ECO 674: Behavioral Economics

Punarjit Roychowdhury
Shiv Nadar University, Delhi NCR
 © Punarjit Roychowdhury
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 Economics is the study of how scarce resources are allocated
given unlimited wants

 The baseline microeconomic model that economists typically

use to study economic problems is the rational choice model

 It tells us how people should allocate their scarce resource to

satisfy their unlimited wants

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 An individual decision problem over two choices x1 and x2
maximizes

𝑚𝑎𝑥 𝑈 (𝑥1 , 𝑥2 )
𝑥1 ,𝑥2

 subject to a constraint

𝑝1 𝑥1 + 𝑝2 𝑥2 ≤ 𝑦

 Where U(.) is the utility from consuming x1 and x2, and p1 and
p2 are the price of each good and y is the total budget

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 Utility is increasing in x1 and x2
 Preferences are complete and transitive
 Completeness: Consumers can always rank two consumption
bundles – no possible pair of bundles exists for which the consumer
has no preference
 Transitivity: If x is preferred to y, and y is preferred to z, then z
cannot be preferred to x
 Utility encodes peoples choices as a real number that
corresponds to each possible combination of x1 and x2

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 The utility maximization problem can be solved graphically

x2

x2 *

U  U  x1*, x2 *
U  U  x1*, x2 *

U  U  x1*, x2 *
x2   y  p1 x1  p2

x1 * x1
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 Otherwise, calculus gives the solution as:

𝜕
𝑈 (𝑥1 ∗, 𝑥2 ∗) 𝑝
𝜕𝑥1 1
=
𝜕
𝑈 (𝑥1 ∗, 𝑥2 ∗) 𝑝2
𝜕𝑥2

 Where -𝑝1 Τ𝑝2 is the slope of the budget constraint, and the left
hand side is the slope of the indifference curve

 We could solve the above problem to obtain two demand

functions x1*(p1,p2,y) and x2*(p1,p2,y).

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 Assumption #1: Individuals have well understood and stable
preferences

 Assumption #2: Individuals know the results of her choices

 Assumption #3: People will make the best possible choice and
execute it

 QUESTION: DO INDIVIDUALS REALLY BEHAVE

ACCORDING TO THESE ASSUMPTIONS?
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 Individuals have well understood and stable preferences
 If people have well understood and stable preferences what is
the role of advertising other than to inform customers about the
availability or characteristics of a product?
 Were this the case, advertisements for well known products should
not be terribly effective
 However, marketers of well-known products continue to buy
advertising (often providing ads that yield no new information to
the consumer)
 In fact, not only do consumers have preferences which are not
well understood by themselves and which are unstable, often
they have incomplete preferences because often they come
across unfamiliar goods (or goods that they have never
purchased)

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 Individuals know the results of her choices
 Do they really know how their choice will result in a particular
outcome?
 If you decide to purchase 4 apples, do you know how many contains
worms or have irregularities in taste or texture?
 In fact, consumers seldom face decisions with completely certain
outcomes even for the simplest actions
 Often, consumers do not even know what are the possible
choices available!
 In an restaurant, do you read the full menu to know the full range of
choices that you have?
 Have do done that EVER??

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 People will make the best possible choice and execute it
 Then why do people “regret” after making a choice?
 Students often believe (after the exam) that they should have
studied more
 People often overeat (or have a calorie loaded fries or chocolate
dessert)

 Many of us have regretted for having dated the wrong guy or girl!
(Haven’t we?)
 What’s going wrong? Why aren’t individuals able to choose and
execute the correct strategy? 11
 It turns out people do not always behave in the way they should

 Systematic deviations from the rational model are often

observed in reality (as discussed)

 Such systematic deviations – called behavioral anomalies –

are either difficult to explain through conventional economic
theory or represents outright violation of the standard
economic model

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 In such situations, economists seek to explain individual
behavior by augmenting the rational choice model with
principles developed in the fields of psychology, sociology and
even anthropology

 Such models form the core foundations of Behavioral

Economics

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 “It [Behavioral Economics] is about how people actually
behave...That is, it is about flesh-and-blood humans who often
do not seem to know what they want or how to get things in the
most logical way. The other, more mainstream, economics
perspective focuses on how people should behave.”
- Corr and Plagnol (2018, Behavioral Economics – The Basics, p. 7)

