Hum1046 PPT (17543)

Behavioural Economics
1
Behavioral economics
Behavioral economics increases the explanatory power of

economics by providing it with more realistic psychological
foundations.
Camerer and Loewenstein.
2
Behavioral perspectives on economic
rationality
‘A rational being should pursue enlightened self-interest.
• Enlightened’ implies that an individual has perfect

knowledge, something that is obviously not realistic.
• There may be many reasons why we fail to judge what is in
our ‘self-interest’.
• We may have incomplete knowledge or we may have cognitive
failures in terms of the processing of information within given
time constraints.
3
Heuristic approach to decision-making
The term ‘heuristic’ means that people use simple ‘rules-of-

thumb’, often unconsciously, in order to make decisions when
there is a lot of information involved, much uncertainty, and a
realistic time constraint.
Thus we may have a personal rule always to pay by cash for purchases of
less than $100, even if we have a credit card handy. Sometimes this can
result in inconsistent or incoherent behaviour.
4
Bounded rationality
Bounded rationality is not concerned with optimality, or even sub-

optimality; the heuristics involved in the decision-making processes of
bounded rationality are more related to ‘satisficing”.
5
Self-serving bias
Self-serving bias is the ‘above-average’ effect: well over half of

survey respondents typically rate themselves in the top 50% of
drivers (Svenson, 1981), ethics (Baumhart,1968), managerial
prowess (Larwood and Whittaker, 1977), productivity (Cross,
1997) and health (Weinstein, 1980).
Some economists and psychologists would claim that such acts
are irrational.
6
Self-interest
Many or indeed all of our actions may be arational in terms of

not being caused by any kind of conscious deliberation.
We may have dual attitudes toward many things in our lives, one
a rapid response and the other a more studied reaction that takes
into account the context and our personal theory of what we
ought to be feeling.
Wilson, Lindsay and Schooler (2000)
7
Rationality
Rationality may be seen as demanding something other than just

consistency of choices between different subsets. It must, at
least, demand cogent relations between aims and objectives
actually entertained by the person and the choices that the
person makes.
- Sen (1990)
cogent-> logical
8
Nature of the standard model
 A concise description of the relevant factors affecting

decision-making.
 An illustration of the various components of the model.
 A general consideration of the assumptions underlying the
model in terms of how they relate to the various components.
9
The model can be stated in the following terms:
10
11
Limitations in the standard model
Consider the following questions:
1. Why is the return on stocks so much higher on average than
the return on bonds?
2. Why do sellers often value their goods or assets much higher

than buyers?
3. Why are people willing to drive across town to save $5 to

purchase a $15 calculator but not to purchase a $125 jacket?
12
4. Why are the fresh fruit and vegetables usually found at the
entrance of the supermarket when they are easily damaged in
the shopping trolley?
5. Why are people delighted to hear they are going to get a 10%
raise in salary, and then furious to find out that a colleague is
going to get 15%?
6. Why do people forever make resolutions to go on a diet or

stop smoking, only to give in later?
13
7. Why do people go to the ATM and withdraw a measly $50?
8. Why do people prefer to postpone a treat like a luxury dinner

rather than have it sooner?
9. Why is someone unwilling to pay $500 for a product, but then
delighted when their spouse buys them the same product for the
same price using their joint bank account?
10. Why is someone willing to drive through a blizzard to go to
see a ball game when they have paid for the ticket, but not when
they have been given the ticket for free?
14
More Examples
• Jeffrey and I somehow get two free tickets to a professional basketball game in
Buffalo, normally an hour and a half drive from where we live in Rochester. The
day of the game there is a big snowstorm. We decide not to go, but Jeffrey
remarks that, had we bought the (expensive) tickets, we would have braved the
blizzard and attempted to drive to the game.
• Stanley mows his lawn every weekend and it gives him terrible hay fever. I ask
Stan why he doesn’t hire a kid to mow his lawn. Stan says he doesn’t want to pay
the $10. I ask Stan whether he would mow his neighbor’s lawn for $20 and Stan
says no, of course not.
• Thaler, Richard H.. Misbehaving (p. 20). Penguin Books Ltd. Kindle Edition.
15
More Examples
• Linnea is shopping for a clock radio. She finds a model she likes at what her research has
suggested is a good price, $45. As she is about to buy it, the clerk at the store mentions
that the same radio is on sale for $35 at new branch of the store, ten minutes away, that
is holding a grand opening sale. Does she drive to the other store to make the purchase?
On a separate shopping trip, Linnea is shopping for a television set and finds one at
the good price of $495. Again the clerk informs her that the same model is on sale at
another store ten minutes away for $485. Same question … but likely different answer.
• Thaler, Richard H.. Misbehaving (p. 20). Penguin Books Ltd. Kindle Edition.
16
More Examples
• Lee’s wife gives him an expensive cashmere sweater for Christmas. He had
seen the sweater in the store and decided that it was too big of an
indulgence to feel good about buying it. He is nevertheless delighted with
the gift. Lee and his wife pool all their financial assets; neither has any
separate source of money.
• Some friends come over for dinner. We are having drinks and waiting for
something roasting in the oven to be finished so we can sit down to eat. I
bring out a large bowl of cashew nuts for us to nibble on. We eat half the
bowl in five minutes, and our appetite is in danger. I remove the bowl and
hide it in the kitchen. Everyone is happy.
• Thaler, Richard H.. Misbehaving (pp. 20-21). Penguin Books Ltd. Kindle Edition.
17
History and evolution of behavioral economics
 Daniel Bernoulli (1738), who might be regarded as the

originator of the theory of choice under risk, explaining risk
aversion in terms of the diminishing marginal utility of money.
 Adam Smith is best known for his Wealth of Nations, in 1776,

he was also the author of a less well-known work, The Theory
of Moral Sentiments, in 1759. The latter contains a number of
vital psychological insights and foreshadows many more recent
developments in behavioral economics, particularly relating to
the role of emotions in decision-making.
18
History and evolution of behavioral economics
Jeremy Bentham, best known for introducing the concept of

utility, had much to say about the underlying psychology of
consumers.
Francis Edgeworth wrote Mathematical Psychics in 1881, the

title indicating his concern with psychology; this is reflected in
the well-known ‘Edgeworth Box’ diagram, named after him,
which relates to two-person bargaining situations and involves a
simple model of social utility.
19
The resurgence of behaviorism in economics
 Simon (1955) introduced the term ‘bounded rationality’ to refer

to the cognitive limitations facing decision-makers in terms of
acquiring and processing information.

20
The resurgence of behaviorism in economics
 The first, in 1979, was entitled ‘Prospect theory: An analysis of decision

under risk’, and was written by two psychologists, Daniel Kahneman and
Amos Tversky, being published in the prestigious and technical economic
journal Econometrica. Both Kahneman and Tversky had already published
a number of papers relating to heuristic decision-making, but prospect
theory introduced several new and fundamental concepts relating to
reference points, loss-aversion, utility measurement and subjective
probability judgments.
The second paper, ‘Toward a positive theory of consumer choice’, was
published by the economist Richard Thaler in 1980. In particular he
introduced the concept of ‘mental accounting’, closely related to the
concepts of Kahneman and Tversky.
21
Principles of (Behavioral) Economics
22
Behavioral Economics Defined
Behavioral economics uses variants of traditional economic

assumptions (often with a psychological motivation) to explain and
predict behavior, and to provide policy prescriptions.
23
Behavioral economics is a series of amendments to, not a rejection of,
traditional economics.
Behavioral economics adopts and refines the three core principles
of economics: optimization, equilibrium,
and empiricism.
Both traditional and behavioral economists believe that
(I) People try to choose their best feasible option (optimization);
(ii)People try to choose their best feasible option when
interacting with others (equilibrium); and
(iii)Models need to be tested with data (empiricism).
24
PRINCIPLE 1: People try to choose the best feasible
option, but they sometimes don’t succeed.
People try to make the optimal choice—they are optimizers—but they
sometimes make mistakes. It’s important to emphasize that these
mistakes are partially predictable.
One of the key explanatory factors is experience and training:
experienced decision-makers tend to make better choices than
inexperienced decision-makers.
Credit card users pay fewer and fewer fees—for instance, late payment
fees—the more experience they have with their card.
Consumers switch telephone plans, moving toward the best one, as
they gain experience.
25
PRINCIPLE 2: People care (in part) about how
their circumstances compare to reference points.
For example, a reference point could be the amount of money a

person expected to earn during summer break, or the amount of
money that she started with when she entered a casino, or the price
she paid for 100 shares of Apple stock, or the price she paid for her
home.
26
loss aversion
It matters whether a person is losing or gaining relative to their
reference point. Losses get far more weight than gains.
27
These phenomena have implications for market transactions. Loss
aversion discourages trade, since each trade generates two losses and
two gains (the buyer has a loss and a gain and the seller has a loss and
a gain), and the losses are weighted more than the gains. Accordingly,
people are prone to hold on to their endowments (Thaler, 1980).
28
Endowment effect
For example, give half of your students a mug and half of your students
a (big) chocolate bar, randomizing this endowment by switching every
other seat in the classroom. Let the students examine their own and
their neighbors’ endowments, and then ask the class who wants to
trade with you for the good that they didn’t receive. Fewer than a
quarter of the students will take up this offer, but traditional economic
theory predicts that half of them should.
29
• The endowment effect describes a circumstance in which an
individual places a higher value on an object that they already own
than the value they would place on that same object if they did not
own it.
• Endowment effect can be clearly seen with items that have an
emotional or symbolic significance to the individual.
• Research has identified "ownership" and "loss aversion" as the two
main psychological reasons causing the endowment effect.
30
PRINCIPLE 3: People have self-control
problems.
In a traditional economic model there is no gap between a

person’s good intentions and their actions. By contrast, in the
model of present bias, people plan to work hard (or diet, or
exercise, or quit smoking, or save for retirement, or stop
borrowing on their credit card, etc.) and then renege at the last
second (Laibson 1997; O’Donoghue and Rabin 1999).
31
Instructors can show how the present-biased discount function {1, 1/2,
1/2, 1/2, … } leads to preference reversals if studying has an immediate
effort cost of 6 and a delayed benefit of 8. In this case, studying
tomorrow looks good in the eyes of the student because 1/2 × [−6 + 8]
= 1 > 0, but immediate studying does not (because −6 + 1/2 × 8 = −2 <
0). In this simple example, studying never takes place.
32
Examples include
 Postponing planned work tasks
 Placing savings in a lockbox
 Workplace productivity commitments
 Committing to not smoke cigarettes or drink alcohol
Snacks chosen in advance are overwhelmingly healthy, but

snacks chosen for immediate consumption are not.
33
PRINCIPLE 4: Although we mostly care about
our own material payoffs, we also care about the
actions, intentions, and payoffs of others, even
people outside our family.
An anonymous sender and an anonymous recipient are paired. The sender

divides an endowment of $10 (any division is allowed, rounded off to the
nearest penny). The recipient either accepts or rejects the division. In the
event of rejection, both players go home empty-handed. Most senders
propose a division in which the recipient receives at least $2.00, because
the senders correctly anticipate that half of the recipients will retaliate
against an offer that is less generous than this (even though the retaliation
hurts the recipient).
34
Such social preferences respond to incentives, just like all other
economic decisions. As the stakes get large, the recipient
becomes more and more willing to accept unfair offers.
When the pot to be divided is nearly a year’s wages, almost no

recipients reject a 20 percent offer from the sender.
35
PRINCIPLE 5: Sometimes market exchange
makes psychological factors cease to matter,
but many psychological factors matter even in
markets
36
PRINCIPLE 6: In theory, limiting people’s
choices could partially protect them from their
behavioral biases, but in practice, heavy-handed
paternalism has a mixed track record and is
often unpopular
Is obesity a problem that the government should try to “solve”

with nudges or other types of paternalism (like sugar taxes), or is
obesity a reflection of personal preferences over diet and
exercise with little or no role for government intervention?
37
The decision-making process
38
Values, Preferences and Choices
39
Consumer behaviour[Indifference Curve Analysis]
‘People choose the best things they can afford’.
This is essentially a constrained optimization problem.
The objects of consumer choice are referred to as consumption
bundles, and these relate to a complete list of the goods and services
that are involved in the particular choice problem being considered.
Any bundle of goods can be described in the most simple terms as
(x1,x2) or just X, where x1 denotes the amount of one good and x2 the
amount of another good, or the amount of all other goods. By limiting
the number of parameters to just two it is possible to use a graphical
method of representation and analysis.
40
Preferences
41
Indifference curves
42
Indifference curves
43
Equilibrium
44
Indifference curves and consumer equilibrium
45
Axioms
46
Axioms
47
Types of Utility
• The concept of utility is one of the most basic building blocks in

economic theory.
• The assumption that the objective of consumers is expected utility
maximization is the most fundamental single component of the
standard model.
• The term ‘expected’ implies an element of risk or uncertainty.
48
Cardinal and ordinal utility
• Early economists believed that utility could be measured
quantitatively, in terms of an arbitrary unit called ‘utils’, using a ratio
scale with a zero point. Thus if consumption of basket A yielded 10
utils and basket B yielded 20 utils, then it could be said that basket B
yielded twice as much utility as basket A.
• Ordinal measure, where baskets of commodities are simply ranked
according to preference.
49
Decision utility
Imagine that you have just completed a graduate degree in
communications and you are considering one-year jobs at two
different magazines.
(A) At Magazine A, you are offered a job paying $35,000.

