Behavioral economics borrows insights from psychology to understand human decision-making. It recognizes that people can be systematically irrational or make biased judgments due to two types of thinking: intuitive/automatic vs reflective/rational. The automatic system is fast but prone to errors, while the reflective system is slower but more accurate. Behavioral economics also acknowledges that people have bounded rationality, willpower, and self-interest due to cognitive limitations. This helps explain puzzles like market bubbles and procrastination that cannot be understood from a traditional economic assumption of perfect rationality.

1. Behavioral and Experimental
Economics

2. What is the ratio of the length to
the width of each table?
Source: Nudge (2008), Thaler and Sunstein

3. The Answer:
The Two Tables are Identical
The legs and orientation facilitate the illusion that the table tops
are different
Source: Nudge (2008), Thaler and Sunstein

4. The Key insight that Behavioral
Economics borrows from Psychology
Normally the human mind works
remarkably well. Examples:
-Recognize people we haven’t
seen in years
- Run down a flight of stairs
- Speak 12 languages
But people can be systematically wrong.
We are prone to biased judgment

5. Recent Examples of Biased Judgment?

6. Recent Examples of Biased Judgment?

7. How can people be simultaneously
so smart and so dumb?
Two types of thinking:
1) Intuitive and Automatic
2) Reflective and Rational

8. The Role of Evolution

9. Competing Brain Systems

10. Two Cognitive Systems
Automatic System Reflective System
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Conscious
Skilled Rule-following
Source: Nudge, Thaler and Sunstein, 2008

11. A Shaky Plane
Automatic: “The Airplane is shaking. I’m going to die”
Reflective: “Planes are safe”

12. Dr. Spock and Captain Kirk

13. Was Adam Smith a behavioral
economist?
The Theory of Moral Sentiments, (1759)
He argued that behavior was determined
by struggle between “passions” and the
“impartial spectator.”

14. What do you see?

15. Context and Accessibility
An ambiguous
stimulus that is
perceived as a
letter in one context
is seen as a
number in another
We “see” the
interpretation that is
most likely in its
context but have no
subjective indication
that it could be seen
differently.

16. Three Dimensions of Bounded
Rationality
 Computational Power
 Willpower
 Self-interest
Unbounded
bounded
Neoclassical
economics
A Continuum
 B.E. 

17. Example: Build a robot to catch a ball
The Optimization Team
Instruments to measure initial distance,
velocity, projection angle, wind speed
and direction, spin, etc.
Program to determine how this
information interacts.
Robot runs to spot where ball predicted
to land and waits

18. Example: Build a robot to catch a ball
The Heuristic Team
Have robot freeze during first ½ second
and make crude estimate of whether the
ball is coming down in front or behind it.
Then run in this direction while fixing its
eye on the ball.
Robot catches the ball running.
Adjust running speed so the angle of gaze
remains constant (a simple heuristic).

19. Bounded Rationality
Unbounded Rationality
Bounded Rationality
 Search for information about alternatives
(spouses) & cues (reason/predictors
when deciding between alternatives).
 full information and optimization
 Search performed in the mind (memory) or
outside of it (e.g., internet, other minds,
etc.) is costly. Thus the ideal of arriving at
the optimal decision is hard to achieve.

20. General Points
Use of simple heuristics not necessarily a
disadvantage (cheap and effective).
Simple heuristics can exploit regularities in the
environment (e.g. a constant angle of gaze
causes collision of player and ball).
Simple heuristics are domain-specific rather
than universal strategies.

21. Bounded Rationality:
Simon’s (1956) scissors metaphor
cognitive limits
structure of the
environment
Simple Heuristic:
fix the angle of
your gaze

22. General Points
Emotions can serve as effective stopping
rules for costly search (e.g., the emotion of
disgust and food avoidance).
Social norms can be seen as fast and frugal
mechanisms dispense with individual cost-
benefit computations.
Imitation can lead to fast learning.

23. Gigerenzer and Selten (2002):
Compared to the beauty of optimization, the
actual proximal mechanisms of humans and
animals resemble the tools of backwoods
mechanic. The pleasing ideal of a universal
calculus may have distracted researchers in
many fields…. However, there is also another
sense of beauty; the aesthetics of simplicity.
There is a sense of wonder in how simplicity
can produce robustness and accuracy in an
overwhelmingly complex world.

24. Bounded Self-interest
Selfish and contentious people will not cohere,
and without coherence, nothing can be
effected. A tribe possessing… a greater
number of courageous, sympathetic and
faithful members, who were always ready to
warn each other of danger, to aid and defend
each other… would spread and be victorious
over other tribes… Thus the social and moral
qualities would tend slowly to advance and be
diffused throughout the world..,
-- Charles Darwin, The Descent of Man (1873)

25. Bounded Self-interest
The Americans… are fond of explaining almost
all the actions of their lives by the principle of
self interest… In this respect I think they
frequently fail to do themselves justice; in the
United States as well as elsewhere people are
some sometimes seen to give way to those
disinterested and spontaneous impulses that
are natural to man; but the Americans seldom
admit that they yield to emotions of this kind.
-- Alexis, de Tocqueville,
Democracy in America (1830)

26. Puzzles and Anomalies
 the equity premium
 stock market bubbles
 U.S. savings rates near zero
 procrastination, drug abuse, obesity, etc.
 Involuntary unemployment
 Incomplete contracts
 Institutional genesis

27. Criticism #1 of Behavioral Economics:
Loss of Parsimony not worth the realism
Realism
Generality & Tractability
Neoclassical
Economics

28. Criticism #2 of Behavioral Economics:
Natural Selection leads to survival of the
rational (“smart money”)

29. Criticism #3 of Behavioral Economics:
The Wisdom of the Crowd
Idiosyncratic Irrationality
cancels out in markets
“It does not matter what
I or you do. It is how
the whole group
behaves.”
– Gary Becker
http://magazine.uchicago.edu/0502/features/economics.shtml

30. Behavioral Economics At the
New Millennium
2001
- Akerlof Wins Nobel Prize in Economics
- Rabin Wins John Bates Clark Award
2002
- Kahneman and Vernon Smith Win
Nobel Prize in Economics
2003
- Boston Federal Reserve Conference

31. Themes from Boston:
1. Because human brains have evolved to solve complex
social problems, people’s behavior tends to change as
their circumstances change, undermining consistency
across time and context; however, this lack of
consistency is not a fault — rather, it is a defining
capacity that enables us to engage in complex social
situations.
2. Although individuals perceive themselves to be unitary
creatures, that impression is largely illusory; the brain
consists of multiple subsystems, and, although the
various subsystems do communicate, the dominant role
shifts across subsystems according to context.

32. Themes from Boston:
3. Unconscious behaviors are the ones that are relatively
predictable; it is consciousness that introduces the
element of unpredictability in human behavior.
4. Given the structure of the human brain, it is unlikely that
humans will behave as if they are consistently
maximizing any single utility function.
5. Neural evidence distinguishes four different kinds of utility
— anticipated, remembered, choice, and experienced.
6. The role of fairness and trust in informal contractual
relations is especially crucial for understanding the limits
to markets and the roles of relational contracts.