Behavioral and Experimental Economics: Chapter Outline

Behavioral and
Experimental Economics
17
Chapter Outline
17.1
When Human Beings Fail
to Act
the Way Economic
Models Predict
(Insert image of text cover)
17.2
Does Behavioral
Economics Mean Everything
Weve Learned
Is Useless?
17.3
Testing Economic
Theories with
Data:
17.4 Conclusions and the Future
of Microeconomics
17-1
Copyright 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/Syverson
1/e
Introduction
17
The model of economic behavior we have considered

throughout this book is restrictive in a number of ways
Economic agents are assumed to be perfectly rational

Agents are assumed to perfectly understand risk and uncertainty
Agents are assumed to be self-interested
In reality, people exhibit a number of departures from this

rational agent model of decision making
Behavioral economics Branch of economics that incorporates
insights from human psychology into models of economic behavior
17-2
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Introduction
17
Behavioral economics is concerned with systematic departures

from rational choice
Behavioral economists attempt to identify systematic biases

Departures from rational choice can inform the development of
more general, descriptive models of economic behavior
Models can be used to develop testable hypotheses and predict
economic behavior
17-3
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When Human Beings Fail to

Act the Way Economic
Models Predict
17.1
17
Systematic Bias 1: Overconfidence

A belief that something is better than it actually is
Numerous studies have shown that humans tend to

overestimate positive attributes about themselves
In one survey, 93% of college students said they were better than
average drivers
On a popular dating website, 73% of individuals describe
themselves as having very good or better than average
physical attractiveness
17-4
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Models Predict
17.1
17
How Economic Markets Take Advantage of

Overconfident People
Firms take advantage of overconfidence
Consider gym memberships: Why do gyms charge
monthly memberships instead of per-visit fees?
Individuals who sign up for a health club tend to be far too
optimistic about the prospects of sticking to their exercise goals
Health clubs tailor their offerings to exploit such overoptimism
Charging monthly fees allows health clubs to extract surplus from
over-optimistic clients
17-5
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Models Predict
17.1
17
Systematic Bias 2: Self-Control Problems and Hyperbolic

Discounting
People have a strong preference for NOW
Chapter 3 discussed the issue of discounting
A 10% discount rate implies that $1.00 today is equivalent to $0.90
next year
There is evidence that many people have a much higher discount
rate when making decisions about immediate consumption
Hyperbolic discounting Tendency of people to place much

greater importance on the immediate present than even the near
future when making economic decisions
17-6
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Models Predict
17.1
17
Systematic Bias 2: Self-Control Problems and Hyperbolic

Discounting
Problem: Decisions stop being time-consistent
Consistencies in a consumers economic preferences in a given

economic transaction, whether the economic transaction is far off
or imminent
When consumers are not time-consistent, they will, for instance,
specify their preferred exercise and diet routine for next week now,
but then when they get to next week, they wont want to stick with
the plan they set up
17-7 1/e
Copyright 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson

Models Predict
17.1
17
How Economic Markets Take Advantage of People with

Self-Control
Problems
Firms take advantage of hyperbolic discounters
Consider credit card companies: why do credit card
companies offer low interest rates to entice customers?
Offers of 0% interest for the first 30 days, low minimum payments
on your monthly bill, and free balance transfers from other cards
are designed to tempt consumers into big purchases
If consumers dont pay off their bills before the trial period expires,
they will start paying interest
17-8
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Application
17
Commitment Markets
Ian Ayers and Dean Karlan (economists at Yale) formed
a business based on helping people follow through with
their commitments
StickK.com helps people stick with their
commitments through the use of a couple of techniques
that have been shown to work in experiments
Participants are asked to make a series of payments that

will be forfeited to a charity in the case of the commitment
being broken
Participants must designate a referee to let StickK know if
you are complying, and supporters who are made aware
of your progress
These tools leverage a mix of economic and social pressures
to induce people to stick to their goals
17-9
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Models Predict
17.1
17
Systematic Bias 3: Falling Prey to Framing

