INTRODUCTION TO BEHAVIOURAL ECONOMICS (EC200)

Course duration: 54 hours lecture and class time (Over three weeks)
Summer School Programme Area: Economics
LSE Teaching Department: Department of Economics
Lead Faculty: Dr Matthew Levy and Dr Gianluca Benigno (Dept. of Economics)
Pre-requisites: Introductory macroeconomics and microeconomics.

Aims:
This course will provide students with a clear introduction to the principles and methods of Behavioural
Economics. Behavioural economics considers the ways that people are more social, more impulsive, less adept
at using information, and more susceptible to psychological biases than the standard economic models assume.
We will explore key departures, and the consequences for individuals, firms, and policy.

- To provide students with an introduction to the principles and methods of Behavioural Economics.
- To provide an overview of how behavioural principles have been applied to economic problems both in
microeconomics and macroeconomics.
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Objectives:
By the end of the course students should be able to:
- Identify and evaluate evidence for systematic departures of economic behaviour from the
predictions of the neoclassical model, and psychological explanations for these anomalies.
- Incorporate psychologically motivated assumptions into economic models, and interpret the
implications of these assumptions.
- Explain how these models change the predictions for equilibrium behaviour and welfare analysis,
and assess the implications for optimal policy.
- Compare the predictions of neoclassical and behavioural models, and evaluate the best method for
approaching a given topic.

Content:
This course provides an introduction to the foundations of behavioural economics. The focus of the course is
on the understanding of the principles behind the behavioural approach in addressing economics problems
and on the development of up-to-date analytical tools, drawn from recent research, and their application to a
variety of economic situations.
The course will be thematically organized as ‘behavioural macroeconomics’ and ‘behavioural
microeconomics’. In the behavioural macro part, there will be an introduction on the rational expectations
Course content is subject to change. Last updated: January 2018
framework and then there will be an overview of a variety of applications of behavioural models to finance,
labour market, saving choices and monetary policy to address “anomalies”. We also plan to cover models of
learning and applications of sunspot theories. Behavioural micro will focus on departures from the
assumptions of selfishness, time consistency, rational inference, and strategic sophistication with applications
to markets, policy, and strategic settings. Behavioural game theoretic models (e.g. “level-k”) will be introduced
(Nash equilibrium not required as a prerequisite).

Assessments:
Formative assessments
One problem set for each part of the course (Behavioural Microeconomics and Behavioural Macroeconomics)
will be graded. For Behavioural Microeconomics the assessment will be problem set 2 and the feedback will be
provided by Monday of week two. For Behavioural Macroeconomics the assessment will be problem set 2 and
the feedback will be provided by Monday of week three.
This will not count towards students’ final overall grade, but should provide good preparation for the
summative assessments.
Summative assessments
Mid-session examination
A two-hour mid-session exam (worth 50% of the overall grade) will take place on Tuesday of week two.
Results will be released by Monday of week three. The precise time and location of the exam will be circulated
during the programme. 2

Final examination
A two-hour final exam (worth 50% of the overall grade) will take place on Friday of week three. Results will be
released within a week of the exam. The precise time and location of the exam will be circulated during the
programme.

Reading:
One suggested (non-mandatory) textbook for the course is An Introduction to Behavioural Economics by Nick
Wilkinson and Matthew Klaes. Another good reading is Animal Spirits by George Akerlof and Robert Shiller.
Almost all of the journal articles in the reading list can be accessed via the LSE Library electronic journals
collection. Hyperlinks are given for working and discussion papers. CC refers to Course Collection.

General:
- An Introduction to Behavioral Economics, N. Wilkinson and M. Klaes (2012), Palgrave Macmillan.
- Animal Spirits, G. Akerlof and R. Shiller (2009), Princeton University Press.

Course content is subject to change. Last updated: January 2018

Review:
Students wishing to review their microeconomic theory should consult a textbook on intermediate
microeconomic theory, such as Morgan, Katz and Rosen (2006) Microeconomics, McGraw Hill (CC HB172 M84)
or J Perloff (2008) Microeconomics: Theory and Applications with Calculus, Pearson (CC HB172 P45).

