Because psychology systematically explores human judgment, behavior, and well-being, it can teach us important facts about how humans differ from the way they are traditionally described by economists. (Rabin,M.1998)
We proceed with a detailed discussion of departures of behavioral economics from conventional economics
- Choices involving Preferences through Time:
- Choices involving Preferences based on Social Motives:
- Choices involving departures from Perfect Rationality:
- Choices and judgement involving Uncertainty and Risk:
I. Choices involving preferences through time-The first departure that is discussed is-Caring about changes-Here to be noted the concept of “Reference-Points”-the point from which the individual makes the consumption decision. (Pindyck. R, Rubinfield. D,2006)
“A Person's preferences are often determined by changes in outcomes relative to her reference level, and not merely by absolute levels of outcomes. In particular, relative to their status quo (or other reference points), people dislike losses significantly more than they like gains.” (Rabin,M. 1998)
The core concept (Rabin,M. 1998)is the concept of reference level rt, determined by factors like past consumption or expectations of future consumption. Understanding that people are often more sensitive to changes than to absolute levels suggests that we ought incorporate into utility analysis such factors as habitual levels of consumption.Thus we summarise from Rabin “Instead of utility at time t depending solely on present consumption, ct, it may also depend on a "reference level”.
- The Psychology of Decision making-revisiting Reference Dependence-The validity of reversibility of preferences is brought into question by the growing evidence that people commonly demand much more to give up an entitlement than they are willing to pay to acquire a fully commensurate one.
(Knestch,J.1992) undertook two direct tests of the reversibility of indifference curves.The first used an experimental method, initially demonstrated by (MacCrimmon and Toda,1969), the first test empirically derives individual indifference curves between a single good, pens and money.The second uses a simpler incentive compatible experimental design to test reversibility between two Consumption Goods.
In order to show the concept of reference dependence, let us summarise the result of Knestch’s second experiment- where he endowed some subjects randomly with a mug, while others received a pen.Both groups were allowed to switch their good for the other at a minimal transaction cost, by merely handing it to the experimenter.
“If preferences are independent of random endownments, the fractions of subjects swapping their pen for a mug should add to roughly one.In fact 22% of subjects traded. The fact that so few chose to trade implies an exaggerated preference for the good in their endownment, or a distaste for losing what they have.” (Camerer, C.F et.al, 2006, page 15.)
“While the identification and measurement of how we feel about changes is an active area of research, one core aspect of our reference-based preferences is known to be crucial:
Loss aversion. The sensation of loss relative to the status quo and other reference points looms very large relative to gains. This has been identifed and emphasized in a great deal of experimental work. It is seen in the evaluation of losses and gains in money, and hence attitudes towards financial risk. And it is seen in the evaluation of loss and gains of consumer items, as revealed in the “endowment effect” – the fact that people who have randomly been given virtually any object will instantly value the object more than those who have not been endowed with the object.” (Rabin,M. 2002)
Time-Variant Preferences (Rabin,M.2002). People have a taste for immediate gratification. We procrastinate on tasks that involve immediate costs and delayed rewards such as mowing the lawn and do soon things that involve immediate rewards and delayed costs such as seeing a movie. Traditionally economists model such tastes by assuming that people discount streams of utility over time exponentially.
An important qualitative feature of exponential discounting is that it implies that a per- son's intertemporal preferences are time-consistent: A person feels the same about a given intertemporal trade-off no matter when she is asked. However casual observation, introspection, and psychological research all suggest that the assumption of time-consistency is importantly wrong. Our tendency in the short term to pursue immediate gratification is inconsistent with our long term preferences. While today we feel that it is best that we not overeat tomorrow, tomorrow we tend to overeat;
The behavior predicted by models of time-variant preferences often differs dramatically from the behavior predicted by the exponential model.Efforts at self-control are the most notorious examples., You may scheme to manipulate your future options because you may not like the way you will behave in the future.
You commit to do the task on April 14; you commit to do the task on April 15; or you wait until April 14 and then choose on which day to do the task. Which would you choose? The advantage of waiting is manifest:, if there are any uncertainties that may be resolved between now and April, by not precluding either of your options, the flexibility you have retained may be valuable. Yet we sometimes engage in behavior precisely to restrict our own future flexibility. You might want to commit on February 1 to the April 14 date if there were few uncertainties. You wish to restrict your future self from procrastinating given your current preference to do the task earlier. More generally, researchers have explored many self-commitment devices we employ to limit our future choices.
Forecasting Future Tastes and Needs-In behavioural economics one bias that is studied is the projection bias which is basically about the tendency to evaluate future consequences based on tastes and needs at the moment of decision-making.Whenever our actions have consequences in the future, then the accuracy of our forecasts will determine the quality of our decisions.Whatever we need in the future we will favour alternatives which provide that in the future,if we are hungry we will want to be fed , if we are thirsty we will prefer alternatives which will satisfy our thirst.