However, the other workers who have the same training and
experience as you do are making $38,000.
(B) At Magazine B, you are offered a job paying $33,000.
However, the other workers who have the same training and
experience as you do are making $30,000.
50
Decision utility
Approximately half the students were asked which job they would
choose, while the other half were asked which job would make them
happier. The first question relates to decision utility while the second
relates to hedonic, or experienced utility.
This difference was reflected in the survey results: 84% of the subjects
chose (A), the job with the higher absolute salary and lower relative
position, but 62% of the subjects thought that (B), the job with the
lower absolute salary and higher relative position, would make them
happier. In this sense then it could be claimed that people preferred
(B), thus indicating a distinction between choice or revealed preference
on the one hand and actual preference in terms of happiness on the
other.
51
Experienced utility
a) Remembered utility is measured using a memory-based approach;
this involves a retrospective evaluation of past experience. The
concept is therefore subject to bias, in particular the application of
the Peak-End rule.
b) Real-time utility is measured using a moment-based approach; this
is a more difficult procedure to implement, since it involves a
continuous monitoring of the subjects. For example, in the
colonoscopy studies the subjects were asked to rate their pain on
a scale of 0 (no pain at all) to 10 (intolerable pain) every 60
seconds.
52
Anticipatory utility
People gain hedonic utility from the anticipation of events in the
future, for example by looking forward to a holiday or dreading a visit
to the dentist. This anticipatory utility is based on a person’s expected
or predicted utility, meaning their belief about the future experienced
utility of an event.
Playing the lottery presents an interesting application, since this type of
behavior is not readily explained by expected utility theory, as
discussed in more detail in the next two chapters. Unrealized hopes
and fears can give rise to positive or negative endowment in terms of
anticipatory utility. The probability of winning a lottery is very low,
which means that the failure to win does not cause much
disappointment.
53
Residual utility
Whereas anticipatory utility looks forward to future events, residual utility

relates to pleasure or pain felt at later periods of time in separate episodes.
This phenomenon arises because utility profiles may be concatenated or
disjunctive.
For example, a person may gain anticipatory utility regarding going on
holiday in Hawaii for a month before the actual event, then enjoy the holiday
for a week, and then maybe suffer a contrast effect when they return to
work. In addition, maybe a month later, they may feel another ‘utility boost’
related to the same holiday experience, when they reminisce with friends.
These later episodes may be repeated at various intervals after the original
experience to which they relate.
54
Diagnostic utility
Diagnostic utility refers to the situation where people infer their utility from their
actions. It was seen that the phenomenon that is relevant here is the process of
self-signaling, which is particularly important for people who are uncertain where
they stand in terms of certain personal attributes, for example the possession of
strong willpower.
Thus, when we consider the situation of someone deciding whether they should
have an alcoholic drink, we should not just consider the experienced or hedonic
utility of the good consumed, we should also consider the utility to be inferred
from the action of consumption, in terms of signaling the vice of a weak will or the
virtue of a strong will. It may be that the negative diagnostic utility of an action may
outweigh the positive expected experienced utility related to the good consumed.
In this case the person will abstain from consumption.
55
Transaction utility
1. Acquisition utility – this represents the value of the good obtained

relative to its price, equivalent to the concept of consumer surplus.
2. Transaction utility – this corresponds to the perceived value of the ‘deal’,
in other words the difference between the reference price and the price
paid.
People are often tempted to buy ‘deals’, where transaction utility
dominates acquisition utility; we then often find that these items are seldom
used.
Marketing strategies skillfully manipulate the framing of offers, using
reference prices and emphasizing savings.
56
The evolutionary biology of utility
Biological fitness This term can be understood as meaning our ability
to survive and reproduce.
Inclusive fitness, where the ability extends to our kin, since that
increases the overall likelihood of ‘spreading our genes’.
Biological fitness is therefore closely linked to the number of offspring,
and this allows the construction of testable models of economic
behavior.
Utility exists as the criterion that humans, and other animals, use when
selecting actions in response to the variety of environmental situations
they encounter.
57
The evolutionary biology of utility
Nature imbues rankings or preferences over consumption goods, which

are really intermediate goods as far as the ultimate goal of producing
offspring is concerned.
Individual is prompted to maximize hedonic pleasure as a means to the
ultimate end of maximizing biological fitness.
58
Criteria for rationality
1. Attitudes and preferences should adhere to the basic rules of logic and
probability theory.
2. Attitudes and preferences should be coherent.
3. Attitudes and preferences should not be formed or changed based on
immaterial or irrelevant factors.
4. Attitudes and beliefs should not be incompatible with empirical
observations known to the individual, including their own conscious actions.
In particular the first three criteria above relate closely to completeness, transitivity,
independence, monotonicity (or dominance) and invariance.
59
Happiness is a three-act tragedy
1. Happiness involves an inter-personal comparison of one’s perceived

wellbeing or subjective wellbeing (SWB) with that of others.
‘it is not enough to succeed. Others must fail’.
2. Happiness also involves an intra-personal comparison of one’s
perceived wellbeing with one’s previous wellbeing. This again involves
reference dependence, but in this case the reference point is related to
a previous self-state rather than a current other-state, as in the
previous case.
“Lottery winners were not much happier than a control group,
and paraplegics not much unhappier”.
60
Happiness is a three-act tragedy
3. Happiness and unhappiness are not symmetrical reflections of gain

and loss. The impact of losses is greater than equivalent gains.
‘I hate to lose more than I like to win.’
61
Peak-End rule
The peak–end rule is a psychological heuristic in which people judge
an experience largely based on how they felt at its peak (i.e., its most
intense point) and at its end, rather than based on the total sum or
average of every moment of the experience.
62
Expectations effects
There is some evidence that high expectations of happiness can lead to

disappointment.
Those people who spent the most time, effort and money tended to
be the least satisfied.
Anticipation of pleasure can itself be pleasurable, with the result that

people may defer the pleasurable experience in order to prolong the
anticipatory utility. It is this factor that may at least partly explain the
saying that revenge is a dish that is better served cold.
63
Expectations effects
A study by Waber et al. (2007) involved using a placebo for reducing

pain. Subjects were administered electric shocks in two consecutive
treatments, but given a ‘drug’ purported to be a pain-killer before the
second treatment. Sure enough, the subjects reported less pain in the
second treatment compared to the first, even though the ‘drug’ was
actually a vitamin C capsule. The interesting point was that in a
following test the subjects reported a very different response according
to the advertised price of the pill; at a price of $2.50 almost all the
subjects experienced pain relief, but at a discounted price of 10 cents
only half of them did.
64
Addiction and abstention
There are goods that give too much pleasure, and excessive consumption
is associated with various problems in terms of health, and time and
money spent.
65
Endowment effects
Utility is not independent of possession. Those people who have

acquired a good in some way, through either purchase or gift, tend to
value it more highly than others.
Coffee Mug and Chocolate experiment.
66
Framing effects
People’s responses, in terms of values, attitudes and preferences,

depend on the contexts and procedures involved in eliciting these
responses.
This phenomenon relates to situations where people favor option A
when a question or problem is posed or framed in one way but favor
option B when the same problem is posed in a different way.
67
Framing effects
68
Framing effects
There is evidence that products are evaluated more favorably, and

chosen more frequently, when the surrounding environment contains
more perceptually or conceptually related cues.
There is much evidence that people’s eating habits, especially the

quantity consumed, can be influenced by the size of plates, packages or
serving bowls used.
69
Anchoring effects
These are effects where people’s responses are ‘anchored’ to other

phenomena in their consciousness, however irrelevant these might
appear to be.
The urinals at Amsterdam airport have houseflies etched(engrave) into
them. This ‘anchor’ has apparently had the effect of reducing spillage
by 80%.
70
Anchoring effects
A group of students was asked as a preliminary question to write down the last two digits of their
social security number (essentially a random number between 00 and 99). They were then asked
to value half a dozen different products, including a box of chocolates, two different bottles of
wine, a cordless trackball, a cordless keyboard and a design book. The results showed remarkable
consistency in the sense that the students with higher-ending social security digits valued all the
products more highly.
Those in the top 20% (from 80 to 99) bid highest, and the difference between their bids and those
of the lowest 20% (from 00 to 99) varied between 216% and 346%!
71
Menu Effect
72
The ‘attraction effect’
also known as
• ‘Decoy effect’, since it has become a much-used marketing practice.
• “a bird or mammal, or an imitation of one, used by hunters to attract

other birds or mammals”.
73
Preference for the salient
Evidence suggests that people simplify complex decisions by choosing a

salient option.
This may apply to supermarket shoppers, for example, when faced with
a large shelf filled with different brands, although the factor of limited
attention is also important here.
Investors prefer to buy stocks of companies that are currently in the
news, even if the news is bad.
74
Preference for the salient
This heuristic also applies in voting in the political arena. Ho and Imai
(2008) conducted a study in California, where the order of candidates
on the ballot is randomized, and found that there was a significant
advantage for a candidate in being first on the list.
75
Choice avoidance[paradox of choice]
Marketing managers may feel that they are both maximizing profits and
benefiting consumers by offering them a greater range of choices, but
the end result may be that consumers avoid the choice altogether,
which often means not purchasing any item in the range.
76
Choice avoidance[paradox of choice]
For example, Iyengar and Lepper (2000)
compare the behavior of consumers who were offered the opportunity to taste
six jams (the simple-choice treatment) with consumers who were offered the
opportunity to taste twenty-four jams (the difficult-choice treatment). They find
that, although more consumers stop to sample jams when there is more choice,
substantially fewer actually buy jams (four compared with thirty-one customers).
Choi, Laibson and Madrian (2006) report the same paradox in financial decision making,
in that a smaller number of investment options increases participation in a
401(k) plan. Kida, Moreno and Smith (2010) find a similar effect for inexperienced
investors, but the opposite effect for experienced investors, who were actually less
likely to invest when faced with a limited choice set.
Evidence suggests that making complex decisions is stressful and people may try to avoid
this stress.
77
The momentum effect
78
The vicarious consumption effect
A study related to choice of food items has shown that adding a healthy
item to the list of available options has the perverse effect of causing
people to choose less healthy food items than otherwise (Wilcox et al.,
2009). Apparently ‘the mere presence of the healthy food option
vicariously fulfills nutrition-related goals and provides consumers with
a license to indulge.’ It would be interesting to follow up this research
and observe if supermarkets that display fruit and vegetables near the
entrance actually sell more of these items.
79
Confusion
A final behavioral deviation noted by Della Vigna (2009) concerns