Please note:
You should not attempt to read everything on the reading list; the supplementary readings are provided for
students interested in pursuing a particular topic in more depth or for those seeking an alternative approach.
It is not important to read a huge amount, but vastly important to really understand what you do read.

PART I – Behavioural Microeconomics

1. Introduction: what is behavioural economics?

Introduction to the themes and methods of behavioural economics. Anticipation and information avoidance as
introductory example.
- Loewenstein (1987) “Anticipation and the Valuation of Delayed Consumption”. Economic Journal, 97(387): 666—
684.
- Oster, Emily, Ira Shoulson, and E. Ray Dorsey. 2013. "Optimal Expectations and Limited Medical Testing: 3
Evidence from Huntington Disease." American Economic Review, 103(2): 804-30.
- Brunnermeier, Markus, K., and Jonathan A. Parker (2005). "Optimal Expectations." American Economic Review,
95(4): 1092-1118.

2. Making Choices Under Risk: Prospect Theory

How to people really make choices when faced with uncertainty? The role of reference-dependent
preferences in both risky (loss-aversion) and risk-free (the endowment effect) choices.
- Kahneman and Tversky (1979) “Prospect Theory: An Analysis of Decision Under Risk”, Econometrica, 47(2): 263–
291.
- List (2003) “Does Market Experience Eliminate Market Anomalies?”, Quarterly Journal of Economics, 118(1): 41–
71.
- Koszegi and Rabin (2006), “A Model of Reference-Dependent Preferences”, Quarterly Journal of Economics,
121(4): 1133–1165.
- Sydnor, Justin. 2010. "(Over)insuring Modest Risks." American Economic Journal: Applied Economics, 2(4): 177-99.

3. Social Preferences
How do people care about those around them? Both distributional social preferences (altruism, inequality
aversion) and intentions-based social preferences (reciprocity, fairness). The possibility of self-deception.

Course content is subject to change. Last updated: January 2018

 - Charness and Rabin (2002) “Understanding Social Preferences with Simple Tests” Quarterly Journal of Economics,
117(3): 817–869.
- Lazear, Edward P., Ulrike Malmendier, and Roberto A. Weber. 2012. "Sorting in Experiments with Application to
Social Preferences." American Economic Journal: Applied Economics, 4(1): 136-63.
- DellaVigna, List, Malmendier. 2012. “Testing for Altruism and Social Pressure in Charitable Giving”. Quarterly
Journal of Economics, 127(1): 1–56.
- Rabin (1993) “Incorporating Fairness into Game Theory and Economics”, American Economic Review, 83(5): 1281–
1302.
- Fehr and Gachter, (2000),“Fairness and Retaliation: The Economics of Reciprocity”, Journal of Economic
Perspectives, 14(3): 159–181.
- Fehr, E. and Schmidt, K. (1999) “A Theory of Fairness, Competition, and Cooperation” The Quarterly Journal of
Economics, 114(3): 817—868.
- Thaler, Richard H. 1988. "Anomalies: The Ultimatum Game." Journal of Economic Perspectives, 2(4): 195-206.

4. Heuristics and Biases

How do people make predictions about the world around them? The heuristics and biases displayed in
judgment and decision-making.
- Tversky, A. and Kahneman, D. (1974) “Judgment Under Uncertainty: Heuristics and Biases”, Science, 185(4): 1124–
1131.
- Rabin (2002) “Inference by Believers in the Law of Small Numbers”, Quarterly Journal of Economics, 117(3): 775–
816. 4
- Matthew Rabin, Joel L. Schrag (1999) “First Impressions Matter: A Model of Confirmatory Bias”, The Quarterly
Journal of Economics, 114(1),37–82.