Evidence suggests that we are often biased in our forecasts of the future based on our needs at a particular point of time, we often project our current states of mind into the future, even if our current states of mind don’t necessarily hold in the future for e.g.-we may not be hungry in the future but we may favour those alternatives which provide food in the future.
Even those decisions that have only long term consequences may be affected by a temporary state of mind.For e.g., in controlled experiments that manipulate subjects hunger prior to grocery shopping those subjects who are hungry prior to shopping will tend to stock up in supplies to a greater extent as compared to those who are sated.
People also tend to underestimate their adaptability based on projection bias, certain events which might have a smaller impact or to which a person may be able to adjust much faster are predicted to have an impact based on an intensity which is according to current state of mind.
II. Caring about others:
People Care about Fairness
1. Example: the ultimatum game.
a. Two volunteers are told they are going to play a game and could win a total of $100.
b. The game begins with a coin toss, which is used to assign the volunteers to the roles of Player A and Player B.
c. Player A’s job is to propose a division of the prize between himself and the other player.
d. After Player A makes his proposal, Player B decides whether to accept or reject it.
e. If Player B accepts the proposal, both players are paid according to the proposal. If Player B rejects the proposal, both players receive nothing.
2. Conventional economic theory suggests that Player A should know that if he offers $1 to Player B and keeps $99 for himself, Player B should accept it ($1 is greater than $0).
3. In reality, when the offer made to Player B is small, Player B often rejects it.
4. Knowing this, people in the role of Player A often offer a more substantial portion of the money to Player B.
5. This implies that people may be driven by a sense of fairness.(Mankiw,G.2007)
Many people do things because they think it is fair and appropriate to do so.
Indeed, they sometimes help others for no apparent benefit to themselves
(Pindyck. R, Rubinfield. D,2006)
III.Choices involving Departures from rationality :
Incoherent-Choices-Choices are supposed to reflect preferences, this idea is central to the theory of consumer decision-making as described in basic Economic Lessons.But according to some psychologists and behavioral economists, people, atleast in some situations do not make choices that reflect sensible preferences
Choice Reversals-Laboratory Subjects sometimes display behavior that violates what is known as- The Ranking Principle,this type of incoherent behavior consisting of circular choices is seen sometimes when laboratory subjects are confronted with certain types of choices.
Subjects were asked to make decisions involving two different bets in one series of experiments.The first type of bet was the type called-the low stakes bet, it involved a high probability of winning a small amount of money.The second bet involved a low probability of winning a larger amount of money.This was- the high stakes bet.The standard finding that was obtained was that people choose the more conservative A bet over bet B when asked to choose, but are willing to pay more for the riskier bet B when asked to price them separately.Joint and Separate evaluation of pairs of goods show another form of preference reversal(Hsee et al.1999;Hsee and LeClerc 1998).People will evaluate an item B higher than A when the two items are compared and priced at the same time, but will price or otherwise evaluate an item A higher than B when the two are evaluated independently. (Camerer, C.F et.al, 2006.)
The anchoring effect was classically demonstrated(Tversky and Kahnemann,1974) in the context of judgement rather than choice. This is a phenomenon that violates standard theory.It was demonstrated in the following way- the spin of a wheel of fortune that could range between 0 and 100 was shown to subjects and they were asked to guess whether the number of African nations in the United Nations was greater than or less than this number.They were then asked to guess the true value.Subjects’ guesses were strongly influenced by the spin of the wheel even though the wheel of fortune was absolutely random.As interpreted by Kahneman and Tversky, subjects seemed to “anchor” on the number spun on the wheel and then adjusted for whatever else they thought or knew, but adjusted insufficiently.As opposed to judgements as above anchoring effects have also been demonstrated for choices.Subjects were asked in one study whether their certainty equivalent for a gamble was greater or less than a number chosen at random and then were asked to specify their actual certainty equivalent for the gamble(Johnson and Schkade 1989).The stated values were again correlated significantly with the random value.
(Ariely, Loewenstein and Prelec,2003) in a study of anchoring sold valuable consumer products to a test population of post graduate (MBA)business students.Then an interesting experiment was conducted with these students, the students were presented with a product they were asked if they would buy it for the last two digits of their social security number’s dollar equivalent which is a roughly random identification number required to work in the United States. These students were then asked what is the maximum they would be willing to pay.It was observed that these students had a pattern in their behaviour-those with high numbers were willing to pay more for their products, even though they were reminded that the pattern was random.