confusion. This does not reflect a preference, but is really an effect of
cognitive failure. Examples include mistaken trades of stocks (confusing
MCI with MCIC), reported by Rashes(2001), and mistaken voting in
elections, where votes are placed for candidates whose names are
adjacent to the intended candidate on the ballot, reported by Shue and
Luttmer (2009).
80
The neuroscientific basis of utility
There have been many neuroeconomic studies relating to utility, in

terms of how it is correlated with neural activity.
Positron emission tomography (PET) can detect changes in

neurotransmitter release, and although there are some technical
problems here, these studies can detect which areas of the brain are
activated.
81
The neuroscientific basis of utility
Other neural studies examine the effects of lesions or disruption of

neural activity using transcranial magnetic stimulation (TMS). Such
studies are useful in identifying the necessary (but not sufficient)
conditions for a particular psychological effect or economic behaviour
to occur.
The major findings related to utility that need to be discussed at this
stage relate to:
(1) the nature of utility and reference dependence;
(2) loss-aversion; and
(3) measurement of utility.
82
Nature of utility and reference dependence
Animal studies have for a long time indicated that reward was
associated with dopamine release, which creates a hedonic ‘high’.
It was not consumption itself that stimulated dopamine release, but

the expectation of consumption.
For example, when monkeys learned that the tone of a bell was likely
to be followed by a reward of juice, there was a release of dopamine at
the tone but not at the later point of consumption.
83
If the utility from consumption is fully anticipated, then there is no
prediction error and no dopamine release. The key point here is that
utility is reference dependent.
84
Loss-aversion
Gains and losses appear to activate or deactivate different areas in the
brain.
Measurement of utility
85
Beliefs, Heuristics and Biases
86
Beliefs, Heuristics and Biases
The component we now need to examine is related to probabilities or

beliefs.
The main assumptions in the standard model are
• Decision makers have perfect as opposed to bounded rationality, and
that they are
• Bayesian probability estimators.
87
1 Perfect rationality
This means that people not only have all the relevant information
pertaining to a decision but also have the cognitive resources to
process it instantly and costlessly.
If this is not the case, and it is obviously unlikely in most real-life
situations, then we can say that there is bounded rationality.
88
The most general implication is that we tend to use heuristics in many
decision-making situations; these are ‘methods for arriving at
satisfactory solutions with modest amounts of computation’ (Simon,
1990).
The term heuristic was originally introduced in psychology to refer to
simple processes that replace complex algorithms (Newell and Simon,
1972), and has become extended now to include any decision rules
that we implement as short-cuts to simplify and or accelerate the
decision-making process.
89
A good example is to never order the lowest price or highest price
items on the menu in a restaurant. This might imply that the decision-
maker believes that neither of these items represents good value.
The most significant implication of using heuristics is that they often

result in biases, meaning systematic errors.
In terms of beliefs these errors are factual; biases can also occur in
terms of preferences, where the errors may result in non-optimal
choice.
90
Bayesian probability estimation
People are able to estimate probabilities correctly, given the relevant

information, and in particular are able to update them correctly given a
sequence of prior outcomes.
When a coin is tossed several times and comes up heads each time, a
correct Bayesian updater will still estimate the probability of heads on
the next coin toss as being 0.5, since the prior outcomes have no effect
on the next outcome in this situation.
91
92
Probability estimation
The availability heuristic
People are often lousy at estimating probabilities of events occurring,
especially rare ones. They overestimate the probability of dying in
plane crashes, or in pregnancy, or suffering from violent crime.
An often-quoted example of overestimating low

probabilities concerns playing the lottery
93
The California lottery, one of the biggest in the world, requires

matching six numbers between 1 and 51 in order to win the main prize.
The odds against doing this are over 18 million to one. In other words,
if one played this lottery twice a week, one could expect to win about
every 175,000 years.
It was found by Kahneman, Slovic and Tversky (1982) that people
overestimated the odds of winning by over 1000%.
94
In many of their papers Kahneman and Tversky have suggested that

people use an availability heuristic when estimating probabilities. This
means that people believe that events are more frequent or more
probable if examples of it are easier to remember.
The main source of error here is salience; this factor features in other
types of bias also, but the main effect here is that events that have
been well publicized or are prominent in people’s memories tend to
be estimated as having exaggerated probabilities.
95
The representativeness heuristic
This means that people have the tendency to evaluate the likelihood
that a subject belongs to a certain category based on the degree to
which the subject resembles a typical item in the category.
Although this strategy may be effective in certain circumstances, the

basic principles of probability and set theory are often ignored by
people in making judgments involving representativeness.
96
The representativeness heuristic
Respondents are given a description of a personality of a woman, Linda, who has

the characteristics of a typical feminist.
The majority of respondents rank the statement ‘Linda is a bank teller’ as less likely
than the conjunctive statement ‘Linda is a bank teller and an active member of the
feminist movement’ (Tversky and Kahneman, 1983). In this case the strong
representativeness of feminism overcomes the basic probability rule that P(A and
B) can never be higher than P(A).
The difficulties that people have in reasoning related to connectives and
conditionals has been observed in a number of studies (Johnson-Laird, Byrne and
Schaeken, 1992; Johnson-Laird et al., 2000).
97
Linda is thirty-one years old, single, outspoken, and very bright. She
majored in philosophy. As a student, she was deeply concerned with
issues of discrimination and social justice, and also participated in
antinuclear demonstrations.
Linda is a teacher in elementary school.

Linda works in a bookstore and takes yoga classes.
Linda is active in the feminist movement.
Linda is a psychiatric social worker.
Linda is a member of the League of Women Voters.
Linda is a bank teller.
Linda is an insurance salesperson.
Linda is a bank teller and is active in the feminist movement.
98
• The set of feminist bank tellers is wholly included in the set of bank
tellers, as every feminist bank teller is a bank teller.
• Therefore the probability that Linda is a feminist bank teller must be
lower than the probability of her being a bank teller.
99
Base Rate Bias
• A cab was involved in a hit-and-run accident at night. Two cab

companies, the Green and the Blue, operate in the city. You are given
the following data:
• 85% of the cabs in the city are Green and 15% are Blue.
• A witness identified the cab as Blue. The court tested the reliability
of the witness under the circumstances that existed on the night of the
accident and concluded that the witness correctly identified each one
of the two colors 80% of the time and failed 20% of the time.
What is the probability that the cab involved in the accident was Blue
rather than Green?
100
First Version
• In the absence of a witness, the probability of the guilty cab being

Blue is 15%, which is the base rate of that outcome.
• If the two cab companies had been equally large, the base rate would
be uninformative and you would consider only the reliability of the
witness, concluding that the probability is 80%.
• The two sources of information can be combined by Bayes’s rule. The

correct answer is 41%.
101
• However, you can probably guess what people do when faced with
this problem: they ignore the base rate and go with the witness. The
most common answer is 80%.
102
Second Version
Now consider a variation of the same story, in which only the

presentation of the base rate has been altered. You are given the
following data:
• The two companies operate the same number of cabs, but Green
cabs are involved in 85% of accidents.
• The information about the witness is as in the previous version.
103
• In contrast, people who see the second version give considerable
weight to the base rate, and their average judgment is not too far
from the Bayesian solution.
Why?
104
In the first version, the base rate of Blue cabs is a statistical fact about
the cabs in the city. A mind that is hungry for causal stories finds
nothing to chew on: How does the number of Green and Blue cabs in
the city cause this cab driver to hit and run?
In the second version, in contrast, the drivers of Green cabs cause more
than 5 times as many accidents as the Blue cabs do. The conclusion is
immediate: the Green drivers must be a collection of reckless madmen!
You have now formed a stereotype of Green recklessness.
105
Base Rate Bias- Another Example
A more complex example involving conditional probabilities is given by Casscells,
Schoenberger and Grayboys (1978), and relates to the problem of ‘false positives’.
This involves a situation where a person takes a medical test, maybe for a disease
like HIV, where there is a very low probability (in most circumstances) of having the
disease, say one in a thousand. However, there is a chance of a false prediction; the
test may only be 95% accurate. Under these circumstances people tend to ignore
the rarity of the phenomenon (disease) in the population, referred to as the base
rate, and wildly overestimate the probability of actually being sick. Even the
majority of Harvard Medical School doctors failed to get the right answer. For every
thousand patients tested, one will be actually sick while there will be fifty false
positives. Thus there is only a one in fifty-one chance of a positive result meaning
that the patient is actually sick.
106
The ‘law of small numbers’
People apply principles that apply to infinite populations to small
samples.
People are observing a sequence of signals from a process that involves

independent and identically distributed (iid) random variables.
This means that each random variable has the same probability
distribution as the others and all are mutually independent.
107
The ‘law of small numbers’
A simple example is a sequence of coin tosses, where the probability

distribution is 0.5 for a head and 0.5 for a tail for each toss, and the
outcome of each toss has no effect on the outcome of any other toss.
The model assumes that people believe, incorrectly, that the signals are
drawn from an urn of finite size without replacement, whereas the
correct assumption in this case is that there is replacement after each
draw from the urn.
108
The ‘gambler’s fallacy’ effect
This effect derives its name from the observation that gamblers
frequently expect a certain slot machine or a number that has not won
in a while to be ‘due’ to win.
109
The ‘gambler’s fallacy’ effect
If an urn contains 10 balls, 5 representing Up and 5 representing Down,
and one ball is drawn at a time with replacement, this experiment is
identical to tossing a coin. Thus if 3 successive draws all result in an Up
outcome (equivalent to 3 heads in a row), then the rational person will
estimate the probability of an Up on the next draw as 0.5. However, if
the person believes that the balls are not being replaced, this means
that there is only 2 Up balls left in the urn out of 7 balls in total, so they
will estimate the probability of the next draw being Up as only 2/7 or
about 0.286, with the probability of Down being 0.714. This is an
example of the representativeness heuristic, in that the sequence Up,
Up, Up, Down is judged as being more representative of the population
than the sequence Up, Up, Up, Up.
110
The ‘hot hand’ effect
The "hot hand" is the notion where people

believe that after a string of successes, an
individual or entity is more likely to have
continued success.
Psychologists believe that the hot hand is a
fallacy that stems from the representative
heuristic, as identified by behavioral
economics.
Still, some research shows that for certain
sporting events, the hot hand may be real. 111
The ‘hot hand’ effect
The mistaken belief among basketball players and fans that a player’s
chance of hitting a shot is greater following a hit than following a miss
on the previous shot.
112
Self-evaluation bias
Self-evaluation bias as a general all-embracing

term that includes all aspects of beliefs where some
kind of evaluation of the role of the self relative to a
situation is involved.
113
Overconfidence
“No problem in judgment and decision-making is more

prevalent and more potentially catastrophic than overconfidence’.
Overestimation
This relates to overestimation of one’s actual ability, performance, level
of control or chance of success. Empirical evidence suggests that this is
a widespread phenomenon extending to many situations. People
overestimate their abilities to perform various tasks, overestimate how
quickly they can finish a project.
114
Overconfidence
Overplacement
‘better-than-average’ (BTA) effect: well over half of survey respondents

typically rate themselves in the top 50% of drivers (Svenson, 1981),
ethics (Baumhart, 1968), managerial prowess (Larwood and Whittaker,
1977), productivity (Cross, 1997), health (Weinstein, 1980), and skill in
solving puzzles (Camerer and Lovallo, 1999).
115
Overconfidence
Overprecision
This refers to excessive certainty regarding the accuracy of one’s
beliefs.
Studies frequently ask their participants questions with numerical
answers (e.g. ‘How long is the Nile River?’) and then have participants
estimate confidence intervals for their answers).
Results show that these confidence intervals are too narrow, suggesting
that people are too sure they know the correct answer.
116
Underconfidence
Sometimes people underestimate their abilities, control, and

also underplace their performance relative to others.
Some studies have reported overconfidence when the tasks

