Behavioral Economics Final Exam – Flashcards

Some politicians use economic opinions to push their agenda, and forget to leave personal preference out of it.

Standard Economic Model

Economic Man

a. Unbounded rationality b. Unbounded willpower c. Unbounded selfishness

Refers to the fact that economists try too hard to make a social science fit into formulas of mathematical certainty.

a. German philosopher Arthur Schopenhauer said, "In history... revolutionary ideas come along at uncertain points in time, and almost without exception radical ideas will be challenged by those who have a stake in the status quo. Three stages occur: a. First, it is ridiculed. b. Second, it is violently opposed. c. Third, it is accepted as being self-evident."

a. Sometimes people have to die off for new theories to be accepted. b. "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it."

He said in 1979: "All theoretical models are wrong, but some are useful." What Box meant was that natural processes are sometimes so complicated that they defy easy solutions and maybe even complex modeling. Theoretical models, therefore, have to simplify the actual situation to make it solvable. But if the model is too simple, it loses both its predictive ability and its sense of being realistic.

a. The Wealth of Nations, Theory of Moral Sentiments b. The Wealth of Nations is embraced by Neoclassicist b. They ignored the moral Sentiments because it said the opposite that Wealth of Nations Says

Leon Walrus, he said that the interaction of demand and supply will result in an overall general equilibrium.

a. Led neoclassic econ revolution, b. University of Chicago, c. He said, "Models can only be simplifications of actual events, because events are too complicated to explain with models..."

Even though the SEM principles may be unrealistic or flawed, the theory could still be used if it makes accurate predictions, since agents could behave "as if" they knew the rules even if they didn't. This is known as the methodological view.

Neocons are more concerned with the behavior of the group.

1950s

a. Both have very similar characteristics, both believe similar to the following: b. Economic Man is selfish and wants to maximize his own utility (satisfaction) c. All decisions are tradeoffs between outcomes, so there isn't any ultimately correct answer d. Decisions should be made without a societal consideration of right or wrong e. Decisions should be made without a sense of fairness to other parties f. Decisions are not based on how they might affect others

Methodological view: feeling that it didn't matter if economic theories had any psychological plausibility or necessarily made any sense. The only thing that mattered was if the theories made good predictions (that is, if people behaved "as if" the theories were true).

?

Financial Incentives

a. A theory should make good sense b. It should be testable c. Results should be repeatable and remain valid d. A good theory should explain past behavior and make valid predictions for the future

a. Neither side can agree on how to do experiments b. Econs use financial incentives, no trickery or confederates, and are concerned with revealed preferences and are more concerned with group behavior c. Psychologists are concerned with motivation, often use deception and lies, and are more interested in individual reaction

a. Risk means something may go wrong, but you have an idea of the chances of the outcome. b. Uncertainty means you have no historical information to use when processing a situation.

a. This was the experiment in which those participating were continually shocking a person in another room for answering questions wrong. b. It told us that most members of the Nazi party were more likely obeying authority when committing atrocities, rather than being personally evil and enjoying torturing fellow human beings.

Under risk and uncertainty

Model of Rational Crime: Becker said criminals commit crimes because they expect the benefits to outweigh the consequences. If people didn't commit crimes, it was because the system offered sufficient deterrents (such as a high certainty of getting caught).

?

a. Daniel Kahneman & Amos Tversky: b. Fathers of Behavioral Economics c. 1979 paper Prospect Theory, started Behavioral Econ revolution d. They split as collaborators because people gave Kahneman more credit

a. Prospect Theory: people have bounded rationality, use rules of thumb, biases, loss aversion, anchoring and framing, favor the present over the future and don't understand actual probabilities of events occurring. b. Neoclassic economics: people always make unemotional decisions to maximize their utility or satisfaction (ex: Becker's rational crime model)

Losses are perceived to be much worse than gains are. Wealth initially does not matter.

For our purposes in economics, rationality means that reason leads to consistent choices.

a. Judgement appears quickly in the conscious mind. b. Underlying reasons are not known c. The hunch is strong enough to act on

a. People don't have perfect information b. They don't have the ability to make perfect decisions even with perfect information.

a. Short cuts, or rules of thumb. b. They use them to make everyday decisions, because we don't have time to think deeply about everything.

John Maynard Keynes' term for "people don't always act rational, they respond emotionally to everything."

