Introduction to behavioral economics

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INTRODUCTION TOBEHAVIORAL

ECONOMICS

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INTRODUCTION TOBEHAVIORAL

ECONOMICS

NONECONOMIC FACTORS THAT

SHAPE ECONOMIC DECISIONS

David R. Just

Cornell University

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Library of Congress Cataloging-in-Publication Data

Just, David R.

Introduction to behavioral economics: noneconomic factors that shape economic decisions /

David R. Just, Cornell University.

pages cm

Includes bibliographical references and index.

ISBN 978-0-470-59622-7 (pbk.)

1. Economics–Psychological aspects. 2. Human behavior –Economic aspects. I. Title.

HB74.P8J87 2014

330.01'9—dc23

2013019192

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

To Vibeka, Liam, Alex and Caden for the inspiration

and education they have lovingly provided me.

BRIEFCONTENTS

Preface xv

1 Rationality, Irrationality, and Rationalization 1

Part 1 Consumer Purchasing Decisions

2 Transaction Utility and Consumer Pricing 17

3 Mental Accounting 41

4 Status Quo Bias and Default Options 70

5 The Winner’s Curse and Auction Behavior 93

Part 2 Information and Uncertainty

6 Bracketing Decisions 125

7 Representativeness and Availability 156

8 Con rmation and Overcon dence 187

9 Decision under Risk and Uncertainty 214

10 Prospect Theory and Decision under Risk or Uncertainty 250

Part 3 Time Discounting and the Long and Short Run

11 Disagreeing with Ourselves: Projection and Hindsight Biases 281

12 Naïve Procrastination 309

13 Committing and Uncommitting 347

Part 4 Social Preferences

14 Sel shness and Altruism 389

15 Fairness and Psychological Games 417

16 Trust and Reciprocity 450

Glossary 473

Index 495

vii

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CONTENTS

PREFACE xv

1 RATIONALITY, IRRATIONALITY, AND RATIONALIZATION 1

Rational Choice Theory and Rational Modeling 2

Rationality and Demand Curves 4

Bounded Rationality and Model Types 8

Special Relationship between Behavioral Economics

and Experimental Economics 10

Biographical Note: Herbert A. Simon 12

Thought Questions 13

References 13

Advanced Concept: Deriving Demand Curves 13

PART 1 CONSUMERPURCHASINGDECISIONS

2 TRANSACTIONUTILITY AND CONSUMERPRICING 17

Rational Choice with Fixed and Marginal Costs 18

Fixed versus Sunk Costs 21

The Sunk Cost Fallacy 22

Theory and Reactions to Sunk Cost 25

History and Notes 28

Rational Explanations for the Sunk Cost Fallacy 28

Transaction Utility and Flat-Rate Bias 29

Procedural Explanations for Flat-Rate Bias 31

Rational Explanations for Flat-Rate Bias 33

History and Notes 33

Transaction Utility and Consumer Preferences in Reference 34

Theory and Reference-Dependent Preferences 35

Rational Explanations for Context-Dependent Preferences 36

Biographical Note: Richard H. Thaler 37

Thought Questions 38

References 38

Advanced Concept: Fixed Costs and Rational Choice 39

ix

3 MENTALACCOUNTING 41

Rational Choice with Income from Varying Sources 42

The Theory of Mental Accounting 45

Budgeting and Consumption Bundles 49

Accounts, Integrating, or Segregating 52

Payment Decoupling, Prepurchase, and Credit Card Purchases 55

Investments and Opening and Closing Accounts 57

Reference Points and Indifference Curves 60

Rational Choice, Temptation and Gifts versus Cash 61

Budgets, Accounts, Temptation, and Gifts 62

Rational Choice over Time 64

Rational Explanations for Source-Based Consumption and Application 66

Biographical Note: George F. Loewenstein 67

Thought Questions 68

References 69

4 STATUSQUO BIAS ANDDEFAULTOPTIONS 70

Rational Choice and Default Options 71

Preference Formation, Framing, and the Default Option 72

Rational Explanations of the Status Quo Bias 76

History and Notes 76

Reference Points, Indifference Curves, and the Consumer Problem 77

An Evolutionary Explanation for Loss Aversion 81

Rational Choice and Getting and Giving Up Goods 83

Loss Aversion and the Endowment Effect 85

Rational Explanations for the Endowment Effect 87

History and Notes 88

Biographical Note: Amos N. Tversky 89

Thought Questions 89

References 90

Advanced Concept: The Shape of Indifference Curves with Constant Loss Aversion 91