5. State-Dependent Preferences and Mis-Prediction

How do people make predictions about their own future utility? State-dependent preferences (e.g. habit-
formation and addiction) and projection bias.
- Stigler, G., & Becker, G. (1977). “De Gustibus Non Est Disputandum”. The American Economic Review, 67(2), 76-
90.
- Loewenstein, G, O’Donoghue, T, and M Rabin (2003) "Projection Bias in Predicting Future Utility, Quarterly Journal
of Economics 118(4), 1209-1248.
- Meghan R. Busse, Devin G. Pope, Jaren C. Pope, Jorge Silva-Risso (2015) “The Psychological Effect of Weather on
Car Purchases”, Quarterly Journal of Economics, 130(1), 371–414.
- Acland and Levy (2015) “Naivete, Projection Bias, and Habit Formation in Gym Attendance”, Management Science,
61(1):146-160.

6. Behavioural Game Theory

How do people make predictions about their opponents in strategic interactions? Models of limited social
inference (level-k reasoning, cursedness).

Course content is subject to change. Last updated: January 2018

 - Stahl, Dale and Wilson, Paul. "On Players' Models of Other Players: Theory and Experimental Evidence". Games
and Economic Behavior, 10, 1995.
- Thaler, Richard H. 1988. "Anomalies: The Winner's Curse." Journal of Economic Perspectives, 2(1): 191-202.

7. Nudges, Policy, and Happiness

How and when should governments intervene if people are “behavioural”? The theory of nudges, and
happiness as an outcome.
- Kahneman and Krueger (2006) “Developments in the Measurement of Subjective WellBeing”, Journal of
Economic Perspectives, 20(1): 3–24.
- Thaler and Sunstein (2003) “Libertarian Paternalism”, American Economic Review (Papers and Proceedings),
93(2): 175–179.

PART II – Behavioural Macroeconomics

8. Background: Rational Expectations and Neo-Classical Synthesis in Macroeconomics

Review of the principles behind rational expectations and its implications for macroeconomics. In particular,
we are going to focus on its implications for theory of macroeconomics fluctuations (business cycle), labour
market equilibrium (unemployment), the role of monetary policy and the determination of asset prices.

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- I. Ayala and A. Palacio-Vera (2014) “The Rational Expectations Hypothesis: An assessment from Popper’s
Philosophy”, http://www.levyinstitute.org/pubs/wp_786.pdf
- Muth, J.F. 1961. Rational Expectations and the Theory of Price Movements, Econometrica, 29(3), pp. 315-335.
- S. Rebelo (2005) “Real Business Cycles Models: Past, Present and Future”
http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc.pdf
- R. Lucas (1995) “Monetary Neutrality”, Nobel Price Lecture
https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1995/lucas-lecture.pdf
- A. Lo (2007) “Efficient Markets Hypothesis” in L. Blume and S. Durlauf, The New Palgrave: A Dictionary of
Economics.

Animal Spirits

9. Animal Spirits
(i) What are animal spirits? (ii) How does Human Psychology drive the economy? We overview five different
aspects of animal spirits and how they affect economic decisions.
- G. Akerlof, (2001), “Behavioral Macroeconomics and Macroeconomic Behavior”, Nobel Prize Lecture.
- G. Akerlof and R. Shiller, (2009), Animal Spirits, Princeton University Press.

Course content is subject to change. Last updated: January 2018

10. Theory of Economic Fluctuations
Phillips curve and the macroeconomic framework in a low inflation environment. Theory of economic
fluctuations based on sunspots.
- Lucas, Robert E., Jr. and Thomas J. Sargent, “After Keynesian Macroeconomics,” in Federal Reserve Bank of Boston,
After the Phillips Curve: Persistence of High Inflation and High Unemployment, Conference Series, 1979.
- Farmer, R., Macroeconomics of Self Fulfilling Prophecies, MIT press.
- Blanchard, Olivier J. and Mark W. Watson., ‘Bubbles, Rational Expectations and Financial Markets’, Crises in the
Economic and Financial Structure, Paul Wachtel, editor, pp. 295-316. Lexington, MA: D.C. Heathand Company,
(1982).
- Akerlof, George and William T. Dickens and George L. Perry, “The Macroeconomics of Low Inflation,” Brookings
Papers on Economic Activity, 1996:1, pp. 1–59.
- Akerlof, George and William T. Dickens and George L. Perry, ”Near-Rational Wage and Price Setting and the Long-
Run Phillips Curve,” ,” Brookings Papers on Economic Activity, 2000.