People often make incompatible (and thus irrational)
decisions depending on how a decision or problem is framed
Endowment effect Possessing a good makes it more valuable; that
is, the possessor must be paid more to give up the good than they
would have paid to buy it in the first place
Nominal loss aversion consumers prefer avoiding economic losses
over acquiring economic gains
Loss aversion is not irrational; concave utility suggests people are
hurt more by losses than gains.
Nominal loss aversion occurs when people care about nominal
losses without accounting for inflation (they care about the dollar
amount)
17-10
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Models Predict
17.1
17
Systematic Bias 3: Falling Prey to Framing

Anchoring A type of framing bias in which a persons decision is
influenced by specific pieces of information given
Mental accounting A type of framing bias in which people divide
their current and future assets into separate, nontransferable portions,
instead of basing purchasing decisions on their assets as a whole
Instead of considering savings as one whole, homogenous
category, for example, people keep mental accounts for college
money, vacation money, and retirement money
Similarly, if a consumer finds $100 (a windfall), they may go spend
it immediately, since it does not subtract from any predetermined
mental account
17-11
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Models Predict
17.1
17
How Economic Markets Take Advantage of People Who

Fall Prey to Framing
Marketers are adept at taking advantage of framing biases
Endowment-effect bias: some firms offer free trials and moneyback guarantees, knowing that biased consumers will experience
an inflated personal value once they own an item
Anchoring bias: a firm might artificially inflate the base price of a
good and then advertise a 50-percent off sale. By anchoring in
the consumers mind the idea that the good is worth the original
inflated price, the half-price good looks like a bargain.
Mental accounting: salespeople ask consumers how much they
are willing to pay for a good. Knowing this, salespeople are likely to
get every bit a consumer has allocated to a purchase (and
sometimes more)
17-12
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Application
17
Mental Accounting and Car Sales

Car salespeople are very good at taking
advantage of mental accounting
After going on a test drive and deciding on a make

and model, your salesperson will sit you down with
a four-square sheet like the one on the right
Four negotiating points: vehicle price, trade-in
price, down payment, and monthly
payment/financing
Many consumers focus on one or two of these
attributes (e.g., trade-in price and down payment)
when negotiating
Salespeople, knowing that you are more likely to
purchase once you are satisfied on your priority
accounts, will simply increase their margins on
the down payment and financing side!
Citation:
B. 2007.
Dealerships
You Off With
The "Four-Square,"
Here's How To BeatIt. The Consumerist
To Popkin,
avoid
this,
try to Rip
reduce
points
of negotiation
http://consumerist.com/2007/03/30/dealerships-rip-you-off-with-the-four-square-heres-how-to-beat-it/, accessed 1/26/2013.
(avoid trade-ins,
secure outside financing, etc.)
17-13
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Models Predict
17.1
17
Systematic Bias 4: Paying Attention to Sunk Costs

In Chapter 7, we showed that rational agents should not pay attention
to sunk costs when making economic decisions, since the money is
already spent
However, numerous studies have shown that people often fall victim
to the sunk cost fallacy
The mistake of allowing sunk costs to affect decisions
Systematic Bias 5: Generosity and Selflessness

Finally, while the economic model of rational choice assumes rational
self- interest, many people often engage in acts of generosity and
exhibit altruism
Acts motivated primarily by a concern for the welfare of others
Donations to charity are the most obvious example
17-14
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Does Behavioral Economics

