Behavioral Economics – Class Notes – Flashcards

- at the core of standard economic models. - rational choice produces greatest amount of satisfaction - distinction between rationality of means and rationality of ends

1. Preferences: determined exogenously, stable, ranking of alternatives, complete, transitive, only change with new information. Pure vs. Reasoned vs. All things considered. 2. The future and the unknown: we consider our utility in the future when making decisions. We discount the future in a consistent, logical way (future reward lowers the value). We accurately assess probabilities and Bayesian updates — We incorporate new information into assessments of probability. 3. Choices: We treat money as fungible (don't think of it as having a label) and ignore sunk costs. We evaluate costs and benefits and maximize utility. We think marginally about individual utility gained from each additional unit. We don't make choices that make us worse off knowingly.

- Model is not totally inflexible: individual-specific utility function and risk preferences can be unique. - Deviations from rational thinking are possible in the model, considered mistakes, but not systematic ones.

- self interest/ selfishness — no room for altruism - perfect competition and profit maximization - perfect information - only buyers and sellers are affected by a transaction (no negative externality)

- utility function could include term for another person's utility — accounts for altruism - Models trade off between accuracy and parsimony - Focus attention on key elements of environment

1. derives from consumer theory model of choice under the assumptions that utility is ordinal and cannot be quantified. 2. Always assumes that more is better. 3. Consumer theory model allows for two goods (sometimes this can be manipulated by including composite good). 4. Demand is the plot points of the intersection between the budget line and optimized indifference curve as the price of one of the goods increases.

1. Assumes profit-maximizing firms in perfect competition. 2. The supply curve includes marginal cost, average total cost, average variable cost. Where marginal revenue and marginal cost intersect is the optimal point. 3. Allows firms to forecast future demand. 4. Although we cannot get a true assessment of opportunity cost, we assume that firms are rationally calculating opportunity cost. 5. The model also assumes that firms are responding rationally to changes in market and have perfect foresight for customers' future desires.

1. Market Equilibrium adjusts precisely when curves shift. 2. Agents respond rationally to changes in prices 3. There is no room for ethics.

externalities, market power, merit goods, asymmetrical information, demerit goods, public goods, issues with equity and efficiency, immobility of factors of production. These failures are not caused by irrationality.

discount for the future consistently uncertainty — we don't know the probabilities of outcomes uncertainty is quantified using probabilities associated with risk accounted for as an element of risk preferences.

1. Individuals and Firms assumed to optimize. - Aggregate supply: firms act rationally for profit maximization. - Aggregate demand: Individuals respond rationally, which means that they spend more when they expect future output to increase and spend less when they expect the interest rate to increase. 2. Models are used to determine output and inflation.

- agents act in accordance to models predictions - the forecast of the outcomes do not differ from the equilibrium of the models — our expectations can be wrong, but right on average. - expectations provides restraint on economic models

1. Implication of the Rationality Expectations assumed in the Model 2. If the money supply increases, people rationally expect more inflation in the future —> prices will rise quickly —> offsets expansionary effects o the policy.

assets can't be over or under valued. Because people are rational consumers, they will correct prices.

A person's consumption is a future of permanent income. It is assumed that an individual takes into consideration their whole projected life income while making immediate purchases. This implies consumption smoothing — transitory changes in income are spread out over a lifetime. This means that short term policies are hypothesized to have minimal impact on behavior. People obviously respond differently to short term and long term policy changes.

Increase in government spendings will result in less public savings which will offset private savings. Not a popular theory anymore.

Macroeconomics assumes that people respond to real variables , not nominal.

1. Efficiency Wages: firms pay people more to motivate them/make them feel more valued 2. Sticky Wages/prices and monetary policy: prices don't immediately go up —> results in mini-boom in the economy. 3. Money illusion: discrepancies between nominal vs. real values. 4. Behavioral finance: irrational exuberance, herding, excess trading and overconfidence, imperfect assessment of risk.

Normative: how should decisions be made. Descriptive: how do we actually make decisions Prescriptive: how should we, given what we are like, make decisions.

1. Identify relevant features of each alternative. 2. Assign each an importance weight. 3. Assign a value for each alternative 4. Utility of an option = the values compared Expected Utility = value x probability = Expected Value make a single decision as if you were to make it again and again.

Utility does not equate to money: money is objective and utility is subjective ( principle of diminishing marginal utility —> nonlinear relationship of the two). Utility calculations include value, probability and weight of the choice.

- reduce work to make decisions. - processes of evaluation or assessment that happen automatically. - Automatic evaluations are moderated and reaffirmed by controlled processes.

not deliberate strategies, shortcuts, automatic processes, mental reflect.

System One: Intuitive System, automatic, effortless, opaque to awareness, mandatory. System Two: Reflective System, controlled, rule-based, slow, self-aware.

- Coin Flip Example - If it looks most representative of what we think a random process or something looks like. - We answer how typical when asked how likely without realizing we are answering a different question than the ones we were asked.

Examples: Are there more words that start with "t" or have "t" as the third? Do more people die of diabetes or of traffic accidents?

target price estimated in relation to anchoring number. Examples: Credit Card Payment Selling Prices of Houses Criminal Sentences

- captures response to things that happen to us - inflection point at origin - gains —> risk averse, but loss —> risk loving

by changing the reference point, you can change people's preferences. Every decision is relative.