11. Money Illusion and Monetary Policy

(i) New Keynesian rationalization of price stickiness and its implications for the effectiveness of monetary
policy as a stabilization tool.
- Akerlof, G. and Janet L. Yellen, “A Near-rational Model of the Business Cycle, with Wage and Price Inertia,”
Quarterly Journal of Economics, 100 (Supp. 1985).
- Akerlof, ,G. and Janet L. Yellen, “Can Small Deviations from Rationality Make Significant Differences in Economic 6
Eqilibria?”, American Economic Review (1995).
- Mankiw, N. Gregory, “Small Menu Costs and Large Business Cycles: A Macroeconomic Model”, Quarterly Journal
of Economics, 1985.

12. Consumption and Savings behaviour

Why do people save too little? Hyperbolic discount factor and its implication for consumption and saving
behaviour.
- Pagel, Michaela, “Expectations-Based Reference-Dependent Life-Cycle Consumption”, Review of Economic
Studies (forthcoming).
- Laibson D., “Golden Eggs and Hyperbolic Discounting”, Quarterly Journal of Economics, 1997;112(2):443-477.
- Akerlof, George, “Procrastination and Obedience”, American Economic Review, Papers and Proceedings 81,
(1991).
- Labison, David, Andrea Repetto, and Jeremy Tobacman, “Self-Control and Saving for Retirement”, Brooking
Papers on Economic Activity, 1998.

13. Labour market

The efficiency wage labour market. How does it work and comparison with the neoclassical counterpart.

Course content is subject to change. Last updated: January 2018

 - Akerlof George and Janet L. Yellen “The Fair Wage-Effort Hypothesis and Unemployment”, Quarterly Journal of
Economics, 1990.
- Akerlof, George and Andrew K. Rose and Janet L. Yellen, “Job Switching and Job Satisfaction in the U.S. Labor
Market”, Brooking Papers on Economic Activity, 1988.
- Akerlof, George, “Labor Contracts as Partial Gift Exchange”, Quarterly Journal of Economics, 97 (November 1982).
- Shapiro, Carl and Joseph E. Stiglitz, “Equilibrium Unemployment as a Worker Discipline Device”, American
Economic Review, (1984).
- Yellen, Janet L., “Efficiency Wage Models of Unemployment”, American Economic Review, Papers and
Proceedings of the Ninety-Sixth Annual Meeting of the American Economic Association (May, 1984).
- Solow, Robert, “Another possible source of Wage rigidity”, (1979), Journal of Macroeconomics.

14. Asset prices and Behavioural Finance

Excess Volatility and the Equity Premium Puzzle. Non-rational theories of asset price determination.
- Pagel, Michaela “Expectations-Based Reference-Dependent Preferences and Asset Pricing”, Journal of the
European Economic Association.
- Shiller, Robert J., “Do Stock Prices Move Too Much to be Justified by Subsequent Changes In Dividends”,
American Economics Review (1981).
- Siegel, Jeremy J. and Richard H. Thaler, “Anomalies: The Equity Premium Puzzle”, The Journal of Economics
Perspectives, (1997).
- Campbell, John and Robert Shiller, “Stock Prices, Earnings and Expected Dividends”, Journal of Finance, (1988).

Credit Transfer: If you are hoping to earn credit by taking this course, it is advisable that you confirm
it is eligible for credit transfer well in advance of the start date. Please discuss this directly with your
home institution or Study Abroad Advisor.
As a guide, our LSE Summer School courses are typically eligible for three or four credits within the
US system and 7.5 ECTS in Europe. Different institutions and countries can, and will, vary. You will
receive a digital transcript and a printed certificate following your successful completion of the
course in order to make arrangements for transfer of credit.
If you have any queries, please direct them to summer.school@lse.ac.uk

Course content is subject to change. Last updated: January 2018