 Behavioral economics focuses on

 Systematic deviations from the best possible decision
 How observed behavior impacts allocation
 The odds and ends of economic theory

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1. Behavioral economics may be used therapeutically to help
people make better decisions
2. Alternatively, retailers and firms may use behavioral
economics strategically to exploit consumer biases and
increase profits
3. Or behavioral economics may just give academics a richer
understanding of the world

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 The rational model is the first theory behavioral economists
apply when describing individual behavior
 Only if the rational model becomes impractical or inaccurate
do we seek alterative explanations

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 In the 1950s, the brilliant polymath Herbert Simon – later a
Nobel laureate in economics – attempted at unifying
psychology and economics

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 In contrast to early economic theorists, Simon advocated
theories of individuals in economics
 These theories were based on algorithms that embodied cognitive
mechanisms
 He acknowledged the “bounded rationality” of humans and
argued that in contrast to the standard rational choice theory
(e.g. utility maximization, profit maximization, etc.) people
always do not (or are not be able to) optimize and as a result
might often fail to behave rationally

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 Specifically, though people might have a desire to find the
optimal decision, they have limits (“bounds”) on their cognitive
abilities, limits on access to information, and perhaps limits on
other necessary resources for making decisions
 E.g. “The beliefs upon which people make their choices are not
unbiased [and hence might represent bounds]. Overconfidence
may not be in the economists' dictionary, but it is a well established
feature of human nature [that impact optimal decision making]”
(Thaler, 2015)

 Because of these bounds, rather than optimize, people seek to

simplify their decision problem
 by narrowing the set of possible choices
 by narrowing the characteristics of outcomes that they might
consider
 by simplifying the relationships between choices and outcomes

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 In other words, instead of optimizing by making the best overall
choice, a (boundedly rational) person makes decision using
some simplified decision framework
 The decision mechanism for boundedly rational individuals
may be termed as heuristic, or a simple general rule that may
be used to approximate the solution to the utility or profit-
maximization problem
 Note:
 The heuristic may result in a close approximation of the true
optimum under some circumstances (see example #1)
 In other circumstances the difference between heuristic and
rational optimum may be substantial (see example #2)

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Example of Boundedly Rational Behavior #1
 Imagine you were in the jungle and you saw a tiger
 What would you do?
 Stop? Pause? Think? Take out an excel spreadsheet and
calculate what are the costs and benefits of running so that your
optimization exercise is flawless?
 Or just create a situation where you run as fast as you can the
moment you see the tiger?
 Thus you just turn your cognition off – you just feel, not think in this
situation; emotions take over and you execute a command
 Basically, instead of optimizing, you make the decision using some
simplified decision framework based on your emotions

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Example of Boundedly Rational Behavior #2
 You and your partner both know the benefits of safe sex
(prevention of STDs, avoiding unwanted pregnancies, etc.)
 However, one night you end up with your partner in a hotel room
 You guys are not carry any kind of protection (and suppose
there are no stores nearby from where you can get one)
 At the moment of temptation, what do you do?
 Stop? Pause? Think about the costs and benefits of unprotected
sex? Do some research for a couple of hours? Recall what you
have been taught in your microecon class? Call up your
microecon prof for advice?
 Or you just give in to your emotions?
 Again, your emotions drive your decisions (which of course may be
far from the rational optimum)

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 “Global rationality, the rationality of neoclassical theory,
assumes that the decision maker has a comprehensive,
consistent utility function, knows all the alternatives that are
available for choice, can compute the expected value of utility
associated with each alternative, and chooses the alternative
that maximizes expected utility. Bounded rationality, a
rationality that is consistent with our knowledge of actual
human choice behavior, assumes that the decision maker must
search for alternatives, has egregiously incomplete and
inaccurate knowledge about the consequences of actions, and
chooses actions that are expected to be satisfactory (attain
targets while satisfying constraints).”
- Simon (1997, p. 17)

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Homo economicus: perfectly rational

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Homo economicus: perfectly rational Homo sapien: boundedly rational