5 THE WINNER’S CURSE ANDAUCTIONBEHAVIOR 93

Rational Bidding in Auctions 93

Procedural Explanations for Overbidding 97

Levels of Rationality 98

Bidding Heuristics and Transparency 99

Rational Bidding under Dutch and First-Price Auctions 101

History and Notes 105

Rational Prices in English, Dutch and First-price Auctions 105

Auction with Uncertainty 106

Rational Bidding under Uncertainty 107

x CONTENTS

The Winner’s Curse and Anchoring and Adjusting 110

History and Notes 116

Rational Explanations for the Winner’s Curse 117

Biographical Note: Matthew Rabin 117

Thought Questions 118

References 119

Advanced Concept: Bayesian Nash Equilibrium and Bidding

under Uncertainty 119

PART 2 I NFORMATION ANDUNCERTAINTY

6 BRACKETINGDECISIONS 125

Multiple Rational Choice with Certainty and Uncertainty 126

The Portfolio Problem 133

Narrow versus Broad Bracketing 135

Bracketing the Portfolio Problem 139

More than the Sum of Its Parts 140

The Utility Function and Risk Aversion 140

Bracketing and Variety 144

Rational Bracketing for Variety 144

Changing Preferences, Adding Up, and Choice Bracketing 145

Addiction and Melioration 146

Narrow Bracketing and Motivation 149

Behavioral Bracketing 149

History and Notes 150

Rational Explanations for Bracketing Behavior 151

Biographical Note: Drazen Prelec 151

Thought Questions 152

References 152

Advanced Concept: The Portfolio Problem 153

Advanced Concept: Bracketing the Portfolio Problem 154

7 REPRESENTATIVENESS ANDAVAILABILITY 156

Statistical Inference and Information 157

Calibration Exercises 162

Representativeness 165

Conjunction Bias 167

The Law of Small Numbers 169

Conservatism versus Representativeness 178

Availability Heuristic 180

Bias, Bigotry, and Availability 181

History and Notes 183

Contents xi

Biographical Note: Daniel Kahneman 184

Thought Questions 185

References 185

8 CONFIRMATION ANDOVERCONFIDENCE 187

Rational Information Search 188

Con rmation Bias 192

Risk Aversion and Production 203

Overcon dence 204

Self-Serving Bias 207

Is Bad Information Bad? 208

History and Notes 210

Biographical Note: Colin F. Camerer 211

Thought Questions 211

References 212

9 DECISION UNDERRISK ANDUNCERTAINTY 214

Rational Decision under Risk 215

Modeling Intransitive Preferences: Regret and Similarity 220

Independence and Rational Decision under Risk 226

Allowing Violations of Independence 234

The Shape of Indifference Curves 236

Evidence on the Shape of Probability Weights 237

Probability Weights without Preferences for the Inferior 239

Practical Implications of Violations of Expected Utility 240

What to Do When You Don’t Know What Can Happen 242

History and Notes 246

Biographical Note: Maurice Felix Charles Allais 246

Thought Questions 247

References 248

Advanced Concept: The Continuity Axiom 249

10 PROSPECTTHEORY ANDDECISION UNDERRISK ORUNCERTAINTY 250

Risk Aversion, Risk Loving, and Loss Aversion 253

Prospect Theory 257

Prospect Theory and Indifference Curves 259

Does Prospect Theory Solve the Whole Problem? 267

Prospect Theory and Risk Aversion in Small Gambles 269

History and Notes 275

Biographical Note: Peter P. Wakker 276

Thought Questions 276

References 277

xii CONTENTS

PART 3 TIME DISCOUNTING AND THELONG AND SHORT RU N

11 DISAGREEING WITHOURSELVES: PROJECTION ANDHINDSIGHTBIASES 281

The Standard Models of Intertemporal Choice 282

Making Decisions for Our Future Self 287

Projection Bias and Addiction 290

The Role of Emotions and Visceral Factors in Choice 297

Modeling the Hot– Cold Empathy Gap 299

Hindsight Bias and the Curse of Knowledge 303

History and Notes 306

Biographical Note: Dan Ariely 307

Thought Questions 307

References 308

12 NAÏVE PROCRASTINATION 309

The Fully Additive Model 310

Discounting in Continuous Time 312

Why Would Discounting Be Stable? 313

Naïve Hyperbolic Discounting 318

Naïve Quasi-Hyperbolic Discounting 324

The Common Difference Effect 330

The Absolute Magnitude Effect 331

Discounting with a Prospect-Theory Value Function 336

History and Notes 343

Biographical Note: Robert H. Strotz 344

Thought Questions 345

References 345

13 COMMITTING ANDUNCOMMITTING 347

Rationality and the Possibility of Committing 348

Commitment under Time Inconsistency 351

Choosing When to Do It 361

Of Sophisticates and Naïfs 368

Uncommitting 374

History and Notes 378

Biographical Note: David Laibson 378

Thought Questions 379

References 380

Advanced Concept: The Continuous Choice Problem

with Backward Induction 381

Contents xiii