Mean Everything Weve Learned
Is Useless?
17.2
17
While the rational-choice model is not perfect, it does an

excellent job of predicting human behavior in many
circumstances
This model can often be generalized or otherwise extended to

account for behavioral anomalies
Provides a basis for thinking about seemingly irrational behavior,
often illuminating rational motivations (e.g., conspicuous charitable
donations that improve reputation)
Regardless of individual behavior, markets tend to be coldly

rational
Exposure to markets has been shown to reduce the presence of

biased actors and/or behavior
17-15
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Testing Economic Theories

with Data: Experimental
Economics
17.2
17
The evidence from psychology and behavioral economics has

placed an even greater emphasis on the importance of testing
economic models with real data
However, analyzing economic decisions in the real world is
very difficult. In response, two subfields of economics have
emerged as leaders in the evaluation of economic models:
econometrics and experimental economics
Econometrics: Field that develops and uses statistical and

analytical techniques to test economic theory
Experimental economics: Branch of economics that relies on
experiments to illuminate economic behavior
These two fields have helped turn economics into a more

evidence-based science
17-16
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Economics
17.2
17
There are three types of experimental approaches used in
economics
Lab experiment: Test of an economic theory in a laboratory setting
People (often undergraduates looking for a bit of extra money) are
brought into a controlled laboratory setting and asked to perform
tasks
Benefits: can control for many things
Drawbacks: unlike lab mice, people know when they are being
experimented on, a recognition that may alter outcomes; stakes
are often lower than in the real world; tasks are unfamiliar
17-17
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Economics
17.2
17
Natural experiment: A randomization or near-randomization that
arises by happenstance
Oftentimes, policies or other changes affect people in a randomized
way that allows economists to investigate questions using field
data
Financial-aid packages that have hard GPA cutoffs allow economists
to investigate how aid affects school performance by considering
people just above and below the threshold
Field experiment: Research method in which randomizations are
carried out in real-world settings
Avoids biases that might arise in the lab, but field experiments are
often expensive to conduct, and they must still abide by human
subject research guidelines and informed consent rules
17-18
1/e
Conclusions and the

Future of
Microeconomics
17.4
17
In this chapter, we moved beyond the rational-agent model of

economic behavior and introduced a number of biases that
illustrate some of the motivating factors behind the burgeoning
field of behavioral economics
Additionally, we have discussed some of the methods
economists employ to evaluate economic theories and models
Microeconomics is a fast-growing field, offering tools for the
analysis of important public policies and a variety of other
questions pertaining to human behavior. These tools are more
in demand than ever before
Finally, having even a basic understanding of the field of
microeconomics should prove useful for everyday decisions, so
dont be afraid to draw on the knowledge from this course in
the yearsCopyright
to come!
17-19
2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/Syverson
1/e

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Behavioral and

The model of economic behavior we have considered

Economic agents are assumed to be perfectly rational

In reality, people exhibit a number of departures from this

Behavioral economics is concerned with systematic departures

Behavioral economists attempt to identify systematic biases

When Human Beings Fail to

Systematic Bias 1: Overconfidence

Numerous studies have shown that humans tend to

When Human Beings Fail to

How Economic Markets Take Advantage of

When Human Beings Fail to

Systematic Bias 2: Self-Control Problems and Hyperbolic

Hyperbolic discounting Tendency of people to place much

When Human Beings Fail to

Systematic Bias 2: Self-Control Problems and Hyperbolic

Consistencies in a consumers economic preferences in a given

When Human Beings Fail to

How Economic Markets Take Advantage of People with

Participants are asked to make a series of payments that

When Human Beings Fail to

Systematic Bias 3: Falling Prey to Framing

When Human Beings Fail to

Systematic Bias 3: Falling Prey to Framing

When Human Beings Fail to

How Economic Markets Take Advantage of People Who

Mental Accounting and Car Sales

After going on a test drive and deciding on a make

When Human Beings Fail to

Systematic Bias 4: Paying Attention to Sunk Costs

Systematic Bias 5: Generosity and Selflessness

Does Behavioral Economics

While the rational-choice model is not perfect, it does an

This model can often be generalized or otherwise extended to

Regardless of individual behavior, markets tend to be coldly

Exposure to markets has been shown to reduce the presence of

Testing Economic Theories

The evidence from psychology and behavioral economics has

Econometrics: Field that develops and uses statistical and

These two fields have helped turn economics into a more

Testing Economic Theories

Testing Economic Theories

Conclusions and the

In this chapter, we moved beyond the rational-agent model of

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