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 Bounded rationality implies the idea that humans take
reasoning shortcuts that may lead to suboptimal decision-
making
 Behavioral economists engage in mapping the decision
shortcuts that agents use in order to help increase the
effectiveness of human decision-making
 One treatment of this idea in terms of policy comes from Cass
Sunstein and Richard Thaler's Nudge

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 The authors discuss the problem of a nutritionist who faces the
problem of making children opt for healthier foods (like fruits)
over less-healthier (french fries/candies) ones
 The authors urges a simple solution: healthier food may be
placed at eye level in order to increase the likelihood that a
children will opt for that choice instead of less healthy option
 Since people are boundedly rational, they are likely to choose the
fruit that is front of them and not look for fries/candies since the
"cognitive cost" of choosing candy is increased
 So the nutritionist might be able to achieve her goal of formulating a
policy that would increase healthier food intake of children

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 Note, putting the fruit at eye level counts as a “nudge”
 Nudges are not mandates, they are ignored by rational agents,
and are apparently "irrelevant“
 Nudges are instruments, in addition to pure incentives (like
taxes), which can be used to influence choices of humans
 While humans respond to both nudges and incentives, rational
agents do not respond to nudges

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“By properly deploying both incentives and nudges, we can
improve our ability to improve people's lives, and help solve
many of society's major problems. And we can do so while still
insisting on everyone's freedom to choose.”
Thaler and Sunstein (2015, p. 8)

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1. Behavioral Model
2. Procedurally Rational Model

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 Seeks to simply describe observed behavior
 It augments a rational model of behavior with some function or
appendage that describes the observed deviations from rational
decision making
 Based on empirical observations and such models can be used to
describe any type of behavior since they are not based on any
particular assumptions about the underlying motivations of the
individual
 For the same reason behavioral models might not be the best tool
for many jobs
 Because the model is observation based, it is only as accurate as the
observations taken; if we change the decision context substantially, the
model might no longer be appropriate
 Ex: If we observe someone repeatedly with two food objects placed in front of
him -- an apple on the left and a lemon on the right -- choosing an apple, one
behavioral model might suggest that the person always chooses the object on
the left. However, if we reverse the ordering of the fruits, we would be
disappointed if the individual were actually choosing the object that delivered
a preferred taste
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 A person is procedurally rational if his or her decision is the
result of logical deliberation
 This deliberation might include misperceptions or other
constraints, but the process by which the decision is arrived at
itself is reasoned
 Thus, a procedural rational model attempts to provide a
reasoned decision mechanism that might not always arrive at
the correct choice owing to misperceptions, limits on cognitive
ability, or other constraints on decision resources
 Given the decision motivations are properly modeled, a
procedurally rational may be highly predictive of general
behavior over vastly different contexts

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 Throughout the history of economics, the vast majority of
empirical research has employed secondary data sets to
explore the relationships by theory
 Using such data, it is not always possible to examine the effect
of a particular variables on economic decisions of individuals
by controlling other variables that independently influence
decisions
 In other words, estimating causal effects using secondary data is not
always easy
 As such, many of the most prominent behavioral economics
concepts is tested employing experimental data instead of
secondary data

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 Economics experiments offer the researcher tremendous
control to alter the variables that independently influence
decisions
 Typically, an experiment brings a large number of participants
into a lab, where they make decisions that will be rewarded
monetarily or substantially, with the reward structure designed
by the researcher
 The reward system is changed between various treatment
groups in order to test some underlying theory of behavior

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 For instance, a researcher could run experiments on a
random sample of participants and determine if they were
willing to purchase good 1 with p₁=Re. 1, p₂=Re.1 after
having endowed the participants with Rs.10
 A second treatment could increase p₁ while holding the
budget and the price of good 2 constant
 If consumption of good 1 increased, we would have a
rejection of our rational model; alternatively, if consumption
decreased we would fail to reject the rational model