People can't accept new information that conflicts with our deepest beliefs.

a. Panama Canal: France constructed Suez Canal, and immediately thought they could build the Panama Canal as well. This is an example of recency bias. (As well as the failure to recognize sunk cost.) b. McMartin Preschool

a. Criminal investigators have been known to set their mind on a trial outcome because of a hunch, and even when the trial is recounted and proved wrong they hold onto the original analysis. b. Ex: Numerous men were pegged with rape of woman in NYC. After many years in jail, another inmate confessed to the crime. c. His DNA matched that found on the victim. The original prosecutors and detectives denied this outcome, displaying cognitive dissonance.

a. Contextual presentation of information, which is a way to influence decision-making. b. A coffee company has a $20 coffee maker and a $65 coffee maker. Not many of the $65 models are currently selling, so the company comes out with a third model which is $120. c. They know the most expensive model will most likely not sell more, but now they have framed the customer's mind to think the $65 model is not such a bad deal.

Arbitrary starting points, may be in terms of numbers, that become reference points and affect our future decision.

Framing work as pleasure

People chose the options which most displayed a more positive outcome mentally, even though all of the options really gave the same outcome.

a. It is when people have so many choices they can't make a decision. b. No, more choice in a behavioral's POV is worse.

a. Maximizers will see another choice other than the one they picked and be upset for a long time because they didn't make the best choice. b. Satisficers: they're always ok with their choices, ok with imperfect choices, live longer and are happier.

Maximizers are bad at online dating, because there are too many choices and they never stop searching for the perfect person.

People have to make their own decisions about retirement because most companies no longer offer them a plan. (Elaborate more)

People were put into a retirement plan by default, which had a better outcome because they didn't have to make a decision unless they wanted to. Although most didn't deviate from the plan which they were originally placed in.

a. The initial interest in the calculation of risk was driven by a desire to understand the mathematics behind games of chance. b. i.e. Gambling

Only controlled

a. A change in the relative frequency by which one option is favored over another in behavioral experiments. b. Preference reversals contradict the predictions of rational choice.

a. Occurs when a person observes the actions of others and then - despite possible contradictions in his/her own private information signals - engages in the same acts.

a. The human desire to hold on to what we already have, even when a superior alternative is presented to us. b. "My Stuff Is Stuff And Your Stuff Is Crap"

a. Willingness to Pay: the maximum amount an individual is willing to sacrifice to procure a good or avoid something undesirable. b. Willingness to Accept: the minimum amount of money that ? person is willing to accept to abandon a good or to put up with something negative, such as pollution. c. The endowment effect causes the WTP to lower, because value other's good less. It causes WTA to rise, as we value our own goods more than we should.

a. The inability to correctly identify the relationship between numbers; that is, mathematical concepts and methods used to solve problems seems too difficult to understand. b. People make poor choices because they don't understand the mathematical alternatives. c. Neoclassic econ is wrapped around numbers.

a. The probability of a match is mistaken for the probability of not guilty if there is a match. Simpson's defense team was able to quash the statistics related to spousal abuse because they were deemed prejudicial to their case. b. Conditional probabilities are those that depends on something else taking place.

?

a. Businesses constantly update information so they can refine their estimates of how to build products and offer services. b. Thus, old information or techniques are replaced with new and better ones or information.

People use a formula called the Bayes Search Theorem to update old information when new information comes along.

a. This relates to the fact that digits in many real situations are distributed in a predictable, non-uniform way. b. That is, it turns out that the first digit won't be completely random; instead, its chance of appearing instead follows a logarithmic progression.

a. People are hardwired to see patterns, and they will create them when they don't exist. b. People believe in conspiracy theories for this reason.

a. Something that hasn't occurred yet is about to. b. Three cards in a row have been red, then surely the next will be black c. i.e. Roulette Wheel

a. Believed by most people in sports, trends will continue. b. Shooting well in basketball "means you're going to continue to do well on a streak." c. People actually perform at their earned level of ability.

a. Two characteristics: 1. Cost that has already been incurred 2. It can't be recovered b. Sunk Cost Fallacy: when people try to get their money back, but it's almost always near impossible.

Revenge is not the solution, it is a lost cause to waste money and energy to get back at people.

a. The dictator is given a sum of money and then has the opportunity to share it with someone else. Logically, the dictator should keep all of the money because there is no cost from hoarding the prize and the receiver can make no claim on the assets. However, in most cases, the dictator will share some of the value with the second person, often in the range of 30-40% of the original gift. b. In the Ultimatum Game the person with the initial funds may still choose to share or not, but the second person is empowered to accept or reject the offer; if she rejects, neither one gets anything.

a. Neoclassic Econ believes that more goods and services are always better b. More GDP should result in more satisfaction c. Real happiness tends to peak once basic needs are satisfied, "money isn't everything" d. $75,000 is the peak amount with which a salary has an effect on happiness.

