Behavioral
Economics
How selfish soever man may be supposed, there are
evidently some principles in his nature, which interest
him in the fortune of others, and render their happiness
necessary to him, though he derives nothing from it,
except the pleasure of seeing it. Of this kind is pity or
compassion, the emotion which we feel for the misery of
others, when we either see it, or are made to conceive it
in a very lively manner. That we often derive sorrow
from the sorrow of others, is a matter of fact too obvious
to require any instances to prove it; for this sentiment,
like all the other original passions of human nature, is by
no means confined to the virtuous and humane, though
they perhaps may feel it with the most exquisite
sensibility.
Adam Smith, The Theory of Moral Sentiments (1759)
Behavioral Economics uses insights from
psychology to improve economic theory.
Primary contributions from psychology often
involve:
1. Preferences unaccounted for by
economic theory such as fairness or
status.
2. Mistakes.
Early economists expressed and developed
psychological concepts in their work, e.g., Smith,
Bentham and Edgeworth.
In the early 20th century, many economists
turned away from psychological concepts.
Notable exceptions were Irving Fisher, and later,
John Maynard Keynes.
In the latter 20th century, anomalies in behavior
unexplainable by economic theory could no
longer be ignored.
In psychology in the 1960s, the view of the brain
as an information-processing unit rather than a
stimulus-response machine became dominant.
Problem-solving and decision-making gained
interest among psychologists—topics relevant to
economics.
Collaborative work revealed some explanations
for anomalies, and the field of Behavioral
Economics emerged in the early 1980s.
In addition to traditional economic methods,
behavioral economists tend to rely more heavily
on experiments.
Experimental economics is an empirical tool,
like econometrics or cost-benefit analysis.
Experiments take place in a lab setting. The
experimenter sets rules, establishes rewards,
and assigns tasks to the subjects. The behavior
is then observed and documented.
Pair up. Decide who will be player 1 and who
will be player 2.
Assignment: Split $10 between you.
1. Player 1 makes an offer to player 2 as to how
to split the $10.
2. Player 2 accepts the offer or rejects the offer.
3. If Player 2 rejects, no one gets anything.
• Ultimatum Game shows fairness counts.
• Real world tests of offer rejection due to
fairness concerns might be observed in:
• Failures of legal cases to settle before trial
• Costly divorce proceedings
• Labor strikes.
• In the real world, we cannot tell if rejection of
offers occurs because of:
Fairness or
1. Reputation building in repeated games
2. Agency problems, e.g., clients and
lawyers
3. Confusion
Experiment eliminates 1-3.
Advantages of Experiments
• Can control influences on decision-making,
unlike in the complex real world.
• Easier to establish causality.
• Subjects can be interviewed afterwards
about their understanding and thought
processes.
• Easier for the general public to understand
than other empirical techniques such as
regression.
Disadvantages of Experiments
• Small samples
• Unrepresentative samples
• Behavior may be influenced by perceived
expectations of the experimenter.
• Artificial environment
• No meaningful monetary consequences
from decisions.
Anchoring
Occurs when someone’s choices are linked to
prominent but patently irrelevant information.
Experiment:
1. College students asked how many times they
had gone on a date in the past month.
2. Then they were asked how happy they had
been overall.
Correlation between responses = 0.66
Anchoring Experiment-Part 2:
2nd group of students were asked questions in
reverse order.
1. First they were asked how happy they had
been overall in the past month.
2. Then they were asked how many times they
had gone on a date in the past month.
Correlation between responses to 1 and 2 was
close to 0.
• Happiness question was anchored by the
dating question for the first group.
• Order of questions matters.
Would you prefer:
Option A: 2% yearly pay increase after a year
when there has been inflation of 4%
Option B: pay cut of 2% after a year when there
has been zero inflation
What would rationality imply?
Indifference between A and B.
Money illusion– Bias in the assessment of the
real value of transactions induced by their
nominal representation.
Dynamically Inconsistent Preferences
Maintaining Self-Control
e.g., Diets, alcohol, drugs, smoking,…
Standard economic theory assumes preferences
are dynamically consistent -- an individual’s
preferences over the alternatives available at
some future date do not change as that date
approaches or once it arrives, i.e., he/she never
loses self-control.