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 Testing rational models (as that discussed above) using
secondary data is not straight forward (certainly more difficult
than using experimental setup)
 The experimental approach allows us the direct control to set
up choices where an obvious violation of rational choice is
possible
 Real world observations have so many variables (many of them
unobservables), that such clear violations are usually not
discernable
 In real world data, we could get a positive relationship between own
price and quantity, but since there may be other (unobserved))
factors that we might not be able to control, we cannot say that our
finding represents violation of rational choice model
 For this reason behavioral economics is closely associated with
experimental economics

 Technical Details and Detail Discussion of Lab

Experiment: Appendix
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Lab Experiment
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Caveats
 Suppose we find that under some set of conditions, the rational
model fails in the lab
 Before this anomaly could be of use to policy maker/firm, we would
need to know first how likely it would be that these conditions would
occur in the natural market
 Are the conditions under which the experiment is carried out rare or
common?
 We also need to know whether the magnitude of the effect was
sufficiently important in the broader context
 We might find evidence of a violation of the law of demand for some range
of prices
 However if the violation is a relatively small effect or over a very small
range of prices, it is not possible for a producer to determine if increasing
price in this range truly helps!

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 Behavioral Economics is defined in relationship to the
conventional rational choice model
 The rational choice model has normative benefits and offers a
coherent structure for economic science
 Behavioral economics helps better explain how people actually
behave and how firms might take advantage of human biases

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1. Describe a behavior either you or a friend has engaged in
that you would describe as irrational. Why would you
consider this behavior irrational? What was the motivation
for engaging in this behavior?
2. Describe the difference between rational, procedural
rational and behavioral models of economic decisions.

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 APPENDIX:

 Subjects: participants in an experiment

 Session: a sequence of periods, games, or other decision tasks
involving the same group of subjects on the same day
 Cohort: a group of subjects that participated in a session
 Treatment: a particular environment of the experiment
 Experimental design: A specification of sessions in one or more
treatments to evaluate the research question of interest
 Experiment: a collection of sessions

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 APPENDIX:

1. Testing economic theories

2. Elicitation of preferences (over goods, risk, fairness, time)

 How much money should be spent to avoid traffic accidents? (involves risk
preferences)
 How much money should be spent on protecting the natural environment?
(involves preferences for public goods)
 Should the government subsidize savings? (involves time preferences)

3. Exploring “boundedly rational” behavior

 People do not always behave rationally; they rely on cognitive shortcuts
 People form beliefs about the behavior of others‘
 People are prone to money illusion

 Why?

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4. Establish empirical regularities as a basis for new theories
 Well established empirical regularities direct the theorists’ effort
and can help develop empirically relevant theories
 Experimenter can implement important games for which no
game theoretic predictions exist because the analysis is too
complicated (e.g., double auction)

5. Wind tunnel experiments

 The great thing about economic theory is that one can
examine what would happen if one changed policies or
implemented new institutions
 Does the reduction of entry barriers increase aggregate
welfare?
 Do tradable emission permits allow efficient pollution control?
 The great thing about economic experiments is that they
allow us to examine these questions empirically

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APPENDIX:

 Instructions

 Deception

 Incentivization

 Framing

 Anonymity

 One shot vs Repeated

 Partner vs Stranger Matching

 Within/Between Subject Design

 Direct response vs Strategy Method

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 Instructions
 Use written instructions
 Read instructions aloud
 Use illustrative example
 Use trial or practice periods with no rewards

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 Deception
 The golden rule of experimental economics: ”Thou shalt not deceive thy
subjects!”
 Why not? It is crucial that subjects believe the experimenter, e.g. if we
tell subjects they will be paid by piece-rate but they believe they will
be paid a flat wage at the end, then we may misleadingly find no effect
of high-powered incentives
 If subjects are deceived in one experiment, or hear or read of studies
where deception has taken place, they may have suspicions in future
experiments, e.g. MacCoun and Kerr (1987)
 Studies using deception are unlikely to be published or permitted in
economics labs.

