 3. PERVERSE INCENTIVES A perverseincentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequence. “An incentive that produces an adverse consequence due to the actions undertaken to receive the incentive.”
- 4. EXAMPLES Of PERVERSEINCENTIVES In 1902 the governors of the French Indochinese colony of Hanoi were facing a problem with rats overrunning their buildings. Their initial response seemed simple and ingenious; they introduced a one-cent bounty on each rat killed. Each bounty-hunter only needed to show a rattail as evidence of the killing . This led to some industrious folks raising rats on rat farms to collect the bounty, or simply chopping off the rats' tails and releasing them so they could reproduce. The more the government paid to reduce the rat population, the more the rats thrived. Oops! Perverse incentives are incentives that result in unintended negative consequences due to actions people take to receive the incentive They are a common occurrence because decision- makers don't always think things through before acting, often with disastrous results
- 5. •In another well-knownincident, IBM implemented a pay structure that paid their computer programmers by the line for the code they wrote •Their goal was to increase the quality of the code •As a result, the programmers found ways to unnecessarily maximize the line count, increasing their pay and reducing the quality of the code
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- 7. INTRODUCING PARADOX OF VALUE. Thisparadox was proposed by ADAM SMITH in the 1800s as a means understanding the role utility plays in the demand price of a good by differentiating between total utility and marginal utility The problem? Water though a necessity is priced lower than diamonds! Read on……
- 8. •The law ofdiminishing marginal utility is important for resolving this paradox . •According to the law of diminishing marginal utility the price of a commodity is influenced by its marginal utility. •Water provides humans with an enormous amount of total utility as A LOT of wants and needs for A LOT of people •Since water is available in plentiful quantity than diamonds , its marginal utility is lower. •Diamonds, however, are scarce. Because they are harder to find and attain, our marginal utility (additional satisfaction), for adding a diamond to our collection is much higher than someone offering us one more drink of water.
- 9. Example! •Does paying Rs.50,000for a Gucci bag compared to Rs.3000 for a solid pair of shoes make sense? •From a practical and survival standpoint, it certainly doesn't. In order to get around and enable our most basic form of transportation (walking), we need shoes to protect our feet •They are certainly more important and practical than a bag . The price difference comes back to the satisfaction, or marginal utility, we get from purchasing a pair of shoes compared to a Gucci Bag. • If you were in the middle of the jungle and trying to survive, you might pay more for those shoes, but until that happens, most of us will continue to pay more for fashion!
- 10. PROSPECT THEORY It statesthat people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.
- 11. PROSPECT THEORY & FRAMING “Wechoose between descriptions of options. Rather than between the options themselves.”
- 12. IT’S ALL INHOW YOU SPEAK Honestly, what would you prefer? A certain win of $250 A 25% chance of winning $1000 or 75% chance of winning nothing? A certain loss of $750 A 75% chance to loose $1000 and a 25%chance to loose nothing? according to researches it has been concluded that people choose option 1 over option 3 and option 2 over option 4!
- 13. Industries thrive onthis psychology! Banking Insurance Companies on stock exchange
- 14. THE TRAGEDY OFCOMMONS The tragedy of the commons theory assumes that when making decisions, people take the course of action that maximises their own utility. However, if many people seek to do this, the net effect may be to deplete a resource making everyone worse off in the long run
- 15. Common Goods : This means that anyone has access to the good, but that the use of the good by one person reduces the ability of someone else to use it. A classic example of a common good are fish stocks in international waters; no one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for later fishermen are potentially depleted.
- 16. Hardin’s parable involves apasture "open to all." He asks us to imagine the grazing of animals on a common ground. Individuals are motivated to add to their flocks to increase personal wealth. Yet, every animal added to the total degrades the commons a small amount. Although the degradation for each additional animal is small relative to the gain in wealth for the owner, if all owners follow this pattern the commons will ultimately be destroyed..
- 18. GARBAGE INDEX I amnot all that bad, guys!!!! Garbage is dirty, stinky and once it's out of sight — for most of us — it's out of mind. But the truth is, garbage is a good indicator of the economy.
- 19. The Concept Logically, thecorrelation between trash and GDP is that the stronger the economy, the more stuff people buy. And the more people demand, the more waste they produce. Obviously, when they buy new things, they tend to throw out old ones. Simply because if you create things you also have to throw other goods out. It's the circle of life for the economy. Just about everything that gets made, from a half-eaten McDonald’s hamburger to the cover for your Apple iPhone, eventually finds its way to the trash bin.
- 20. •One of themost recent attempts is the "Trash Index," developed by economist Michael McDonough •His index explores the relationship between the gross domestic product and the number of train cars full of trash that are shipped to landfills •When the economy is booming, there are plenty of trains, but when it's in trouble, the flow stops
- 21. The US rankshighest in GDP and waste production, each person producing over 2.5 kilograms of trash per day. Following narrowly behind are large, developed economies like Germany, Japan. Further down the curve further are the emerging economies of Mexico, China, Brazil and India.
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