were easy (like driving), or success likely, and underconfidence
when tasks were difficult (like playing the piano), or success
unlikely. This phenomenon is referred to as the ‘hard-easy’
effect.
117
People often have imperfect information about their own
performances, abilities, or chance of success. However, they often have
even worse information about others.
As a result, people’s estimates of themselves are regressive, and their
estimates of others are even more regressive. Consequently, when
performance is high, people will underestimate their own
performances, underestimate others even more so, and thus believe
that they are better than others.
When performance is low, people will overestimate themselves,
overestimate others even more so, and thus believe that they are
worse than others.
118
Self-serving bias
People ascribe their successes to their own ability or skill, but
ascribe failures to situational factors, the actions of other
people, or bad luck.
119
Confirmatory bias and self-attribution
bias
Confirmatory bias refers to the tendency to interpret new,

ambiguous information as being consistent with one’s prior
beliefs, while self-attribution bias refers to the tendency to
discount information that is inconsistent with one’s prior beliefs.
For example, in financial markets, as traders receive additional
private information, in the short term they interpret the
information that confirms their existing beliefs as being more
informative, rejecting non-confirming information, and this causes
them to become more overconfident and trade excessively.
120
Cognitive dissonance
This psychological theory often relates to people changing

their beliefs in order to reconcile themselves with their past
actions and behavior. The situation is demonstrated by
Aesop’s fable of the fox and the sour grapes. The fox wanted
the grapes, but when she found she couldn’t reach them she
decided that they were probably sour, so she revised her
original intention and believed that she never really wanted
the grapes in the first place.
121
A man with a conviction is a hard man to change. Tell him you

disagree and he turns away. Show him facts or figures and he
questions your sources. Appeal to logic and he fails to see your
point.
Leon Festinger, A Theory of Cognitive Dissonance.
122
Over 60 years ago, Leon Festinger (1957) postulated one of the most
well-known theories of psychology: cognitive dissonance theory.
The theory is based on the idea that two cognitions can be relevant or
irrelevant to each other (Festinger, 1957). Such cognitions can be about
behaviors, perceptions, attitudes, emotions, and beliefs. Often, one of
the cognitions in question is about our behavior. If the cognitions are
relevant, they can be in agreement (consistent) or disagreement
(inconsistent) with one another (Festinger, 1957).
123
Discrepancy between an attitude and a behavior – eating a doughnut

while thinking of reducing calorie intake – leads to psychological
discomfort called cognitive dissonance (Harmon-Jones, 2019).
Cognitive dissonance leads to the motivation to reduce the dissonance
(Festinger, 1957). The stronger the discrepancy between thoughts, the
greater the motivation to reduce it (Festinger, 1957).
124
There are four strategies used to do reduce the discomfort of cognitive
dissonance:
We change our behavior so that it is consistent with the other thought.
We change one of the dissonant thoughts in order to restore
consistency.
We add other (consonant) thoughts that justify or reduce the
importance of one thought and therefore diminish the inconsistency.
We trivialize the inconsistency altogether, making it less important and
less relevant.
125
126
Projection bias
Another kind of bias where people have systematically incorrect beliefs
is that they expect their future preferences to be too close to the
present ones.
For example, we may have learned from experience not to go to the
supermarket when we are hungry – we tend to buy all kinds of junk
that we don’t normally eat or want to eat, and not only is our bill
higher than normal but we also end up with stuff we don’t consume or
don’t want to consume. This happens because at the time of shopping
we incorrectly anticipate that our future hunger will be as great as it is
now.
127
Projection bias
128
Projection bias
Read and van Leeuwen (1998) confirmed this effect in a study of office
workers. These workers were asked to select a healthy snack or an
unhealthy snack to be delivered a week later (in the late afternoon).
One group of workers was asked the question at a time when they may
have been hungry, in the late afternoon, and 78% chose an unhealthy
snack. The other group was asked the same question after lunch, when
they were probably satiated, and only 42% chose the unhealthy snack.
129
Projection bias
130
Hindsight bias
An associated kind of bias is hindsight bias, which could be
considered to be a retrospective projection bias. This means
that events seem more predictable in retrospect than in
prospect, as in ‘we knew it all along’. There is again evidence
for this phenomenon both from experiments and in the field.
For example, a study by Biais and Weber (2009) conducted an
experiment with 85 investment bankers in London and
Frankfurt and found not only evidence of hindsight bias
among some subjects but also that the biased agents have
lower performance.
131
132
Hindsight bias
Your inability to reconstruct past beliefs will

inevitably cause you to underestimate the extent to
which you were surprised by past events.
133
Hindsight bias
The core of the illusion is that we believe we understand the past,

which implies that the future also should be knowable, but in fact we
understand the past less than we believe we do.
134
Hindsight bias
Imagine yourself before a football game between two teams that have
the same record of wins and losses. Now the game is over, and one
team trashed the other. In your revised model of the world, the
winning team is much stronger than the loser, and your view of the
past as well as of the future has been altered by that new perception.
Learning from surprises is a reasonable thing to do, but it can have
some dangerous consequences.
135
Hindsight bias
A general limitation of the human mind is its imperfect ability to

reconstruct past states of knowledge, or beliefs that have changed.
Once you adopt a new view of the world (or of any part of it), you
immediately lose much of your ability to recall what you used to
believe before your mind changed.
136
Hindsight bias
Many psychologists have studied what happens when people change
their minds. Choosing a topic on which minds are not completely made
up—say, the death penalty—the experimenter carefully measures
people’s attitudes. Next, the participants see or hear a persuasive pro
or con message. Then the experimenter measures people’s attitudes
again; they usually are closer to the persuasive message they were
exposed to. Finally, the participants report the opinion they held
beforehand. This task turns out to be surprisingly difficult. Asked to
reconstruct their former beliefs, people retrieve their current ones
instead—an instance of substitution—and many cannot believe that
they ever felt differently.
137
Hindsight bias
Your inability to reconstruct past beliefs will inevitably cause

you to underestimate the extent to which you were surprised
by past events.
138
Causes of irrationality
139
Emotional distress
Emotions could be an aid as well as a hindrance.
People who were upset were more inclined to take foolish risks, like
betting on long shots in a lottery.
People who were already upset had less to lose by taking a long shot
and more to gain, while people who were in a good or neutral mood
had more to lose by taking a long shot.
In the above situation emotional distress can lead to irrational
decisions or self defeating.
140
According to Frank our emotions serve as commitment devices,

meaning that they commit us to perform certain actions at a later time
if other people behave in certain ways.
Frank’s insight was to see the role of emotions in prompting us to
perform actions that we would not carry out if we were acting on
purely ‘rational’ grounds.
141
Imagine that we make an agreement with another person such that we
perform some work for them now in exchange for being paid
afterward. Such ‘delayed exchange’ contracts have been extremely
common in human history, on both a formal and informal basis. The
person doing the work first is always subject to a ‘holdup’ problem
(unless the details are formalized in a written contract), in that the
other party can renege(abandon)on the deal. Without any formal
contract the cheated party has no comeback, and a ‘rational’ person
may simply write off the loss, and put it down to experience. An
‘emotional’ person on the other hand would be angry with the cheat
and take steps to gain revenge, at risk and cost to himself, which the
‘rational’ person would be unwilling to take. However, the knowledge
that an emotional person may react in this way might well be enough
to prevent the other party from cheating in the first place. This is an
example of what is called a ‘reputation effect’; emotional people may
gain a reputation for not standing for any nonsense or backsliding in 142
their dealings, thus encouraging others to be straight with them.

Doomsday devices
The problem with doomsday devices is that they cannot be disarmed,

even if they are activated by mistake, and will explode regardless of the
consequences. Thus they may lead to futile and self-destructive
reactions; a well-known example is the successive rounds of retaliation
that occur with feuds between gangs or clans. It is possible that the
reaction to social rejection, discussed in more detail later, is of this
type. Emotions are indeed a two-edged sword.
143
Memory
1. People tend to revert to a ‘normal emotional state’ after any kind of

emotional experience, whether it be pleasant or unpleasant.
2 People tend to overestimate the length of time that it will take to
revert to this normal state.
144
Memory
There is now a substantial body of research showing that emotional
reactions to life-changing events are surprisingly short-lived.
When people win large amounts of money in a lottery, they do not
remain happy for very long.
In the opposite direction, the majority of bereaved spouses reported
themselves to be doing well two years after the death.
Similarly, people who have suffered serious injury confining them to a
wheelchair have recovered equanimity within a period of a year.
145
Durability bias
There is a tendency for people to overestimate the duration

of their reactions to both positive and negative emotional events.
146
Self-deception is an important category of irrational behavior.
This theory states that people are motivated to avoid having their
attitudes and beliefs in a dissonant or conflicting relationship, and they
feel uncomfortable when dissonance occurs. This discomfort can cause
people to do many things that could be classed as irrational.
Thus cognitive dissonance generally involves people justifying their
actions by changing their beliefs. This is because it is often easier to
change one’s beliefs than to change actions that have already been
taken.
147
Threat to self-esteem
Self-esteem can affect the quality of decision-making. In particular

there appears to be a relationship between low self esteem and self-
defeating behavior such as self-handicapping, binge eating and alcohol
abuse.
People with high, but misplaced, self-esteem may also indulge in
alcohol and drug abuse, believing that they are strong enough to
withstand the harmful physical effects and the tendency to addiction.
This can be referred to as the ‘peacock’s tail’ syndrome.
148
Threat to self-esteem
People with high self-esteem made better decisions in risk
taking experiments, in terms of judging their own
performance better than people with low self-esteem, and
gambling in an appropriate manner. However, when people
with high self-esteem received a blow to their pride they
started to make bad decisions, worse even than those with
low self-esteem, by making large bets that were not justified
by their own performance. They seemed to be anxious to
wipe out the loss of face involved.
149
Failure of Self-regulation
Self-regulation refers to the need for individuals to reflect on

advantages and disadvantages before making decisions rather than
acting Impulsively.
Self-regulation involves the weighing of long-run costs against short
run benefits of decisions.
150
Failure of self-regulation
Self-regulation involves the delay of gratification. The ability for self-

regulation is obviously a useful adaptation, enabling our ancestors to
withstand temptations that would have resulted in early death, and
encouraging them to make long-run investments in the health of
themselves and their families.
151
Decision fatigue
It seems that people not only tire when it comes to self-control, they
also tire of making decisions in general. This may well be the main
reason that people are creatures of habit; having a routine avoids the
need to expend scarce resources by making choices.
They found that a group of respondents who had to make a series of

product choices had a reduced capacity for self-regulation compared
with a control group.
152
Decision fatigue
A group of respondents who had to make a series of product choices

had a reduced capacity for self-regulation compared with a control
group. The capacity for self-regulation was measured by asking the
respondents to drink as much as they could of an unpleasant, bitter
tasting beverage. This finding suggests that people tire of making
decisions, and when they do so it is possible that any further decisions
that are forced on them before they have had time to recover may
result in a fall in quality.
153
Module 4. Choice Under Uncertainty
154
Expected Utility Theory
Expected utility theory is concerned with people’s preferences

with respect to choices that have uncertain outcomes
(gambles). According to this theory, if certain axioms are
fulfilled, the subjective value of a gamble for an individual is
the statistical expectation of the values the individual assigns
to the outcomes of that gamble.
155
Expected Utility Theory
Certain conditions have to be satisfied for an individual to have rational

preferences.
To understand these conditions, let us introduce some notation.
Suppose an individual is faced with a choice between two outcomes, A

and B. The symbol > indicates strong preference, thus A > B means that
A is always preferred to B. The symbol ~ indicates indifference so that A
~ B means the individual values the two outcomes equally. Finally, the
symbol ≥ suggests weak preference, so that A ≥ B means that the
individual prefers A or is indifferent between A and B.
156
The von Neumann-Morgenstern Axioms
157
158
159
Utility Maximization
Utility reflects the satisfaction derived from a particular
outcome – ordinarily an outcome is represented by a
“bundle” of goods.
The utility function, denoted as U(*) assigns numbers to
possible outcomes such that preferred choices are assigned
higher numbers. Suppose you have to choose between two
sandwiches plus one chocolate bar or one sandwich plus two
chocolate bars. If you prefer the latter, it means that: U(1
sandwich, 2 chocolate bars) > U (2 sandwiches, 1 chocolate
bar)
160
Mathematically, the utility of wealth can be defined in various ways. One of the
mathematical functions commonly used is the logarithmic function. This means that
the utility derived from wealth w is U(w) = ln(w). Exhibit 2.1 shows the utility of
wealth as per the logarithmic function.
161
Exhibit 2.2 represents this utility function graphically. Note that as wealth increases,
the slope of the utility function gets flatter.
162
Expected utility theory
163
Decision-making under risk can be considered as a process of

choosing between different prospects or gambles. A
prospect consists of a number of possible outcomes along
with their associated probabilities. Thus any theory of
decision-making under risk will take into account both the
consequences of choices and their associated probabilities.
164
165
166
167
168
monotonicity
Objective improvements to a prospect, meaning

increasing some of its payoffs while holding others
constant, should make it at least as attractive if not more
so than before.
169
170
171
172
Essentially, Bernoulli invented the idea of risk aversion.
He did so by positing that people’s happiness—or utility, as
economists like to call it—increases as they get wealthier, but
at a decreasing rate.
173
This principle is called diminishing sensitivity. As wealth grows, the
impact of a given increment of wealth, say $100,000, falls. To a
peasant, a $100,000 windfall would be life-changing. To Bill Gates, it
would go undetected.
174
A utility function of this shape implies risk aversion because
the utility of the first thousand dollars is greater than the
utility of the second thousand dollars, and so forth.
This implies that if your wealth is $100,000 and I offer you a
choice between an additional $1,000 for sure or a 50%
chance to win $2,000, you will take the sure thing because
you value the second thousand you would win less than the
first thousand, so you are not willing to risk losing that first
$1,000 prize in an attempt to get $2,000.
175
176
177
178
179
180
181
182
183
184
185
186
Bernoulli’s Errors
From the book