Once you own something, it becomes worth more to you.

depends on information/framing and influences decisions. Examples: 1. Owning a car vs. a taxi 2. health insurance with no deductible fee 3. health club membership over daily gym fee 4. Credit card spending results in things appearing immediately free and buries the cost of the goods you actually buy, this results in people spending more. 5. Tax rebates: most money was saved if given in lump sum because people mentally segregated it from the rest of their income.

Autonomy with error — individuals are free to choose, if they make errors , so be it. Displays respect for dignity and autonomy of the citizen.

people should be allowed to screw themselves up. However, if they screw other people up, the government should be allowed to intervene.

who knows better than the individual what serves their own utility? the government shouldn't presume to know what makes someone better off.

everything matters — small details have large effects. For example: Google plate size, location of options on food lines. There is no neutral way to present anything —> we are more likely to choose things on the left because read from left to right. Help people get what they want. Example: stikk.com

bulk junk foods are divided into small packs as a way of controlling portion size, sold for much more expensive price.

Paternalistic - pay attention with the aim of getting people to act according to their preferences Libertarian - always have the choice

1. Short term gain, long term pain (or reverse) 2. Complex decisions (people are cognitively busy and lazy, which means that they won't be able to or inclined to put in the work to think through things. 3. Infrequent decision: frequent decisions means that we get feedback and are able to make corrections. When its a one-time choice, we would benefit from a nudge. 4. Multiple options 5. Poor feedback on decisions 6. Ill-formed preferences — those that are likely to get pushed around by the structure of the situation and are subject to manipulation.

- Setting defaults. When something is a default, people assume its a default for a reason. Thus, it carries with it an implicit recommendation. For example, privacy settings on social networks or software settings installation allows you to just choose the standard, because people usually customize wrong. - You can design errors out. For example, ATM machines don't let you get your money without first removing your card. Similarly, birth control pills included placebos for the 7 days of your period so individuals don't have to count. These fixes make common errors essentially impossible to make. - Foot in the door technique: provide people with an easy step to take now and it will be easier for them to take a larger step later, or requiring an individual make a small commitment now makes it easier to make a larger commitment in the future.

- In general, nudges that appeal to system two are more acceptable than one that appeal to system one. - People with high empathy support nudges more. Communitarians, politically liberal ad those with a less strong desire for control favor nudges. - When interventions show social benefits, they receive more support than when they only show individual benefit. - Those that highlight the cost of NOT accepting the nudge, receive more support

active decisions in sign-up, reminders and emails with behavioral messaging doubled the sign-up rates.

Sent eight text reminders of deadlines —> increased enrollment.

used sports car traders —> more trades lessened the endowment effect

charitable giving at the door is induced by social pressure, rakes in a lot of small bill donations that otherwise wouldn't have been donated.

- found that people are willing to pay to have someone hold money and not let them have it

farmers have seasonal cash restraints. The prepaying allowed farmers to pay for fertilizer when they had the funds. Takeaway: catch people when flushed with cash.

showed the original tag and the exposed tag on each shop item. wanted to test whether the effect of tax is the same whether it is consumer or producer based showing the sales tax on each item in the store resulted in decreased demand for the items people don't respond rationally to taxes. Takeaway: We extract more money through sale tax. When the price of something is hidden, people are willing to pay more which allows prices to increase (I-pass, FastTrak, Social Security, etc.)

People don't enroll for earned tax income credit because they are not aware, have to fill out a small form. If shown more information, people are less likely to sign up When the benefits are clearly displayed, there are more sign ups Personal and social stigma was lessened, however there was less of an increase in sign-ups. Takeaway: Simplicity is key. Stigma does not seem to prevent take up and people do not take "free cash" as you might expect. Welfare programs need to consider non-rational tendencies of potential beneficiaries.

Lots of policy challenges require something else first: get the prices right —> need prices to reflect market value. Don't neglect neoclassical economics. fix the policy system —> If tax code is too complicated to begin with need restructuring. develop better contextual understanding of what is going on. Examples: California Water Crisis - can't raise the price of water, because politically impossible.

mini buses are public transportation, but they are privately held and have a lot of accidents. driver incentives: the owner gets a certain fixed cut a day, the surplus is the drivers to keep. Which encourages driving faster —> accidents. There is a disconnect between the owner and the driver so the drivers don't care about the damage done to the car. Solutions: Put GPS sensors on the buses. This will lead to more oversight. Allow individuals to text complaints to a central source. Divers are provided with a phone that has a app that shows them feedback (how their driving measures up to others, driving quality, how likely are you to crash). Mystery riders will be hired as critics of drivers, sent out to collect information.

1. When is information disclosure enough? Sometimes, a nudge is not necessary. It is only necessary when there is a problem comprehending the information, which makes disclosure not impactful. 2. Do nudges effects last? Do we acclimate to nudging? 3. Why nudge? Why not push and shove? When should things be made into law? will forcing people to make a choice actually lead them to better decisions? Objections to behavioral nudges being made into law will eventually subside. 4. Should we benchmark interventions or social optimizations? What's the goal? What's the right amount, instead of more just always being better? At what point do we stop nudging people? 5. Welfare Implications? People stick with defaults, which means if a decision is defaultsd that isn't that personally good for someone, they will stick with it regardless. 6. Can we make a bigger dent? Can we get beyond micro-interventions and int big economic phenomena?