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 Incentivization
 Subjects in economic experiments should be paid according to
performance
 It is highly unlikely that a non-incentivized experiment will be
published in an economic journal
 It is a common assumption that subjects without appropriate
financial incentives will not exert effort to make optimal choices
 Induced Value Theory (Smith, 1976): Appropriate incentivization
allows experimenters to “neutralize” subjects’ home grown
preference
 Allows subjects’ actions to be driven by only economic
incentives and not by home grown preferences or other
motivators
 In a sense experimenter “induces” new preferences through
appropriate incentivization

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 Framing
 Most economic experiments are done without context (a ”neutral frame”),
e.g. choose option A or B, rather than ”cooperate” or ”defect”
 This is done to retain generality, avoid inducing particular behaviour
because of connotations of words, or ”role-playing”
 However, researchers may use framed experiments if they are interested
specifically in the effects of context
 Also, in some instances, not framing experiments can lead to a loss of
control: subjects may apply their own context to help understand an
abstract situation, and if different subjects apply different contexts there
will be uncontrolled heterogeneity

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 Anonymity
 In experiments that involve social interactions (e.g., gift exchange game),
typically subjects in such economics experiments do not know the identity
of the subjects with whom they are interacting (they will know they are
interacting with someone in the room, but not precisely who)
 This controls for effects related to individual characteristics that may
influence behaviour in others
 Subjects are usually told that their name will not be connected to data
from the decisions they have made, so subjects make more ”natural”
decisions as they would if unobserved
 Sometimes experimenters are interested in how specific elements of
identity affect decisions, so gender, class, nationality, etc. may be revealed,
either directly or indirectly (e.g. by name)
 As a rule of thumb, you need a good reason to run a non-anonymous
experiment

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 One shot vs Repeated
 Reasons for repeating games:
 It may take time for subjects to learn to understand game
 May be interested in learning process
 Getting more observations
 Possible problems with repeating games
 Dilutes incentives
 Extra observations will not be statistically independent

 Note: When a game is repeated, typically only one randomly chosen round
is paid to avoid ”wealth effects” (once a subject knows they have already
earnt a certain amount they may become more risk-averse or exert less
effort, but we want each game they play to be comparable)

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 Partner vs Stranger Matching
 If a game is repeated, subjects can play with the same person (people)
each time, or be randomly rematched
 Stranger matching: randomly rematched every time
 May only interact once with a given subject (”perfect stranger
matching”) or possibly multiple times
 Typically anonymity means that in the latter case subjects will never be
sure whether they have played with a subject before or not
 Used if interested in one-shot interactions
 Partner matching: play with the same subjects each time
 This option will be used if interested in repeated-interactions e.g. to
study reciprocity or reputation effects

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 Within/Between Subject Design
 When looking for a difference in behaviour between two treatments we
can choose either a within or between subject design
 Within subject design: Each subject participates in both treatments
 Offers the possibility to test theories at the individual level, and hence
may be useful when interested in effect on individuals rather than on
averages
 Research shows WS design leads to more statistical power (more likely
to correctly reject a null hypothesis in favour of an alternative
hypothesis)
 More worry about “order effects” (the order of treatment may affect
decisions of subjects – the efforts exerted by a subject under two
treatments, “high wage” and “low wage” might depend on whether the
first treatment is “high wage” or “low wage”)
 Between subject design: Each subject participates in only one treatment
 Less statistical power for same number of subjects
 Fewer worries about “order effects”

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 Direct response vs Strategy method
 Experiments involving dynamic games can be implemented in two
different ways
 Direct-response: Manager makes a decision between two alternatives –
“high wage” and “low wage” (say); Worker is informed of the decision
then makes his/her own decision between “high effort” and “low effort”
 Strategy method: Manager makes a decision, and simultaneously worker
decides what they would do if manager chose “high wage” and what they
would do if manager chose “low wage”; the strategies of the two players
are combined and the outcome determined

 Advantages of the strategy method:

 Can categorize individuals: with direct-response, if we see worker
chose “high effort” after manager chooses “high wage”, we don’t know
if they are highly motivated or not
 Obtain more data

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 Experiment
Theory: Design – Plan dates
Research Related Hypothesis, Details and and
Question Literature Prediction, Appropriate finances
Expectation ness of
Proposed
Recruitmen Pilot Methods
t of Session Setup lab Instruction
Subjects and test
equipment List of
Distribute procedure
instructions for the
Registratio , pencils, Experiment experiment
n of calculators, starts with
Subjects envelops, experiment
upon seat er reading
arrival numbers out the
instructions
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