Kahneman, Daniel. Thinking, Fast and Slow (p. 269). Penguin Books Ltd.
187
The German psychologist and mystic Gustav Fechner (1801–1887) was
obsessed with the relation of mind and matter. On one side there is a
physical quantity that can vary, such as the energy of a light, the frequency
of a tone, or an amount of money.
On the other side there is a subjective experience of brightness, pitch, or
value. Mysteriously, variations of the physical quantity cause variations in the
intensity or quality of the subjective experience. Fechner’s project was to
find the psychophysical laws that relate the subjective quantity in the
observer’s mind to the objective quantity in the material world.
He proposed that for many dimensions, the function is logarithmic—which
simply means that an increase of stimulus intensity by a given factor (say,
times 1.5 or times 10) always yields the same increment on the psychological
scale. If raising the energy of the sound from 10 to 100 units of physical
energy increases psychological intensity by 4 units, then a further increase of
stimulus intensity from 100 to 1,000 will also increase psychological intensity
by 4 units. 188
BERNOULLI’S ERROR
Bernoulli observed that most people dislike risk (the chance of

receiving the lowest possible outcome), and if they are offered a choice
between a gamble and an amount equal to its expected value they will
pick the sure thing.
people’s choices are based not on dollar values but on the
psychological values of outcomes, their utilities. The psychological
value of a gamble is therefore not the weighted average of its possible
dollar outcomes; it is the average of the utilities of these outcomes,
each weighted by its probability.
189
Adding 1 million to a wealth of 1 million yields an increment of 30
utility points, but adding 1 million to a wealth of 9 million adds only 4
points. Bernoulli proposed that the diminishing marginal value of
wealth (in the modern jargon) is what explains risk aversion—the
common preference that people generally show for a sure thing over a
favorable gamble of equal or slightly higher expected value.
190
BERNOULLI’S ERROR
Consider this choice:
191
The expected value of the gamble and the “sure thing” are equal in
ducats (4 million), but the psychological utilities of the two options are
different, because of the diminishing utility of wealth: the increment of
utility from 1 million to 4 million is 60 units, but an equal increment,
from 4 to 7 million, increases the utility of wealth by only 24 units. The
utility of the gamble is 84/2 = 42 (the utility of its two outcomes, each
weighted by its probability of 1/2). The utility of 4 million is 60. Because
60 is more than 42, an individual with this utility function will prefer
the sure thing. Bernoulli’s insight was that a decision maker with
diminishing marginal utility for wealth will be risk averse.
192
As you can see in the table, the loss of 1 million causes a loss of 4
points of utility (from 100 to 96) to someone who has 10 million and a
much larger loss of 18 points (from 48 to 30) to someone who starts off
with 3 million.
193
Today Jack and Jill each have a wealth of 5 million.
Yesterday, Jack had 1 million and Jill had 9 million. Are they equally happy?
(Do they have the same utility?)
Bernoulli’s theory assumes that the utility of their wealth is what makes
people more or less happy. Jack and Jill have the same wealth, and the
theory therefore asserts that they should be equally happy, but you do
not need a degree in psychology to know that today Jack is elated and
Jill despondent. Indeed, we know that Jack would be a great deal
happier than Jill even if he had only 2 million today while she has 5.
So Bernoulli’s theory must be wrong.
194
Today Jack and Jill each have a wealth of 5 million.
Yesterday, Jack had 1 million and Jill had 9 million. Are they equally happy?
(Do they have the same utility?)
The happiness that Jack and Jill experience is determined by the recent
change in their wealth, relative to the different states of wealth that
define their reference points (1 million for Jack, 9 million for Jill).
195
For another example of what Bernoulli’s theory misses, consider
Anthony and Betty:
Anthony’s current wealth is 1 million.
Betty’s current wealth is 4 million.
They are both offered a choice between a gamble and a sure thing.
The gamble: equal chances to end up owning 1 million or 4 million
OR
The sure thing: own 2 million for sure.
196
In Bernoulli’s account, Anthony and Betty face the same choice: their
expected wealth will be 2.5 million if they take the gamble and 2
million if they prefer the sure-thing option.
Bernoulli would therefore expect Anthony and Betty to make the same
choice, but this prediction is incorrect.
Here again, the theory fails because it does not allow for the different
reference points from which Anthony and Betty consider their options.
If you imagine yourself in Anthony’s and Betty’s shoes, you will quickly
see that current wealth matters a great deal.
197
Anthony’s current wealth is 1 million.
Betty’s current wealth is 4 million.
Anthony (who currently owns 1 million): “If I choose the sure thing, my
wealth will double with certainty. This is very attractive. Alternatively, I
can take a gamble with equal chances to quadruple my wealth or to
gain nothing.”
Betty (who currently owns 4 million): “If I choose the sure thing, I lose
half of my wealth with certainty, which is awful. Alternatively, I can take
a gamble with equal chances to lose three-quarters of my wealth or to
lose nothing.”
You can sense that Anthony and Betty are likely to make different
choices because the sure-thing option of owning 2 million makes
Anthony happy and makes Betty miserable.
198
Note also how the sure outcome differs from the worst outcome of the
gamble: for Anthony, it is the difference between doubling his wealth
and gaining nothing; for Betty, it is the difference between losing half
her wealth and losing three-quarters of it.
Because Bernoulli’s model lacks the idea of a reference point, expected
utility theory does not represent the obvious fact that the outcome
that is good for Anthony is bad for Betty. His model could explain
Anthony’s risk aversion, but it cannot explain Betty’s risk-seeking
preference for the gamble, a behavior that is often observed in
entrepreneurs and in generals when all their options are bad.
199
Prospect theory
EUT is a model of preference maximization, assuming that agents

behave as if optimizing some underlying preference function.
Bounded rationality implies that the agent has both imperfect

information in a complex and dynamic decision environment, and
limited computational ability; the agent’s objectives may also be
imperfectly defined. Thus the concept of optimization becomes more
complex, with constraints of time, computational resources, and often
conflicting objectives.
200
Prospect theory
Prospect Theory (PT) was originally developed in the KT paper of 1979, and
then extended in a later paper by the same authors in 1992, being renamed
cumulative prospect theory.
But to create a better descriptive model, Kahneman and Tversky recognized

that we had to change our focus from levels of wealth to changes in wealth.
Kahneman and Tversky focus on changes because changes are the way
Humans experience life.
When we have adapted to our environment, we tend to ignore it.
201
.
202
Prospect theory
The same is true in financial matters. Consider Jane, who makes
$80,000 per year. She gets a $5,000 year-end bonus that she had not
expected.
How does Jane process this event? Does she calculate the change in
her lifetime wealth, which is barely noticeable? No, she is more likely to
think, “Wow, an extra $5,000!” People think about life in terms of
changes, not levels. They can be changes from the status quo or
changes from what was expected, but whatever form they take, it is
changes that make us happy or miserable. That was a big idea.
203
Prospect theory - Continued
204
Reference Point
As Kahneman and Tversky (1979) say:

This assumption is compatible with basic principles of perception and
judgement. Our perceptual apparatus is attuned to the evaluation of
changes or differences rather than to the evaluation of absolute
magnitudes. When we respond to attributes such as brightness,
loudness, or temperature, the past and present context of experience
defines an adaptation level, or reference point, and stimuli are
perceived in relation to this reference point.
205
Reference Point
The concept of reference points is indeed part of folklore in some

respects. For example, readers who are familiar with the children’s
story A Squash and a Squeeze will recognize the wisdom of the old man
in advising the woman who complains that her house is too small. After
cramming all her animals into the house, and then clearing them all out
again, she finds that her house now seems large.
206
Psychological foundation
Homeostasis is a well-known biological principle, whereby

various systems in the body have an optimal set point, and
deviations from this point trigger negative feedback processes
that attempt to restore it. Examples are body temperature, the
level of blood sugar and electrolyte balance.
207
The term allostasis was introduced by Sterling and Eyer (1988) to refer
to a different type of feedback system whereby a variable is maintained
within a healthy range, but at the same time is allowed to vary in
response to environmental demands. Heart rate, blood pressure and
hormone levels are variables in this category. Thus, when we exercise,
both heart rate and blood pressure are allowed to rise in order to
optimize performance.
208
A simple physical or biological illustration of the phenomenon of reference

points is the experiment where a person places one hand in cold water and
the other in hot water for a certain time, before placing both hands in the
same container of lukewarm water. The subject experiences the strange
sensation of one hand now feeling warm (the one that was in cold water),
while the other hand feels cool (the one that was in hot water). It appears
that the visible evidence from the eyes that both hands should feel the same
is unable to override the separate reference points of previous temperature
in the brain.
209
Loss-aversion
In the words of KT (Kahneman and Tversky, 1979):

A salient characteristic of attitudes to changes in welfare is that losses
loom larger than gains. The aggravation that one experiences in losing
a sum of money appears to be greater than the pleasure associated
with gaining the same amount.
210
Loss-aversion
For example, most people would not bet money on the toss of a coin,
on the basis that a heads outcome gives a specific gain, while a tails
outcome gives an equal loss. In mathematical terms, people find
symmetric bets of the form (x, 0.50; x, 0.50) unattractive.
211
Pinker (1997) has proposed that, whereas gains can improve our
prospects of survival and reproduction, significant losses can take us
completely ‘out of the game’. For example, an extra gallon of water can
make us feel more comfortable crossing a desert; a loss of a gallon of
water may have fatal consequences.
212
Loss-aversion
Regulatory focus theory proposes the coexistence of two motivational

systems, the promotion system and the prevention system. These
each serve fundamentally important but different needs. The
promotion system is concerned with nurturance needs related to
advancement, aspirations and accomplishment, and is marked by a
sensitivity to gains versus nongains. People with promotion focus are
more sensitive to positive than to negative changes from neutrality or
the status quo, i.e. some reference point.
213
Loss-aversion
In contrast, the prevention system relates to duties, responsibilities and
security, and is sensitive to losses versus non-losses. Prevention-
focused people are more sensitive to negative than to positive shifts
from the status quo (Higgins, 2007). Thus, prevention-focused persons
should be more concerned about falling below the previous status quo
or reference point, a negative change or loss, than should promotion-
focused persons.
214
Shape of the utility function
The standard model utility function
215
The Friedman–Savage utility function
Friedman and Savage (1948) observed that the traditional concave
function failed to explain various widely observed phenomena, such as
gambling. They proposed a function that had two concave regions, with
a convex region between them, in order to explain these anomalies.
216
The Markowitz utility function
Markowitz proposed various amendments in order to remedy the failings of other
functions to explain empirical data. He anticipated the work of Kahneman and
Tversky by including both reference points and loss-aversion in his analysis. His
utility function was S-shaped in the regions of both gain and loss. However, as can
be seen in Figure 5.4, in the middle region of small gains and losses between points
A and B, the function has a reversed S-shape. The implications of this shape of
function are that people tend to be risk-seeking for small gains (explaining most
gambling), and risk-averse for small losses (explaining why many people take out
insurance). However, people would be risk-averse for large gains and risk-seeking
for large losses.
217
The Markowitz utility function
218
The Prospect Theory (PT) utility function
KT (1979) proposed a utility function that featured diminishing
marginal sensitivity in the domains of both gains and losses.
219
Key Tenets of Prospect Theory
The key tenets of prospect theory are:

