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Behavioural economics: a primer


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March 16th, 2015


The rational man is known well to any classical economist, writes Philip Grossman. But his devilish counterpart, the irrational man, is uncharted territory. Enter behavioural economics.


It has frequently been observed that people often reach different conclusions from the same set of information, based on how it is presented; this is referred to as the “framing effect.” Tversky and Kahneman (1981) showed how framing can affect the choice made between two life-saving programs. One group of subjects was asked to choose between two programs: Program A which would save 200 out of 600 people; or Program B which would save all 600 people with 1/3 probability and no one with 2/3 probability. A second group of subjects was asked to choose between two “other” programs: Program C which would result in 400 out of 600 people dying; or Program D which would result in nobody dying with 1/3 probability and everybody dying with 2/3 probability.

The important factor to note is, Programs A and C are identical; 200 people will be saved. Likewise, Programs B and D are identical; none of the 600 will die with 1/3 probability. If framing did not matter, then it would be expected that Programs A (B) and C (D) should be chosen equally often. In fact, A was chosen 72 percent of the time, while program C was chosen only 22 percent of the time.

A mainstay of economics is the Rational Man Model. The model assumes: 1) “unbounded rationality” – the ability to process unlimited information and to solve problems optimally; 2) “unbounded willpower” – the ability to forgo impulse purchases; and 3) “unbounded selfishness” – the economic agent cares only about his own well-being. The model implies that an economic agent makes the best decision, based on the available information, which will attain the agent’s given goal. Rational man was considered to be a “calculating, unemotional maximizer … (Mullainathan and Thaler, 2000).”

Examples of these seemingly irrational choices abound. For example, people typically will pay more to avoid the risk of a loss of a given amount than they will pay for the chance to receive a gain of the same given amount (what economists call “loss aversion”).

Behavioral economics explores the ways in which behavior deviates from the standard rational man model and examines how this matters in economic situations. Behavioral economics attempts to increase the realism of economic analysis by introducing psychological factors that influence peoples’ decision-making. Behavioural Economics assumes: 1) “bounded rationality” – the inability to process unlimited information and adoption of simple heuristics (i.e., rules of thumb); 2) “bounded willpower” – limited self-control (i.e., having that slice of cheesecake for dessert even though you know you need to lose 10 pounds); and 3) “bounded selfishness” – a concern for the well-being of others (i.e., giving to charities or helping a stranger).

Departures from “rationality” are observed in many types of decision-making and behavioral biases. For example, people who fail to opt into a program will not opt out when automatically enrolled in the same program. In the United States, many companies offer their employees the opportunity to invest a portion of their wages in a tax deferred superannuation account. In other companies, employees are automatically enrolled in such programs but have the option to opt out if they choose. The benefits to the employee include deferring taxes on this portion of their income to the future when, as a retiree, they may face a lower marginal tax rate. Also many companies match, often dollar for dollar, employee contributions. The employees get an immediate 100 percent return on their savings. A study by Madrian and Shea (2000) of a company that switched its superannuation enrolment procedures for its employees from opting in to opting out, found that workers were 50 percent more likely to participate in the latter than the former. Prior to the change in enrolment procedures, many employees were missing out on tens, or hundreds, of thousands of dollars over their work lives. If choosing to not opt into the superannuation accounts were a rational decision, then failing to opt out would be irrational (and vice versa)

A second example is observed in the way economic agents discount future rewards. For rational man a reward available in n days should be discounted the same whether the n days is from today or n days one year from today. Economists apply exponential discounting to future rewards. The valuation of a future reward falls by a constant factor per unit of delay; the amount the future reward is discounted depends only on the discount rate (r) and the length of the wait (t). The present discounted value of the reward (X) is then = X/(1+r)n.

What is often observed, however, is hyperbolic discounting. An economic agent who applies hyperbolic discounting, discounts rewards more rapidly for small delays than for long delays. To illustrate, consider two choices: Choice 1 offers you either (A) $100 tomorrow or (B) $110 one week from tomorrow; Choice 2 offers you either (C) $100 one year from tomorrow or (D) $110 one year and one week from tomorrow.

The important thing to note is that for both choices the larger reward requires the wait of an additional 7 days. If you applied exponential discounting, if you preferred A (B), you should prefer C (D); If you applied hyperbolic discounting, you might prefer A and D. When given these choices most people choose A for Choice 1 and D for Choice 2.

Other examples of departures from the strict definition of rationality include:

Anchoring: relying too heavily on one piece of information when making decisions;

Money illusion: the tendency to focus on the nominal value of money rather than its true purchasing power (i.e., feeling richer because of a 3 percent increase in your dollar income even though the inflation rate is 5 percent);

Gambler’s fallacy: assuming that future probabilities are altered by past events when in fact the events are independent (i.e., assuming that since the last three roles of a die came up six, the probability of the next role being a six is less than 1/6);

Bandwagon (herding) effect: believing something or doing something because other people believe or are doing the same (i.e., buying Beanie Babies because others are doing so);

Endowment effect: the tendency to demand more for an item you currently possess than what you would be willing to pay for it if you didn’t possess it.

 

Philip Grossman is a professor of economics at Monash University. This article was adapted from: Grossman, P.J. Rational Irrationality. Business Central Magazine January/February (2011): 28.

 

 

References

Madrian B. and D. Shea. 2001. The Power of Suggestion: Inertia in 401(k) Savings Behavior. Quarterly Journal of Economics CXVI, 1149-1187.

Mullainathan, S. and R.H. Thaler. 2000. Behavioral Economics. Working Paper 7948, National Bureau of Economic Research, Cambridge MA.

Tversky, A., and D. Kahneman. 1981. The framing of decisions and the psychology of choice. Science 211, 453-458.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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