a. Most people often lose all money in a year to a year and a half. b. Many are worse off financially than before winning the money.

a. Scrooge was following simple economic practices. b. Scrooge was actually being logical about the way he ran his business.

a. Altruism is a behavior that confers a benefit to others but requires a cost to the giver, who receives no material benefit from it. b. No, not in an economic sense.

a. People only give to charity for social rewards or influence

a. Biases: mental shortcuts that don't take much preparation. b. Availability: A rule of thumb that allows people to estimate the probability of an occurrence. c. Cognitive dissonance: A process where a person can't accept new information that conflicts with their deepest beliefs. d. Confirmation: selective perception that emphasizes inputs that conform to our beliefs and simultaneous rejection or devaluation of inputs that contradict our basic beliefs, or paradigms. e. Durability: People tend to overestimate the duration of their reactions, both for positive and negative events. This bias is often related to the purchase of durable goods that people pay significant sums for and expect to function well for a long time. f. Hindsight: The tendency to falsely believe that an outcome was predicated successfully from the beginning. People tend to believe that they previously knew, or could have predicted, the outcome of future events all along. g. Illusion of control: Tendency to believe that outcomes can be influenced when in fact they cannot. This bias relates to superstitions, especially prevalent among athletes. h. Left-digit: This bias arises out of innumeracy, inattention or using shortcuts to evaluate numerical information. The first, or left, digit is viewed as the one with the most significant importance and those to the right are discounted. i. Loss aversion: Psychologically, the possibility of a loss is mentally weighed as more damaging than the same magnitude of gain. Loss aversion is roughly twice as powerful of a motivator as the a gain of an equal amount is. j. Overconfidence: People have an unwarranted faith in their own reasoning, judgment or cognitive ability. Likewise, people tend to rate themselves as better than the population mean; for example, almost everyone rates themselves as an average or above average driver. k. Recency: A predisposition to recall and emphasize recent events and observations (see also durability bias). People assign additional weight to recent behavior, and assume this trend will continue for some time to come. l. Regret aversion: People may refuse to make decisions because they are concerned that in hindsight they will regret their decision. m. Status quo: This bias predisposes people facing a number of choices to select whatever option ratifies or extends the existing condition. People tend to value what they already have or are already experiencing more than an alternative that might provide real gains in enjoyment, functionality or investment return.

?

a. People tend to overbid for things b. Richard Thaler c. Vermeer Paintings

A return to the average.

Europe's most famous painter. People faked his art pieces, or "re-discovered" new versions.

The Russians thought the US was running a real attack on them and almost launched real missiles at the USA.

a. All assets are supposed to be fungible, although, people put money in mental buckets and think they're different.

a. This means the assets have interchangeability with other individual goods or assets of the same type. b. Ex: Some people view money in a checking account and a savings account as different funds. c. In reality they own all of the money, and any account could be used to purchase the same things.

a. The life cycle hypothesis: states people should maintain the highest smooth consumption path possible. b. It predicts that people will assume their salary over time, and try to smooth the overall life's worth out evenly over their entire life. c. Plans such as Christmas Clubs and automatic increases in retirement savings from increasing salary levels are effective because they remove the potentially irrational decision to spend the money today. d. People spend too much money today.

a. The behavioral life-cycle hypothesis: says that people treat parts of their wealth as non-fungible and noninterchangeable due to mental accounting for current income/assets vs. future income. b. That is, the marginal propensity to consume varies depending on where the income comes from. c. The behavioral version of life cycle theory says instead that people categorize wealth in three areas: 1) Current income, 2) Current assets, 3) Future income. The propensity to consume is greatest for current income and the least for future income.

a. An individual's current decisions affect what options become available in the future. b.Theoretically, by not consuming today, consumption levels could increase significantly in the future, and vice versa. c. Ex: Savings, retirement account, etc.

a. Hyperbolic Discounting refers to the tendency for people to increasingly choose a smaller-sooner reward over a larger-later reward. b. When offered a larger reward in exchange for waiting a set amount of time, people act less impulsively (i.e., choose to wait) as the rewards happen further in the future. c. Exponential Discounting: the amount people discount a future reward depends only on the length of the wait and a discount rate that is constant across different wait times. d. To illustrate, many people prefer $100 now to $110 in a day, but very few people prefer $100 in 30 days to $110 in 31 days. e. People use Hyperbolic Discounting

a. Time, people don't really care about interest rates.

a. Our current behavior is determined by how our brain gradually changing in response to natural selection.

a. The idea that the brain dictates the scull size. b. It is not accurate at predicting behavior.