 Reference dependence
 Diminishing sensitivity
 Loss aversion
 Changes in risk attitude
 Decision weights.
220
Recall that a prospect P(pr, A, B) is a gamble whose outcomes are A (with a
probability of pr) and B (with a probability of (1 – pr)). If the second outcome
is omitted, as in P (pr, A), it means that it is zero. Finally, if the probability
also is omitted, as in P(A), it means that it is a certain (riskless) prospect.
221
Reference Dependence
The value of a prospect depends on gains and losses relative to a

reference point, which is usually the status quo.
Consider the following decision situations:

Decision Situation 1: Assume that you are richer by ₹3,000 than you are
today, and then choose between P1 (₹ 1,000) and P2 (0.50, ₹2,000)
Decision Situation 2: Assume that you are richer by ₹5,000 than you are
today, and then choose between P3 (–₹1,000) and P4 (0.5, ₹2,000).
This means that in decision situation 1 they shun risk, whereas in decision
situation 4, they seek risk.
222
Diminishing Sensitivity
223
Diminishing Sensitivity
.The value function is concave for gains. This means that people feel good
when they gain, but twice the gain does not make them feel twice as good.
The concavity over gains means that people tend to be risk-averse over
moderate probability gains: they prefer a certain gain of 1000 to a 50 per
cent chance of 2000.
The value function is convex for losses. This means that people experience a
pain when they lose, but twice the loss does not mean twice the pain. The
convexity (or diminishing sensitivity) over losses means that people tend to
be risk–seeking over losses: they prefer a 50 per cent chance of losing 2000
to losing 1000 for sure. While the convexity of the value function over losses
captures an important facet of preference, it ignores another. A person
facing a loss that represents a large fraction of wealth tends to be very
sensitive, not insensitive, to further losses.
224
Loss Aversion
.The value function is steeper for losses than for gains. This means that
people feel more strongly about the pain from a loss than the pleasure
from an equal gain – about two and half times as strongly, according to
Kahneman and Tversky. This phenomenon is referred to as loss
aversion. It is quite different from risk aversion.
225
Changes in Risk Attitude
Depending on the nature of the prospect, people sometimes display risk

aversion and sometimes display risk seeking.
To illustrate this aspect of behavior, imagine that you are presented with the
following pair of concurrent decisions situations.
Decision Situation 3: Choose between P5 (₹2400) and P6 (0.25, ₹10000)
Decision Situation 4: Choose between P7 (–₹7500) and P8 (0.75, –₹10000)
In other words, in the first situation you have to choose between a sure gain
of ₹2,400 and a 25% chance of gaining ₹10,000. In the second situation,
you have to choose between a sure loss of ₹7,500 and a 75% chance of
losing ₹10,000. When such decision situations are presented to
respondents in experiments, the respondents typically choose P5 in
decision situation 3, which means that they exhibit risk aversion. However,
in decision situation 4, the respondents typically choose P8, which means
that they exhibit risk seeking. While expected utility theory does not allow
for changes in risk attitude like this, prospect theory allows for variations in
risk attitude depending on the nature of the prospect. 226
Decision Weights
In utility theory, people weight outcomes by their objective

probabilities pi, but in prospect theory people weight outcomes by
transformed probabilities or decision weights πi. The decision weights
are computed using a weighting function W (.) which is a function of
objective probability.
227
Decision Weights
228
Decision Weights
The solid line is the weighting function proposed by Tversky and
Kahneman, whereas the dotted line (a 45 degree line) represents the
objective probabilities used in the expected utility theory. A
comparison of the two suggests that the weighting function
overweights low probabilities and underweights high probabilities.
229
Intertemporal Choice
230
Intertemporal choices relate to decisions involving trade-

offs between costs and benefits occurring in different time
periods.
Governments, firms and individuals are all faced with such
decisions on a frequent and ongoing basis, for example:
investing in roads, schools and hospitals; building a new factory
or launching a new product; buying a new car, spending on a
vacation, or joining a health club.
231
Discounted Utility Model(DUM)
Samuelson introduced the DUM in 1937 in a short article

modestly titled: ‘A note on measurement of utility”.
232
233
Let us take the following consumption profile, measured in

thousands of dollars per year over a period of the next three
years: (20, 20, 20). We will also assume for simplicity that these
consecutive equal amounts of consumption yield equal amounts
of utility.
It should be noted that this assumption violates some of the
behavioral factors considered in earlier chapters, such as the
effects of reference points, habit formation and the desire for
increasing consumption profiles (the ‘happiness treadmill’).
234
If the consumer discounts future utility at the rate of 10% per year
the current utility of the consumption and utility profiles can now
be calculated as follows:
235
Features of the DUM
236
Features of the DUM
237
Features of the DUM
Consumption independence
It is assumed in the DUM that a person’s welfare in any time period is

independent of consumption in any other period. This means that
preferences over consumption profiles are not affected by the nature
of consumption in periods in which consumption is identical in the two
profiles.
238
Consumption independence
Consumption independence says that one’s preference

between an Italian and Thai restaurant tonight should not
depend on whether one had Italian last night nor whether one
expects to have it tomorrow.
239
Features of the DUM
Stationary instantaneous utility
240
Stationary instantaneous utility
Evidence suggests that people tend to exaggerate the degree

to which their future preferences will resemble their current
ones, a phenomenon referred to as projection bias
(Loewenstein, O’Donoghue and Rabin, 2003). Thus they may
expect to like the music of Oasis in 20 years because they like
it now, but then find in 20 years time that they can’t stand it.
241
Features of the DUM
Stationary discounting
242
Features of the DUM
Constant discounting
The DUM assumes that at any period of time the same discount rate is
applied to all future periods. In mathematical terms this means that,
given the discount function
D(k) = (1 / 1+ ρ)k
at time period t the same per-period discount rate is applied to all
periods in the future.
243
Features of the DUM
244
Anomalies in the DUM
245
The ‘sign effect’
This effect means that gains are discounted more than losses, as
proposed by PT.
A study by Thaler (1981) asked subjects how much they would be
willing to pay for a traffic ticket if payment could be delayed for periods of
three months, a year or three years. The responses indicated that people
used much lower discount rates than in situations where monetary gains
were involved.
At the extreme end of the loss-discounting spectrum, there are
several studies that indicate that many people prefer to incur a loss
immediately rather than delay it. This implies a zero discount rate for
losses.
246
The ‘sign effect’ may be accounted for by a phenomenon referred to as
‘temporal loss aversion’.
Intervals preceding losses seem shorter than intervals preceding
gains, and that this effect is driven by perceptions of the quality of
the interval end point rather than by the quality of the interval itself.
For example, for a person moving jobs to a new city in a couple of
months’ time, if that person is not looking forward to the move, the
interval may appear to be shorter than it would for the person who
is looking forward to the move. If the interval is perceived to be
shorter, then a smaller discount rate would be used. This temporal
loss-aversion may occur because the subjective size of the effect is
greater, or because losses may attract more attention than gains.
247
There are other psychological factors related to this kind of loss-aversion.
Anticipatory utility, or in the case of losses, disutility, is important.
People do not like the idea of a loss ‘hanging over’ them, and may prefer to
endure the pain of the loss immediately and ‘get it over and done with’. Thus
people are motivated to maximize savoring events that they look forward to
and minimize the dread associated with unpleasant events in the future.
‘when danger is imminent, it is likely more adaptive to err in the direction of
exaggerating the proximity of the danger because perceiving dangers as
temporally near may galvanize necessary coping resources’.
248
In this case people may forget to pay, or delay payment in the hope of
evading the fine altogether (if authorities fail to follow up on all tickets
issued).
249
The ‘magnitude effect’
Studies that vary outcome size often find that large outcomes are
discounted at a lower rate than small ones.
For example, in Thaler’s study subjects were indifferent between $15
immediately and $60 in a year, $250 immediately and $350 in a year,
and $3000 immediately and $4000 in a year. These matching
preferences indicated discount rates of 139%, 34% and 29%
respectively.
250
The ‘magnitude effect’
It should be noted that the effect works in the opposite direction to the
effect of diminishing marginal utility.
The discount rates calculated for Thaler’s study above are based on the
monetary values, not the actual utilities. If utilities were used to
calculate discount rates instead of monetary values, then, assuming the
law of diminishing marginal utility applies, the differences in discount
rates between small and large amounts would be even greater.
251
The ‘delay-speedup’ asymmetry
Studies have also investigated the effect of changing the delivery time
of outcomes. These changes can be framed either as delays or
accelerations from some reference point in time.
252
The ‘delay-speedup’ asymmetry
Loewenstein (1988) has found that subjects who didn’t expect to
receive a VCR for another year would pay an average of $54 to receive
it immediately (a perceived gain). However, those subjects who thought
they would receive the VCR immediately demanded an average of $126
to delay its receipt by a year (a perceived loss).
Other studies have confirmed these findings in situations where the
outcomes involved payments, i.e. negative outcomes, rather than
positive ones like the delivery of a product. In these situations subjects
demand more to accelerate payment (a perceived loss) than to delay it
(a perceived gain).
253
Preference for improving sequences
The DUM predicts that, total undiscounted utility being equal, people
will prefer a declining sequence of outcomes to an increasing
sequence, since later outcomes are discounted more heavily.
Thus, given the two consumption profiles (50, 60, 70) and (70, 60, 50)
over three consecutive time periods, the DUM predicts that people will
prefer the latter to the former. In contrast, many studies have shown
that people prefer improving profiles. For example, Loewenstein and
Sicherman (1991) have found that, for an otherwise identical job, most
subjects prefer an increasing wage profile to a declining or flat one.
254
Preference for improving sequences
Thus in general, for both gains and losses, people prefer an improving
sequence to a sequence where outcomes are deteriorating.
255
The ‘date/delay effect’
People may make different intertemporal choices when logically identical
situations are presented or framed in different ways.
Studies by Read et al. (2005) and LeBoeuf (2006) find that people use lower
discount rates in situations when time periods are described using end dates
than when the same time periods are described as extents. For example, the
LeBoeuf study asked subjects the following two questions (on 15 February):
1. How much money would you want to receive in 8 months to be equivalent
to receiving $100 now?
2. How much money would you want to receive on 15 October to be
equivalent to receiving $100 now?
256
Violations of independence and preference for
spread
Loewenstein and Prelec (1993) have found that when people are given
a ‘simple’ choice: (A) dinner at a fancy French restaurant next weekend
or (B) dinner at the same restaurant on a weekend two weeks later,
most people prefer the first option, the sooner dinner. This is predicted
by the DUM, as people discount the utility of the later event more
heavily.
257
Violations of independence and preference for
spread
However, the investigators observed different results when subjects are
offered an ‘elaborated’ choice: (C) dinner at a fancy French restaurant
next weekend and dinner at home on a weekend two weeks later, or
(D) dinner at home next weekend and dinner at the French restaurant
on a weekend in two weeks.
In this decision situation most people prefer the second option. Since
the most likely event for subjects is to have dinner at home, the
‘elaborated’ options (C) and (D) amount to the same as the ‘simple’
options (A) and (B). Thus there appears to be a framing effect, causing
preference reversal.
258
The basic idea is that consumption is worth more to you now

