Behavioral Economics

March 6, 2019

I just finished Behavioral Economics: A Very Short Introduction (2017), Baddeley, as a review of the field. Because I have reviews of many books in this area, it is a good time to summarize the area and consider how to best use the information as a tool to explain the dark side of capitalism. The book has nine chapters; briefly reviewing each is step one.


Chapter 1: Economics and Behavior. Behavioral economics extends economic principles by considering social and psychological influences in decision making, plus rational calculations of costs and benefits--mainly based on psychology but including sociology, neuroscience, and (not mentioned in the book) political science. Classical economics includes market failures, but not fallible humans, while behaviorists beginning with Herbert Simon (bounded rationality) considered biases and multiple human limitations. Vernon Smith considered ecological rationality (based on context), Gerd Gigerenzer practical rationality (need for quick decision-making), and Harvey Leiberstein selective rationality (rationality versus status quo--sticky choices). There are problems with rationality, available information, cognitive constraints, and social influences.


Chapter 2: Motivation and Incentives. Incentives drive economic analysis. Economists assume money is the main driver, although many socio-economic and psychological factors affect decisions. Compensation is an extrinsic motivation, but intrinsic motivations (e.g., professional pride, being physically or mentally active are intrinsic motivators). Experiments show that small payments can be demotivating for volunteer work. Other extrinsic motivations include social reputation, image motivation, honors and awards. Efficient wage theory means minimizing wage costs (e.g., higher wages for more productivity).


Chapter 3: Social Lives. Reciprocity is common; when others are trustworthy people usually reciprocate, important for cooperative and collaborative activities. On the other hand people do not like unequal outcomes, inequity aversion. Preference for fairness can explain altruism. Explored in ultimatum game. Social norms are reinforced through peer pressure. Conformity important to customs, traditions and religion--social reference points. Public goods games, making contributions to a communal pot (cooperation versus social sanctions and punishments--altruistic punishment). Analysis of identity (Akerlof): intergroup relations between in-groups and out-groups, particularly important in politics. Herding: follow the crowd and how people are manipulated. Information influence is learning from others' actions and following the crowd may be rational learning device (assumes herd has the correct strategy). The herd provides safety and collective decision-making, but private information is ignored. Keynes: reputations fare better when conventionally wrong than unconventionally right. It is ethically problematic to use social information to manipulate decision-making. Herding is a quick decision-making tool (a heuristic).


Chapter 4: Quick Thinking. Economics focuses on markets, but the price mechanism is fallible. Problems include information overload (plus too many choices). Simple rules of thumb are often used (heuristics) in place of complex calculations. Kahneman & Tversky (KT) focused on heuristics that lead to systematic, predictable mistakes: availability, representativeness and anchoring/adjustment. People typically use information that's easily available, including primacy and recency effects (focus on first and last bits of information obtained). People stick to what they know and slow to switch. People can decide by analogy (representativeness), comparisons  to similar events. Conjunction fallacy (probability of conjoint events occurring together). Stories impact imagination. Confirmation bias occurs when anchoring judgment on prior beliefs, interpreting new information based on existing beliefs. Cognitive dissonance is conflicts between beliefs and actions. Anchoring around a reference point and adjust choices effects judgment (event starting with random factors), choices are distorted by the starting position. Status quo often the reference point, resulting in status quo bias and familiarity bias. Thaler: checking boxes for say pension contributions or organ transplant.


Chapter 5: Risky Choices. Economists assume risks are quantifiable and assume decisions are made based on how much risk people will take. KT prospect theory covers future risky prospects. But perceptions of risk shift in different situations and people use quickly available information. Losses are inflated over gains about two to one (loss aversion). KT critique expected utility theory (future satisfaction). Paradoxes include Allais and Ellsberg (that Ellsberg); people do not have a stable response to different risky outcomes. First is the certainly effect--people prefer certainty even with smaller expected outcome/payment (KT present results of several experiments). Ellsberg experiment involved 90 balls  (red, black or yellow), people asked to bet on outcome of draw to demonstrate ambiguity aversion. People take more risk to avoid losses (reflection effect), roughly the opposite of the certainty effect. Isolation effect is when people ignore important elements when decision making. Prospect theory attempts to explain certainty effects, including reflection effect and isolation effect. Key point is judgments are made about the value of options in different ways. Starting point is based on reference point (anchoring, then adjustment); reflection effect is associated with loss aversion, plus the endowment effect (we care more about things we have and could lose). People will pay for risk reduction but not accept increased risk for compensation (prospect theory value function--anchored around reference point, losses have higher impact than gains). Thaler's mental accounting model and regret theory--choices today versus unknown future outcome (regret theory allows multiple states of the world, while prospect theory has only one).


Chapter 6: Taking Time. People have different time preferences, patience versus impatience with time consistency expected in individuals. Example of military pensions: annuity versus one-off payments (51% of officers chose lump-sum, 92% of enlisted). Generally people are impatient in the short-run and more patient planning for the future (time inconsistency, present bias), tested beginning with Walter Mischel's marshmallow experiments. Thaler developed mental accounting using framing, reference points and loss aversion for spending and savings decisions; mental accounts include windfall accounts, income account and illiquid wealth account. Targeting explained using taxi drivers working toward a target wage for the day.


Chapter 7: Personalities, Moods, and Emotions. Personality includes thrill-seekers, risk-averse and caution, self-control, depression, impulsive. OCEAN can be used to measure personality (openness to experience, conscientiousness, extraversion, agreeableness, and neutroticism); IQ tests, cognitive reflexivity test (CRT). The affect heuristic is using emotions to guide actions; emotions are accessible and available than objective facts and figures. This ties into marketing, sensationalist journalism and the idea of vivid imagery. Emotions and visceral factors contribute to addiction and other self-destructive behaviors. Psychological cues are called somatic markers. Dan Ariely used priming exercises to influence decisions. Duel-system models capture interaction of emotion and affect cognition; links to Kahneman's thingk fast (system 1) and slow (system 2). 


Chapter 8: Behavior in the Macroeconomy. Social and psychological factors can help explain macro fluctuations like optimism and pessimism, or explaining Brexit. Keynes described investors and speculators, where investments are based on "beauty contests." Animal spirits including optimism can explain market actions. Hyman Minsky had a theory of business cycles beginning with euphoria, with Ponzi finance precipitating a bust. 


Chapter 9: Economic Behavior and Public Policy. Ronald Coase artificial trading systems attempt to explain market transactions. Thaler and Sunstein introduce "nudge" as a way policy instruments can be used to improve decision making.




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© 2016 Gary Giroux

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