It has been pointed out by Tversky and Kahnemann that anchoring can occur as a natural part of the assessment process itself. The likely beginning point of an individual asked to construct a probability distribution for the level of the Dow Jones, would be to estimate a median level. For further probability assessments this value would likely then serve as an anchor. If she were asked on the other hand by somebody to construct the probability assessments by stating the likelihood of the Dow Jones exceeding a pre-specified value, she would probably anchor on this value. Different predictions are likely to result from the two procedures, with the first procedure yielding a probability distribution more concentrated around the median than the second. (Rabin,M. 1998)
A similar bias is The Hindsight bias. It is seen from the literature on the hind- sight bias that people exaggerate the degree to which their beliefs before an informative event would coincide to their current beliefs. We tend to think we "knew it would happen all along." After an election has been won by a politician, people label it as inevitable. (Rabin,M. 1998)
Imagining what they would have thought without that information people don't sufficiently "subtract" information they currently have about an outcome.Even when they have better sources of information a pervasive fact about human judgement is that people disproportionately weight salient, memorable, or vivid evidence. Tversky and Kahneman (1973) discuss, for example, how clinicians' assessments of the relationship between severe depression and suicide may be distorted by salience. Incidents in which patients commit suicide are much more likely to be remembered than are instances where patients do not commit suicide. An exaggerated assessment of the probability that depressed patients will commit suicide is going to result from this.
There is a mass of psychological research according to which people are prone toward overconfidence in their judgments. It is argued by the vast majority of researchers that such overconfidence is pervasive. (Rabin,M. 1998)
Loss aversion mentioned earlier is related to the striking endowmnent effect identified by Thaler (1980): A person immediately values a good more than before he possesses it once a person comes to possess a good.This phenomenon is nicely illustrated by Kahneman, Knetsch, and Thaler (1990).
“They randomly gave mugs worth about $5 each to one group of students………………..
Those who were randomly given mugs treated the mugs as part of their reference levels or endowments, and considered leaving without a mug to be a loss, whereas individuals not given mugs considered leaving without a mug as remaining at their reference point.”(Rabin,M. 1998, page 14.)
“A comparable phenomenon-the status quo bias-holds in multiple-good choice problems. “Knetsch and Sinden (1984) and Knetsch (1989), for instance, randomly gave students either candy bars or decorated mugs. Later, each student was offered the opportunity to exchange her gift for the other one-a mug for a candy bar or vice versa. Ninety percent of both mug-owners and candy-owners chose not to trade,…the different behavior for the two groups of subjects presumably reflected preferences that were induced by the initial allocation.”(Rabin,M.1998, page 14-15.)
Another important reference-level effect is diminishing sensitivity: Changes close to one's reference level have greater marginal effects in perceived well being than for changes further away.
“We are more likely to discriminate between 30 degree and 6 degree changes in room temperature than between 23 degree and 26 degree changes. While people are likely to be risk averse over gains, they are often, risk-loving over losses. Kahneman and Tversky (1979) found that 70 percent of subjects report that they would prefer a 3/4 chance of losing nothing and 1/4 chance of losing $6,000 to a 2/4 chance of losing nothing and 1/4 chance each of losing $4,000 or $2,000. The responses of 70 per- cent of the subjects are inconsistent with the standard concavity assumption.” (Rabin,M. 1998, page 15.)
“Framing effect” which shows that the way choices are presented to an individual often determine the preferences that are “revealed”.There is a classical example of a framing effect which is the “Asian disease” problem in which information is given to people about a disease that threatens 600 citizens, these people are asked to choose between two undesireable options(Tversky and Kahneman 1981). There is a positive way of framing the problem in which
A-two hundred people are saved.
B-there is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no people will be saved.
They are asked the question-which of the two programs will you favour?
A second randomly selected group is posed the question in a negative frame with the following two alternatives replacing programs A and B:
C-400 people will die.
D-there is a 1/3 probability that no one will die, and a 2/3 probability that 600 people will die.
Despite the fact that in terms of lives lost or at risk A and C, and B and D, are equivalent, most people choose A over B but D over C.
What explains these results? The salient information in the two frames are different, the positive frame emphasizes lives saved whereas the negative frame emphasizes lives lost. Whereas program A emphasizes saving lives for sure, program C gives the same information but guarantees death so appears comparatively unattractive.
.IV.Choices and judgement involving Uncertainty and Risk:The Laws of Probability: Prospect Theory-
Generally many people appear so risk averse that they prefer not to take even tiny shares of gambles even though they may have positive payoffs , however a risk averse individual in theory is always supposed to be willing to accept gambles with positive expected payoffs.Also this makes large financial risks taken by people imposible to explain. In the 1970’s two psychologists Daniel Kahnemann and Amos Tversky provided an alternative to the standard ecomic theory of risk preference which was intended to solve puzzles like the above-Prospect Theory.(Kahneman and Tversky, 1979). Using prospect theory we evaluate an outcome based on the change in total resources. So, we judge alternatives according to the gains and losses they generate, relative to the staus quo.In this reference let us consider the property of diminishing sensitivity-when we buy a mug we do probably care whether the price is Rs 5 or Rs 15 but when we buy a thing of expensive value do we care whether the price is Rs 14,430 or Rs 14,440?We are less sensitive to the difference in the second case because we are considering a larger change from the status quo.