than later. If given the choice between a great dinner this
week or one a year from now, most of us would prefer the
dinner sooner rather than later.
Using the Samuelson formulation, we are said to “discount”
future consumption at some rate. If a dinner a year from now
is only considered to be 90% as good as one right now, we are
said to be discounting the future dinner at an annual rate of
about 10%.
259
Samuelson correctly notes that if people discount the future at rates

that vary over time, then people may not behave consistently, that is,
they may change their minds as time moves forward.
The specific case he worries about is the same one that worried earlier
economists such as Jevons and Pigou, namely, the case where we are
most impatient for immediate rewards.
260
To understand how discounting works, suppose there is some good,

perhaps the chance to watch a tennis match at Wimbledon. If the
match is watched tonight, it would be worth 100 “utils,” the arbitrary
units economists use to describe levels of utility or happiness.
Consider Ted, who discounts at a constant rate of 10% per year. For him
that match would be worth 100 utils this year, 90 next year, then 81,
72, and so forth. Someone who discounts this way is said to be
discounting with an exponential function.
261
Discounting
Now consider Matthew, who also values that match at 100 today, but at only
70 the following year, then 63 in year three or any time after that. In other
words, Matthew discounts anything that he has to wait a year to consume by
30%, the next year at 10%, and then he stops discounting at all (0%).
Matthew is viewing the future by looking through Pigou’s faulty telescope,
and he sees year 1 and year 2 looking just one-third of a year apart, with no
real delay between any dates beyond that. His impression of the future is a
lot like the famous New Yorker magazine cover “View of the World from 9th
Avenue.” On the cover, looking west from 9th Avenue, the distance to 11th
Avenue (two long blocks) is about as far as from 11th Avenue to Chicago,
which appears to be about one-third of the way to Japan. The upshot is that
Matthew finds waiting most painful at the beginning, since it feels longer.
262
Discounting
The technical term for discounting of this general form that starts out
high and then declines is quasi-hyperbolic discounting.
Just keep the faulty telescope in mind as an image when the term
comes up. For the most part I will avoid this term and use the modern
phrase present-biased to describe preferences of this type.
263
Discounting
To see why exponential discounters stick to their plans while hyperbolic
(present-biased) discounters do not, let’s consider a simple numerical
example.
Suppose Ted and Matthew both live in London and are avid tennis fans. Each
has won a lottery offering a ticket to a match at Wimbledon, with an
intertemporal twist. They can choose among three options. Option A is a
ticket to a first-round match this year; in fact, the match is tomorrow. Option
B is a quarterfinal match at next year’s tournament. Option C is the final, at
the tournament to be held two years from now.
All the tickets are guaranteed, so we can leave risk considerations out of our
analysis, and Ted and Matthew have identical tastes in tennis. If the matches
were all for this year’s tournament, the utilities they would assign to them
are as follows: A: 100, B: 150, C: 180. But in order to go to their favorite
option C, the final, they have to wait two years. What will they do?
264
A: 100, B: 150, C: 180
If Ted had this choice, he would choose to wait two years and go the
final. He would do so because the value he puts right now on going to
the final in two years (its “present value”) is 146 (81% of 180), which is
greater than the present value of A (100) or B (135, or 90% of 150).
Furthermore, after a year has passed, if Ted is asked whether he wants
to change his mind and go to option B, the quarterfinal, he will say no,
since 90% of the value of C (162) is still greater than the value of B. This
is what it means to have time-consistent preferences. Ted will always
stick to whatever plan he makes at the beginning, no matter what
options he faces.
265
A: 100, B: 150, C: 180
What about Matthew? When first presented with the choice, he would
also choose option C, the final. Right now he values A at 100, B at 105
(70% of 150) and C at 113 (63% of 180). But unlike Ted, when a year
passes, Matthew will change his mind and switch to B, the quarterfinal,
because waiting one year discounts the value of C by 70% to 126,
which is less than 150, the current value of B. He is time-inconsistent.
In telescope terms, referring back to the New Yorker cover, from New
York he couldn’t tell that China was any farther than Japan, but if he
carried that telescope to Tokyo, he would start to notice that the trip
from there to Shanghai is even farther than it was from New York to
Chicago.
266
It bothered Samuelson that people might display time inconsistency.
Econs should not be making plans that they will later change without
any new information arriving, but Samuelson makes it clear that he is
aware that such behavior exists.
267
A: 100, B: 150, C: 180
268
A: 100, B: 150, C: 180
269
Confounding factors involved in the
measurement of time preference
Merriam-Webster Dictionary
Confounding : to throw (a person) into confusion or perplexity tactics
to confound the enemy
270
Consumption reallocation
Most studies use monetary rewards as payoffs rather than consumption.

When discount rates are calculated it is normally assumed that rewards and
losses are consumed immediately at the same point in time that they are
received, and that they do not affect the pattern of consumption at other
time periods.
For example, if a reward of $100 is to be received in one year, it is assumed
that this amount will be consumed immediately rather than causing a stream
of higher consumption over a prolonged time period after one year.
Ideally the calculation of discount rates should take into account the effects
of rewards and losses on the whole lifetime pattern of consumption.
271
Intertemporal arbitrage
When rewards are tradable, like money, intertemporal choices may not
reflect time preference directly, but may be caused by intertemporal
arbitrage.
For example, if a person prefers $100 now to $150 in five years time,
this may be because they can invest $100 now at the market rate of
interest and make it worth more than $150 in five years. When
financial markets are efficient it can be argued that discount rates will
converge on the market rate of interest, rather than being a direct
reflection of time preference. Of course market interest rates are
affected by time preference, but they are also influenced by many
other factors, such as default risk, uncertainty, liquidity and so on.
272
Concave utility
The average response of a group of subjects in a study, is that they are

indifferent between $100 now and $150 in five years. The imputed
discount rate (assuming no consumption reallocation) is 8.1% a year on
the basis of the monetary amounts. However it may be that the $150
has only 30% more utility than $100 (this is also ignoring the effect of
inflation). Using utility as the basis for discounting, the imputed
discount rate is only 5.2%. This shows that utility discount rates are
lower than monetary discount rates when utility functions are concave.
273
Concave utility
The majority of empirical studies involve monetary rewards, and base

the calculation of discount rates on the monetary amounts. It is
misleading to calculate discount rates on this basis, since it is implicitly
assumed that utility increases linearly with monetary amounts. This
assumption is in direct contradiction to both the standard model and
the principles of prospect theory.
274
Uncertainty
Future rewards and costs are almost invariably associated with

uncertainty in practice. Thus in field studies it is particularly difficult to
avoid this confound, regardless of whether rewards and costs are
expressed in monetary terms or in other ways. For example, even if we
can be sure that a particular electrical appliance will save us a certain
amount of electricity in the future (which is unlikely in itself), we
cannot be sure what will be the future price of electricity.
275
Inflation
Most studies ignore the effect of inflation in the calculation of discount

rates, assuming that the utility of $100 now is the same as the utility of
$100 in ten years at the times they are received. In practice people are
likely to discount future monetary rewards according to their
experiences with and expectations of inflation. Furthermore, there is
another element of uncertainty here, as the effect of future inflation on
purchasing power becomes more uncertain as the duration of delay
increases.
276
Expectations of changes in utility
If we expect to have higher consumption levels in the future, the marginal

utility of $100 of consumption now is greater than the marginal utility of
$100 of consumption in five years, because of the effect of the law of
diminishing marginal utility. This effect exerts an upward bias on discount
rates.
However, there is another effect at work here. People may wish to defer
consumption to later periods in order to have a rising consumption over
time, but they may lack the self-control to save sufficient income earned
now to provide for this future consumption. In such a situation people may
welcome some sort of commitment device that allows them to have more
money in the future without the opportunity to spend it earlier, in the same
sort of way that they may commit to paying into a pension fund.
277
Anticipatory utility
People may wish to defer consumption of a restaurant dinner, since the

anticipation of the future utility may increase total utility.
The effect is to exert a downward bias on discount rates and can also
cause reverse time-inconsistency of preferences.
278
Social Preferences
279
Social Preferences
The standard model assumes self interest of individuals.

Behavioral economists in general tend to take issue with this stance,
appealing to a large amount of evidence for various kinds of social
preference, such as reciprocity.
280
Anomalies
281
anomalies
These anomalies relate to aspects of behavior that can be described as

either altruistic or spiteful. While altruism can be defined in many
ways, as we will see, a basic definition is that it relates to behavior that
confers a benefit to others, while involving a cost to the originator of
the behavior, with no corresponding material benefit.
282
The nature of social preferences
Fehr and Fischbacher (2005) define social preferences as ‘other-
regarding preferences in the sense that individuals who exhibit them
behave as if they value the payoff of relevant reference agents
positively or negatively’.
First, we shall see that it is not just the payoffs of other people that are
important, but also their beliefs and intentions that are relevant.
Second, these payoffs, beliefs and intentions can be valued positively
or negatively, depending on the reference agent. Our perceptions of
other people’s beliefs and intentions determine whether we are well-
disposed or ill-disposed toward them.
283
The nature of social preferences
If we feel well-disposed to the other agent we value their payoffs

positively, but if we are ill-disposed toward the agent we value their
payoffs negatively.
Third, the relevant reference agents may be a person’s colleagues,
relatives, trading partners or neighbors, depending on the situation.
284
Reciprocity
People are prepared to cooperate as long as others in the game

cooperate, but will ‘defect’ if others do not cooperate. Defection in
two-player games means increasing one’s payoff at the expense of
others.
285
Factors affecting social preferences
286
287
288
Signaling
Many types of game feature asymmetric information, where one player

wants to convey information to the other player(s). Such information
does not necessarily have to be true. Actions taken by players that are
designed to influence the beliefs and behavior of other players in a way
favorable to themselves are often referred to as commitments or
strategic moves.
289
This characteristic requires two factors:
1. Affordability by the signaler’s type
Someone wanting to obtain a good job may want to signal that they are this
‘type’ of person by investing in an expensive education or training program. A
union striking for higher wages must be able to afford to go on strike, taking into
consideration the foregone wages.
2 Non-affordability by other types
A firm producing an inferior, unreliable product cannot afford to give a decent
warranty for it. Thus good warranties are credible signals that products are of high
quality. Profitable firms may use advertising as a signal of this type. Firms lacking
a sound financial foundation may be unable to spend on advertising, so consumers
may view advertising as a signal that a firm is well-established.
290
Signaling and cooperation
Many games involve more than one equilibrium, as we have seen in

