Behavioural and Experimental Economics

Ksenia Panidi
Lecture 1

This course is given in English!

1 September 2017
General information
Contact: kpanidi@hse.ru

Website: https://sites.google.com/site/kpanidibehav/

Office hours: by appointment (send me an email)

Course materials: see website

General information
Home assignments: 15% of the final grade

Essay and/or group presentation: 15%

Midterm: 35%, Friday, 20 October, during lecture.

Final test: 35%, most likely Friday, 15 December, but may be during
exam week.
General information: textbook
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Signs of danger are being ignored;
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Signs of danger are being ignored;
After the Black Tuesday people start to
lose confidence.
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Signs of danger are being ignored;
After the Black Tuesday people start to
lose confidence.
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Signs of danger are being ignored;
After the Black Tuesday people start to
lose confidence.
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
People become overconfident and start
taking loans to buy houses;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
People become overconfident and start
taking loans to buy houses;
Signs of danger are being ignored;
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
People become overconfident and start
taking loans to buy houses;
Signs of danger are being ignored;
After the stock market crash in Sept.
2008 people start lose confidence.
Prior to the Great Depression
Stock market provided a great way for
ordinary people to become rich fast;
Authorities and the most experienced
entrepreneurs were convinced that
growth would continue;
People become overconfident and start
to take loans to make stock market
investments;
Signs of danger are being ignored;
After the Black Tuesday people start to
lose confidence.
Looks very similar
Prior to the crisis of 2008
A boom on a housing market allows
ordinary people to buy better and
larger houses;
Authorities and the most experienced
entrepreneurs were convinced that
housing prices will continue to grow;
People become overconfident and start
taking loans to buy houses;
Signs of danger are being ignored;
After the stock market crash in Sept.
2008 people start lose confidence.
Economics

Emotions and cognitive limitations (like imperfect memory, limited

attention, etc.) where hard to formalize, and they were not
considered important for decision-making;

Rationality was the main model;

Revealed preference principle.

Economics
Human real motivation behind their choices became a black box.

Hence, no need to study cognitive processes.

[There] are evidently some principles in [man's] nature, which interest
him in the fortune of others, and render their happiness necessary to
him, though he derives nothing from it except the pleasure of seeing
it.

Adam Smith, Wealth of Nations

Psychology (first half of XX century)
Behaviourism: human behavior is determined by the environment.
Control over the environment allows to generate any desired
behavior.
Psychology
In the 1950s Behaviorism faced some challenges:

Animals did not always behave the way the theory predicted (e.g.,
experiment with rats);

Human language acquisition studies;

Can we really exclude cognition, thinking processes, feelings and

emotions?
Psychology
Cognitive Psychology started as a field studying how people perceive
different types of information:

attention (cocktail party problem);

categorization;
memory;
reasoning;
problem-solving;
language;
decision-making.

Main idea: human mind is similar to a computer.

Psychology and Economics
The real merge between Economics and Psychology started with the
works of Daniel Kahneman and Amos Tversky.
Behavioural Economics
Daniel Kahneman (left) and Amos Tversky (right)

Kahneman: specific features of human perception (focus on changes

vs. states)
Tversky: heuristics (representativeness, availability, anchoring)
Economics

Emotions and cognitive limitations (like imperfect memory, limited

attention, etc.) where hard to formalize, and they were not
considered important for decision-making;

Rationality was the main model;

Revealed preference principle.

Behavioural Economics

The field is misnamed - it should have been called Cognitive

Economics. We weren't brave enough.

Eric Wanner,
the (former) President
of the Russell Sage Foundation
Purposes of the course
Behavioral Economics is a discipline studying how cognitive and
emotional factors affect human (economic) decision-making.

Purpose 1: To learn about alternative views on human rationality.

Purpose 2: To see how economic science is connected to other social

and natural sciences.

Purpose 3: To learn about various methods of studying economic

behavior.
Consider the following two situations:
Anna has been promised a salary increase of $2000 by her boss. In the end
of the month her boss tells her that due to financial difficulties of the
company he will only be able to increase her salary by $1000.

Bob has been promised a salary increase of $1000 and he receives this
increase in the end of the month.

(suppose they both have a well defined utility of money)

Who of these two people is more satisfied with salary in the end of the month?
Whose utility is higher?
Are your answers to these two question consistent? How can you explain it?
Consider the following two situations:

Anna has been promised a salary increase of $2000 by her boss,

but only received $1000.