brains range in size from about 2.7 pounds to 4.4 pounds

Accounts of 10% of brain's mass

in engineering, a clumsy or inelegant solution that works nonetheless b. sometimes random evolutionary changes or adaptations actually worked.

constantly improving species that are able to adapt and survive

No. Almost all people are also hardwired to do one thing at a time well, and if we try multitasking, it results in less and less attention paid to each task, contrary to popular belief that all tasks can be accomplished with equal quality.

a. System 1: immediate response system, react and don't think about it. i. Running in the background b. System 2: Thinking brain, we rarely use this system because it is costly i. Used to make rational decisions

The current thinking, then, is that emotions and logic are linked together due to biology and can't be separated from one another, regarding of what neoclassical economists want to believe.

a. Memories are biased, not accurate at all. Memories are changed while recalling them.

a. Kahneman b. We remember an experience based on two things: 1. The peak of the experience 2. How it ended

fMRI fMRI machines can directly measure, in general, where in the brain increased activity is taking place, and at what levels of intensity, so that the researcher does not have to rely on personal reports by the subject.

a. Economists can rationally look at certain situations and see what happened.

No

Free Market Capitalism, a form of Social Darwinism predicated on the ability to obtain capital, wherein companies and corporations compete in a Darwinian market that favors whatever is best for business.

the interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects. No, companies who have nothing in common, who join together, rarely do much better than they were alone.

a. Ford said business education sucked b. Said business education needed more math, econ and finance

The ship hit an iceberg and sank at night. There were only enough lifeboats for 1/3 of the people on board. THe captain and crew sailed away in a life boat, while some crew members were left behind to help the survivors. They threw men over board and were tried when they were rescued.

a. Mental threshold on what is ok to take home i. A pad of paper vs stealing a company car

a. Yes, economics says we shouldn't care if a company is ethical

London Inter-Bank Offered Rate. Libor was created in the 1980s by the banks to be used as a benchmark for setting other rates.

a. Only profit matters

a. If the crowd is diverse enough b. If crowd is not manipulated

a. Decisions are the opposite of true diverse crowds

Harry Markowitz

William F. Sharpe. Capital Asset Pricing Model CAPM divides total risk into two parts: 1)Systemic risk, i.e., the risk of the overall market, and 2)Non-systemic, or security, risk, which is the risk posed by buying a particular stock.

a. Something completely unexpected that is destined to happen anyway b. Related to randomness issue c. Term cam up with right before crisis in 2008

a. Banks use this to measure what is going wrong i. The future will be like the recent past ii. Risk is supposed to follow a standard Bell curve Measure of potential risk in the system.

Father of Finance. Efficient Market hypothesis a. He said, past information is included in the prices of things traded on the open market

Professional investors do not typically do better than the market itself.

Speculator: a person who invests in stocks, property, or other ventures in the hope of making a profit, but he doesn't have much evidence or knowledge in his stake. Investor: a person or organization that puts money into financial schemes, property, etc. with the expectation of achieving a profit.

Benjamin Graham

a. He was a Chinese general who produced the classic work, The Art of War, during the Chinese feudal period. b. Art of War

Yes. 1) Capture your market without destroying it 2) Avoid your competitor's strength, and attack their weakness 3) Use foreknowledge & deception to maximize the power of business intelligence. 4) Use speed and preparation to swiftly overcome the competition. 5) Use alliances and strategic control points in the industry to "shape" your opponents and make them conform to your will. 6) Develop your character as a leader to maximize the potential of your employees.

a. January Effect. b. Dogs of the Dow. c. Daily or weekly patterns. d. Data mining. e. Momentum investing. f. Contrarian investing

a. Minsky b. When times are good, banks get sloppy in their lending, i. Three Types of Buyers 1. Speculative Buyers 2. Clumsy Buyers

a. Tulipmania: Scarcity leads to production, which then leads to no scarcity b. South Sea Bubble: Greater Fool Theory: run by a crook, his interest was in stealing as much as possible. Company supposedly traded with different parts of the world. Was a fake c. Mississippi Scheme: Paper without assets is worthless, use paper money to pay for public debts. Worked well for a time, because gold and silver backed paper, then country printed too much paper money. Run on bank and the whole system failed. d. Panic of 1907: i. No Central Bank ii. No Deposit Insurance 1. JP Morgan helped bring the country out of this e. Crash of 1987: Financial drop with no particular cause, accelerated by computer and fear. Had no defineable cause f. Long Term Capital Management: guys betting on bonds that ended up failing. Their theory was that markets will always be efficient. Smart guys aren't always right, marklets are not always efficient. g. Dot Com Bubble: All of the internet businesses were supposedly good. Flimsy business plans will blow up companies.