previous sections.
Even PD situations, when repeated under certain conditions, may give
rise to different equilibrium strategies
291
Signaling and cooperation
292
The essence of this game is that hunting a stag successfully requires the
coordination of two hunters. Success brings a big payoff, but hunting
stag is risky, since if the other hunter does not cooperate, the payoff is
zero. Hunting rabbit is safer, since this can be done on one’s own, and
one is guaranteed a payoff of one. There are two Nash equilibria in this
game: both hunters hunt stag, or both hunters hunt rabbit. Hunting
stag is clearly preferred by both hunters.
293
However, this may not be a focal point because the hunters may be
risk-averse, preferring to pursue the ‘maximin’, or risk-dominant
strategy of hunting rabbit. A ‘maximin’ strategy selects the strategy
that maximizes the minimum payoff. A risk-dominant strategy is
defined as one that minimizes joint risk, measured by the product of
the cost of deviations by other players to any one player who does not
deviate (Harsanyi and Selten, 1988). In the example above, if a hunter
plays stag and the other hunter deviates and plays rabbit, the cost to
the hunter not deviating is 2. The same applies if the roles are reversed,
so the joint risk of the stag-stag strategy is 4. If both hunters hunt
rabbit, there is no cost to deviation and, therefore, zero joint risk.
294
When empirical tests have been performed in stag-hunt situations, it
appears that people tend to be risk-averse. In experiments by Cooper
et al. (1990) 97% of players played the inefficient equilibrium, with no
players going for the efficient one. It should be noted that in this
experiment the efficient equilibrium only gave a payoff of 25% more
for the efficient equilibrium, not 100% more, as in the example in Table
9.9. Increasing the difference in payoffs may change the results signifi
cantly, but the author is not aware of any experiments with efficient
equilibria awarding payoffs in the order of twice the inefficient payoffs.
295
Signaling and Cooperation
The only way that the preferred equilibrium can be reached (ignoring
outside options) is by signaling. The Cooper et al. study found that
signaling by just one player, in effect allowing him to indicate that he
intended to play stag, resulted in an increase in the number of players
playing the payoff-dominant equilibrium from 0% to 55%. When both
players were allowed to signal this fraction increased to 91%.
296
Iterated dominance game
297
Learning
Learning - changing behavior through experience, occurs in
many different types of game, although it is ignored by standard game
theory.
Learning theories and models
Many different theories of learning have been proposed over the years.
These include evolutionary dynamics, reinforcement learning, belief
learning, anticipatory (sophisticated) learning, imitation, direction
learning, rule learning and experience weighted attraction (EWA)
learning.
298
Learning- Theories
Reinforcement learning
Reinforcement learning theories propose that subjects use very little
information in making strategy choices, just their own previous choices
and the resulting payoffs.
Belief learning
Players keep track of the relative frequencies with which other players
play different strategies over time. These relative frequencies then lead
to beliefs about what other players will do in the next period. Players
then calculate expected payoffs for each strategy based on these
beliefs, and choose strategies with higher expected payoffs more
frequently.
299
Learning- Theories
Experience -Weighted Attraction learning
This model was introduced by Camerer and Ho (1999a, b) in response
to the perceived weaknesses of both the reinforcement and belief
learning models.
The most obvious problems were that reinforcement learning models
assumed players ignored information about foregone payoffs, while
belief learning models assumed that players ignored information about
what they had chosen in the past. Since empirical testing indicated that
players seem to use both types of information, the EWA model was
created as a hybrid to take into account all the relevant information.
300
Social Preferences
301
The Standard Model
‘Pure’ self-interest models are in many ways a straw man; they

represent a simplified situation that is easy to model and apply, in a
similar way to the model of pure competition. It is this simplicity that
makes the model attractive, not its realism, since only pathological
individuals have no consideration for the effects of their behavior on
others. Furthermore, such individuals, while motivated by pure self-
interest, are extremely unlikely to achieve their objectives, because
they alienate others. All normal individuals, even those we would
describe as ‘selfish’, take into account the effects of their behavior on
others to some extent, and also take into account the welfare of others.
302
Anomalies
There is an impressive list of anomalies relating to the ‘pure self-interest’ aspect of the standard model, which
arise both from field studies and from experiments.
• Tipping waiters
• Giving to charity
• Voting
• Completing tax returns honestly
• Voluntary unpaid work
• Working harder when there are no monetary incentives than when there are
• Monetary incentives
• Firms laying off workers in a recession rather than cutting wages
• Monopolies not raising prices when there are shortages
• Contributing to the provision of public goods
• Punishing ‘free riders’, even when there is a cost in doing so
• Cooperating in prisoner’s dilemma games
• Investing in others, and trusting them to repay
303
Anomalies
These anomalies relate to aspects of behavior that can be described as

either altruistic or spiteful. While altruism can be defined in many
ways, as we will see, a basic definition is that it relates to behavior that
confers a benefit to others, while involving a cost to the originator of
the behavior, with no corresponding material benefit.
304
Anomalies
This kind of altruism, sometimes called ‘warm-glow’ altruism, is also referred

to as impure altruism, to distinguish it from pure altruism, where a person
experiences a psychic benefit from an increase in someone else’s wellbeing
even if they are not responsible for causing this increase. Thus, if your car
breaks down and I gain satisfaction from giving you a lift, but not if someone
else gives you a lift, then this is an example of impure altruism; if I gain
satisfaction regardless of who gives you a lift, this is pure altruism. The
distinction between these two types of altruism is important, since the
evolutionary factors leading to their existence are different in nature. As we
will see in more detail later, pure altruism is based on empathy and the
mirror neuron system, while impure altruism is related to signaling
intentions and reciprocity.
305
306
Methodological and structural factors

Repetition and learning
When ultimatum games are repeated with strangers, there is mixed
evidence whether there is a learning effect. Bolton and Zwick (1995)
report no learning effect, but other studies have found a slight but
usually insignificant tendency for both offers and rejections to fall over
time.
307
Stakes
The importance and effect of size of stakes has been discussed before,
in both this chapter and earlier ones. One might expect based on this
previous discussion that, in ultimatum games, as stakes rise, the
amount that responders reject should rise, but the percentage of the
surplus they reject should fall. For example, responders should reject
$4 out of $50 more often than $4 out of $10, but should accept 20%
out of $50 more often than 20% of $10.
308
Anonymity
One recurring problem with experimental studies in general is that the

behavior of the subjects can be influenced by lack of anonymity. The
knowledge, or suspicion, that their identity may be known either to the
investigator or to other subjects may cause subjects to want to appear
‘nice’ or to please the investigator.
309
Communication
Several studies show that in dictator games communication by

recipients, for example talking about themselves, increases allocations.
310
Entitlement
When dictators or proposers in ultimatum games feel entitled in some

way, for example by winning a contest, they make less generous offers.
311
Competition
We have already observed that competition has significant effects on
judgments of fairness. For example, it is judged to be fair for firms to
cut wages if their survival is threatened by competition, but not
otherwise.
312
Available information
Another structural variable that can be manipulated in experiments

concerns the information possessed by the players. In ultimatum
games, for example, respondents may be in any one of three situations
in terms of knowledge about the size of the pie to be divided: (1)
perfect information – they know for certain the amount to be divided;
(2) incomplete information – they know the possible payoff sizes and
their probability distribution; and (3) no information at all. Most studies
indicate that responders tend to accept less under conditions of
incomplete or zero information.
313
Multi person games
The addition of other players to games that normally involve only

two players provides a number of new insights regarding reciprocity
and fairness. One general result is that players tend to be mainly
concerned with fairness or equality in terms of their own payoffs
relative to those of a proposer, rather than compared with the payoffs
of third parties.
314
Intentions
Humans, and human institutions like legal systems, place great

importance on the intentions behind a person’s actions as well as on
the consequences. Harm caused by accident is not punished as harshly
as harm caused deliberately. Furthermore, the intention to cause harm
(‘conspiracy’) is usually punished even if there is no harmful
consequence.
315
Opportunity and cost of punishment
Punishment is a vital method of enforcing social norms, in

particular cooperation. Some writers distinguish between punishment
as negative reciprocity and punishment as retaliation (Fehr and
Gächter, 2001). Retaliation is described as relating to situations where
players or agents expect future material benefits from their actions.
Negative (and positive) reciprocity on the other hand does not entail
any expected material benefits. For example, rejecting offers in an
ultimatum game represents negative reciprocity on the part of the
responder.
316
Inequality-aversion models
These models assume that people care about their own payoffs, and
the relative size of these payoffs compared to the payoffs of others.
Pure altruism, where a player’s utility increases as the utility of other

players increases, and impure altruism, where a player’s utility
increases from the act of contributing to others.
Thus, if I am made happier by lending you my car (and thus making you
happier), but not if my neighbor lends you his car, this is impure
altruism.
317
The Fehr–Schmidt model
“Guilt/envy’ model”
They use the term inequity on the basis that fairness judgments are
based on some ‘neutral’ reference point.
Relative material payoffs affect people’s wellbeing and behavior.
In real-life situations the determination of the relevant reference group
and outcome tends to pose modeling problems, but in experimental
situations it seems justifiable to assume that the relevant reference
group is the other subjects in the study, and that the reference
outcome is the average income of these subjects.
318
In the FS model it is therefore assumed that, in addition to purely

selfish subjects, some subjects will also dislike inequitable outcomes.
Such inequity could arise from being either worse off or better off than
others. An individual’s utility function therefore depends not only on
their own monetary payoff, but on differences between this payoff and
those of others.
319
320
321
322
The Bolton –Ockenfels model
This model (BO), proposed by Bolton and Ockenfels (2000), is often

referred to as an ERC model, because it relates to equity, reciprocity
and competition.
It is similar to the FS model in many respects, since players care about
their own payoffs and their relative share.
It is assumed that players prefer a relative payoff that is equal to the
average payoff, meaning that they will sacrifice to move their share
closer to the average if they are either above or below it.
323
324
325
Reciprocity models
Reciprocity is based on the idea that people’s conception of fairness

depends not only on equality or inequality but on people’s intentions.
In general people can have either ‘kind’ or ‘unkind’ intentions toward
other people, depending on what we believe are their intentions
toward us.
For example, if we have no alternative but to make an unequal offer to
someone this is not judged as being as unfair as when we have a choice
between making an equal offer and an unequal offer.
326
The Rabin model
The central basis of the Rabin model is expressed by the statement:
“If somebody is being nice to you, fairness dictates that you be nice to
him. If somebody is being mean to you, fairness allows – and
vindictiveness dictates – that you be mean to him”.
327
The Rabin model
328
329

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Behavioural Economics

Behavioral economics increases the explanatory power of

• Enlightened’ implies that an individual has perfect

The term ‘heuristic’ means that people use simple ‘rules-of-

Bounded rationality is not concerned with optimality, or even sub-

Self-serving bias is the ‘above-average’ effect: well over half of

Many or indeed all of our actions may be arational in terms of

Rationality may be seen as demanding something other than just

 A concise description of the relevant factors affecting

2. Why do sellers often value their goods or assets much higher

3. Why are people willing to drive across town to save $5 to

6. Why do people forever make resolutions to go on a diet or

8. Why do people prefer to postpone a treat like a luxury dinner

 Daniel Bernoulli (1738), who might be regarded as the

 Adam Smith is best known for his Wealth of Nations, in 1776,

Jeremy Bentham, best known for introducing the concept of

Francis Edgeworth wrote Mathematical Psychics in 1881, the

 Simon (1955) introduced the term ‘bounded rationality’ to refer

 The first, in 1979, was entitled ‘Prospect theory: An analysis of decision

Behavioral economics uses variants of traditional economic

For example, a reference point could be the amount of money a

In a traditional economic model there is no gap between a

Snacks chosen in advance are overwhelmingly healthy, but

An anonymous sender and an anonymous recipient are paired. The sender

When the pot to be divided is nearly a year’s wages, almost no

Is obesity a problem that the government should try to “solve”

• The concept of utility is one of the most basic building blocks in

(A) At Magazine A, you are offered a job paying $35,000.

Whereas anticipatory utility looks forward to future events, residual utility

1. Acquisition utility – this represents the value of the good obtained

Nature imbues rankings or preferences over consumption goods, which

1. Happiness involves an inter-personal comparison of one’s perceived

3. Happiness and unhappiness are not symmetrical reflections of gain

There is some evidence that high expectations of happiness can lead to

Anticipation of pleasure can itself be pleasurable, with the result that

A study by Waber et al. (2007) involved using a placebo for reducing

Utility is not independent of possession. Those people who have

Coffee Mug and Chocolate experiment.

People’s responses, in terms of values, attitudes and preferences,

There is evidence that products are evaluated more favorably, and

There is much evidence that people’s eating habits, especially the

These are effects where people’s responses are ‘anchored’ to other

• “a bird or mammal, or an imitation of one, used by hunters to attract

Evidence suggests that people simplify complex decisions by choosing a

A final behavioral deviation noted by Della Vigna (2009) concerns

There have been many neuroeconomic studies relating to utility, in

Positron emission tomography (PET) can detect changes in

Other neural studies examine the effects of lesions or disruption of

It was not consumption itself that stimulated dopamine release, but

The component we now need to examine is related to probabilities or

The most significant implication of using heuristics is that they often

People are able to estimate probabilities correctly, given the relevant

An often-quoted example of overestimating low

The California lottery, one of the biggest in the world, requires

In many of their papers Kahneman and Tversky have suggested that

Although this strategy may be effective in certain circumstances, the

Respondents are given a description of a personality of a woman, Linda, who has

Linda is a teacher in elementary school.

• A cab was involved in a hit-and-run accident at night. Two cab