Bob has been promised a salary increase of $1000 and he receives

this increase in the end of the month.

Utility is based on satisfaction of our needs and not on emotional impact that
decisions have on us.
But what really matters for our choices? Satisfaction of our needs or our
emotions?..

33
Bazerman auction
Concord effect

Faster than the speed of sound

comes the plane of the future. It
has cost at least fifteen times the
original estimates. It is described
as a "commercial disaster" by a
review committee of one of the
countries that built it. It is
besieged by the
environmentalists.
Peter Gillman, 1977
Classical economic theory
Three assumptions underlying classical utility function:
U(w)

1: we care only about total

wealth;

2: we evaluate gains and losses

in the same way;

3: sensitivity to losses
increases with losses. W
Laws of perception by Kahneman-Tversky
Law 1: (reference point effect)
our perception of the state depends not (only) on the state itself, but
(also) on the changes that brought us to this state.
Laws of perception by Kahneman-Tversky
Law 1: (reference point effect)
our perception of the state depends not (only) on the state itself, but
(also) on the changes that brought us to this state.
Consider the following two situations:
Anna has been promised a salary increase of $2000 by her boss. In the end
of the month her boss tells her that due to financial difficulties of the
company he will only be able to increase her salary by $1000.

Bob has been promised a salary increase of $1000 and he receives this
increase in the end of the month.

(suppose they both have a well defined utility of money)

Who of these two people is happier in the end of the month?
Whose utility is higher?
Are your answers to these two question consistent? How can you explain
it?
Laws of perception by Kahneman-Tversky
Law 1: (reference point effect)
our perception of the state depends not (only) on the state itself, but
(also) on the changes that brought us to this state.
What can serve as a reference point?

Status-quo (=current situation)

Expectations about the future (e.g., promised salary)
Incomes of people from our group of comparison
etc.
Laws of perception by Kahneman-Tversky
Law 2: (loss aversion)
people perceive losses emotionally stronger than equally sized gains.
U(w)

This is not assumed by the

standard utility theory!

5 15 w
Laws of perception by Kahneman-Tversky
Law 2: (loss aversion)
people perceive losses emotionally stronger than equally sized gains.

Brain area called amygdala might be

responsible for loss aversion.
 Laws of perception by Kahneman-Tversky
Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. Two alternative programs to
combat the disease have been proposed. Assume the exact scientific
estimate of the consequences of the programs are as follows:

Program : 200 people will be saved 72%

Program B: there is a 1/3 probability that 600 people will be saved,
and a 2/3 probability that no people will be saved.

Program : 400 people will die

Program D: there is 1/3 probability that nobody will die,
And a 2/3 probability that 600 people will die. 78%
FRAMING EFFECT (CONTEXT EFFECT)
Laws of perception by Kahneman-Tversky
Framing effect (context effect) might be analogous to our tendency to
perceive things based on the interpretation of reality.
Laws of perception by Kahneman-Tversky
Law 3: (diminishing sensitivity to losses)
our sensitivity to gains as well as to losses decreases.

What can serve as a reference point?

Status-quo (=current situation)

Expectations about the future (e.g., promised salary)
Incomes of people from our group of comparison
etc.
Laws of perception by Kahneman-Tversky
Suppose you decided to buy a DVD-player for 125 dollars and
a calculator for 15. The seller informs you that you can go to
another shop of the same chain which takes 20 min by foot,
and buy a calculator only for 10 dollars. The DVD-player price
is the same. Would you go to that shop or would you buy
everything in the current shop?

Suppose you decided to buy a DVD-player for 125 dollars and a

calculator for 15. The seller informs you that you can go to
another shop of the same chain which takes 20 min by foot, and
buy a DVD-player only for 120 dollars. The calculator price is the
same. Would you go to that shop or would you buy everything in
the current shop?
Laws of perception by Kahneman-Tversky
Law 1: reference point effect
our perception of the state depends not (only) on the state itself, but
(also) on the changes that brought us to this state.

Law 2: loss aversion

people perceive losses emotionally stronger than equally sized gains.

Law 3: diminishing sensitivity to losses

our sensitivity to gains as well as to losses decreases.
How does utility function look under these laws?
U(w)