Experiments show that individuals often show
present bias– a form of dynamic inconsistency
involving a bias toward immediate gratification.
Individuals aware they might not follow through
on their plans might choose pre-commitment -a choice that removes future options.
e.g., resident rehab, weight-loss spas
Economists and psychologists are working
together to bring psychological factors into
economic models and improve policy
prescriptions.
Behavioral economics models often:
• have additional parameters or change the
form of a relationship or parameter
• “nest” standard economics models
• are now being tested against data.
Neuroeconomics is also bringing information to
bear on economic decision-making.
Neuroeconomics
... imagine an ideally perfect instrument, a
psychophysical machine, continually registering
the height of pleasure experienced by an
individual ... From moment to moment the
hedonimeter varies; the delicate index now
flickering with the flutter of the passions, now
steadied by intellectual activity, low sunk whole
hours in the neighbourhood of zero, or
momentarily springing up towards infinity ...
Francis Y. Edgeworth (1845-1926)
Early economists lamented the inability to
measure preferences directly.
Economists turned to the concept of “revealed
preference” to enable prediction of economic
decision-making, where observed choices are
presumed to reveal individual preferences.
The utility-maximization apparatus yields
predictions without measuring preferences
directly.
Technical advances in neuroscience now make
observation of brain activity related to
preferences and choices possible.
Neuroeconomics uses knowledge from
neuroscience to inform economic theory about
how the brain works in decision-making and
strategic thinking.
Neuroscience also benefits from the conceptual
structure of economics. (Paul W. Glimcher et al.,
“Neuroeconomics: The Consilience of Brain and Decision,”
Science 306, 447, 2004).
Animal Behavior
Brain Imaging
• Electro-encephalogram (EEG)
• Positron Emission Topography (PET)
• Functional Magnetic Resonance Imaging
(fMRI)
• Single-neuron Measurement
• Psychopathology
• Brain Damage in Humans
• Damage occurred prior to study
• Transcranial Magnetic Stimulation (TMS)
•
•
•
Four lobes
•
Frontal – Planning, cognitive control,
integration of cross-brain input.
•
Parietal – Motor action.
•
Occipital – Visual processing.
•
Temporal – Memory, recognition, emotion.
•
Notable features of the brain:
Automaticity – brain processes and
choices can occur without awareness.
• Sense-making – the brain seeks to make
sense of the individual’s behavior
• Modularity – brain is organized into
modules, sometimes anatomically
distinct, which are tied to particular
functions.
• Modules can work independently or in
cooperation in brain processes
• Neuroscience can help to identify brain
areas associated with different factors
affecting decisions.
•
Neuroscience evidence shows that when
Players 2 are faced with unfair offers, particular
parts of the brain are activated more than when
fair offers are made:
• Dorsolateral prefrontal cortex (DLPFC) –
involved in cognitive processes, e.g., goal
setting and executive control.
• Insula cortex – activated during the experience
of negative emotions, e.g., pain, distress, anger
and disgust.
• Anterior cingulate (ACC) – area which detects
cognitive conflict.
Fig.2. Activation related
to the presentation of an
unfair offer. (A) Map of
the t statistic for the
contrast [unfair human
offer – fair human offer]
showing activation of bilateral
anterior insula and
anterior cingulate cortex.
Areas in orange showed
greater activation following
unfair as compared
with fair offers (P <
0.001). (B) Map of the t
statistic for the contrast
[unfair human offer – fair
human offer] showing
activation of right dorsolateral
prefrontal cortex.
A. G. Sanfey et al., Science
300, 1755 -1758 (2003)
Sanfey et al. (2003) conclude that their results
are consistent with “the idea that the areas of
anterior insula and DLPFC represent the twin
demands of the Ultimatum Game task, the
emotional goal of resisting unfairness and the
cognitive goal of accumulating money... “
The ultimate decision-maker is the brain.
Neuroeconomics and behavioral economics can
help us understand how the brain works and
what neural and psychological variables affect
economic choices.
Economic models informed by NE and BE can
make better predictions and policy
recommendations.