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An Introduction to

Behavioral Economics
Behavioural Economics
Staff:
Dr Chris Dawson (Course teacher); room F4;
cgd@aber.ac.uk
Texts:
Camerer, C., Babcock, B., Loewenstein, G. And Thaler, R. (1997)
Labour Supply of New York City Cabdrivers: One Day At A Time,
Quarterly Journal of Economics, pp. 407-411.
Taxi Drivers and Beauty Contests by Colin F. Camerer
Daniel Kahneman; Jack L. Knetsch; Richard H. Thaler. (1991)
Anomalies: The Endowment Effect, Loss Aversion, and Status
Quo Bias. The Journal of Economic Perspectives, Vol. 5, No. 1,
pp. 193-206.
Tversky, A. & Kahneman, D. (1981). The Framing of decisions
and the psychology of choice. Science, 211, 453-458.
Tversky, A. & Kahneman, D. (1974). Judgment under uncertainty:
Heuristics and biases. Science, 185, pages 1124-1130.
Kahneman, D., Slovic, P., & Tversky, A. (1982). J udgment
Under Uncertainty: Heuristics and Biases . New York:
Cambridge University Press.



Behavioural Economics
What is behavioural economics?
1870s Marginalist Revolution
Neo Classical Economics
People have rational preferences among
outcomes that can be identified and associated
with a value.
Individuals maximise utility and firms maximise
profits
People act independently on the basis of full and
relevant information


Behavioural Economics
Neo Classical Economics
Unbounded Rationality
Homo Economicus

Behavioural Economics
Behavioural Economics is a reaction against
the restrictive assumptions of neo-
classical/marginalist revolution.
Seeks to introduce more realistic assumptions
(i.e. we are not all super-rational beings)
Bounded Rationality (Herbert Smith 1955)
Not a complete rejection of neo-classical
economics, instead tendency to augment old
models to make predictions more powerful and
precise.
Behavioural Economics
Departures from rationality emerge both in
judgments (beliefs) and in choices. The ways
in which judgment diverges from rationality are
extensive (see KAHNEMAN et al. 1982).
Overconfidence & Optimism
Loss Aversion
Mental Accounting


Behavioural Economics
Myopia
Framing
Hindsight Bias
Cognitive Dissonance
Better than average effect

Behavioural Economics
Evidence

1. Choose between
A. 1000 with certainty; OR
B. 90% odds of 2000 & 10% odds of -1000

2. Choose between

A. 0 with certainty; OR
B. 50% odds of 150 and 50% odds of -100

3. Choose between

A. -100 with certainty; OR
B. 50% odds of 50; 50% odds of -200
Behavioural Economics
Evidence (Tversky and Kahneman, 1981)

1. Choose between
A. Save 200 people's lives; OR
B. 33% chance of saving all 600 people and 66%
possibility of saving no one

2. Choose between

A. 400 people will die
B. 33% chance that no people will die and a 66%
probability that all 600 will die
Behavioural Economics
Judgements of Fairness and Justice (Kahneman et al.
1991)
1. A shortage has developed for a popular model of
automobile, and customers must now wait two
months for delivery. A dealer has been selling these
cars at list price. Now the dealer prices this model at
200 above list price.

2. A shortage has developed for a popular model of
automobile, and customers must now wait two
months for delivery. A dealer has been selling these
cars at a discount of 200 below list price. Now the
dealer sells this model at list price.


Behavioural Economics
Judgements of Fairness and Justice
1. A company is making a small profit. It is located in a
community experiencing a recession with
substantial unemployment but no inflation. The
company decides to decrease wages and salaries
7% this year.

2. A company is making a small profit. It is located in a
community experiencing a recession with
substantial unemployment and inflation of 12% a
year. The company decides to increase salaries only
5% this year.

Behavioural Economics
Evidence
An example of suboptimal behaviour involving two important
behavioural concepts, loss aversion and mental accounting,
is a mid-1990s study of New York City taxicab drivers
(Camerer et al. 1997).

Study:
Cabdrivers in New York are Independent Contractors
Rent the cab for $76 a day (paid in advance) for 12 hours
Keep all fares can quit anytime and return cab within 12 hours
Good days Rains or snow, during the holidays, conventions in
town
Bad Days weekends and the summer


Behavioural Economics
What is the profit-
maximising (neo-classical)
strategy?
Law of supply sell more
labour when the wage is high
to work longer hours on good
days - rainy days or days with
a big convention in town - and
to quit early on bad days


Behavioural Economics
What do you think actually
happened?

Behavioural Economics
Occupational choice
Why do individuals enter self-employment?
Earn less
Work longer hours
Bear more risk
Accumulating evidence that entrepreneurs overestimate
the returns to starting a business (see Cooper, Woo &
Dunkleberg 1988; Landier & Thesmar 2009)
Cross section studies appear to resolve this issue (see
Arabsheibani et al. 2000; Fraser & Greene 2006; Puri &
Robinson 2007)

Behavioural Economics
Overview
Neo-Classical economics
Strict Rationality
Behavioural Economics
Bounded rationality we are not computers,
were human
For better predictions and more precise theories.