Introduction to Economics and Business

Reading questions: Week 5

Utrecht University School of Economics

ECB1IEBE
 Main question

What is the main contribution of psychology to economics?

Psychology is being used by economists:
▪ To extend the rational choice theory for situations where it was inaccurate, and behavior was hard to
predict

▪ To determine factors that create individual variations in economic behavior (e.g., risk aversion,
altruism etc.)

▪ To ground economic models in psychological theories

▪ To employ experimental settings typical for psychology, but in economic problems

 Question 1

According to Tversky and Kahneman (1974), how do people assess the probability of an uncertain event or the value
of an uncertain quantity?
▪ People rely on a limited number of heuristic principles (i.e., mental shortcuts)

▪ This shortcuts reduce the complex tasks of assessing probabilities and predicting values to simpler
judgmental operations

▪ These judgments are all based on data (of limited validity)

▪ For instance, the apparent distance of an object is determined in part by its clarity (i.e., if it is more
sharply seen → the object is closer)
 Question 2

When do biases occur?

Fast judgments work well with, ‘normal’, day-to-day situations of choices but fail in extreme cases

▪ Using data with limited validity may lead to systematic errors in estimation of distance:
1. Distance is overestimated when visibility is poor because the contours of objects are blurred
2. Distance is underestimated when visibility is good because the objects are seen more sharply

▪ The reliance on clarity (i.e., heuristics) as an indication of distance, leads to common biases

▪ Common biases are mistakes in the intuitive judgment of probability

 Question 3

What is the first heuristic they discuss, and to what kind of biases could it lead?
▪ Representativeness: probabilities are evaluated by the degree to which A is representative of B:
(when A is highly representative of B → the probability that A originates from B is judged to be high)

Consider an individual who has been described by a Question: how do people assess the
former neighbor as follows: probability that Steve is engaged in a
"Steve is very shy and withdrawn, invariably helpful, particular occupation (e.g., farmer vs
but with little interest in people, or in the world of librarian)?
reality. A meek and tidy soul, he has a need for order
and structure, and a passion for detail”

▪ The probability that Steve is a librarian is assessed by the degree to which his description is similar
to the stereotype of a librarian
 Question 3

What is the first heuristic they discuss, and to what kind of biases could it lead?
Biases:
▪ Insensitivity to prior probability. Ignoring external factors that have a major effect on probability
(i.e., there are many more farmers than librarians in the population, so Steve is more likely to be a
farmer)

▪ Insensitivity to sample size. Ignoring sample size (i.e., judging that the average height of 10 men is
180cm because the average height of the entire population is also 180cm)

▪ Misconceptions of chance. Thinking that short sequences of events in a random process (i.e., coin
toss) will represent the features of the entire process
(i.e., H-T-H-T-T-H is more likely than H-H-H-H-T-H as the first one seems to be closer to 50/50 fair
outcome)
 Question 3

What is the first heuristic they discuss, and to what kind of biases could it lead?
Biases:
▪ Insensitivity to predictability. Using “favorable” descriptions for prediction
(i.e., using friend’s opinion about the football team to predict the team’s chances for championship)

▪ The illusion of validity. Feeling confident in prediction when input information matches the possible
outcome
(i.e., guessing that student with all B’s in the first study year will have the same grade in the second
year)

▪ Misconceptions of regression towards the mean. Trying to establish causality between the two
factors based on extreme values (i.e., best will get worse over time, so that constantly winning team
will lose in the next match)
 Question 4

What is the second heuristic they discuss, and to what kind of biases could it lead?
▪ Availability: probabilities are evaluated by the ease with which occurrences are brought to mind
(instances, or examples, of large groups are recalled better than instances of less frequent groups)

Consider that one’s middle-aged acquaintance has had a

Question: how do people assess the
heart attack.
probability (or the risk) of heart
attack among middle-aged people?

▪ The probability of a heart attack among the middle-aged people is assessed by the ease to which one
can recall available occurrences or instances from their mind
 Question 4

What is the second heuristic they discuss, and to what kind of biases could it lead?
▪ Retrievability of instances. Thinking that something is more probable if it is more easily retrieved from
memory (i.e., thinking that driving a car is more dangerous because you’ve recently seen a car accident)

▪ Effectiveness of a search set. It is easier to think about relatively simple sets of information
(i.e., thinking that abstract words starting with letter r are more common in written English than words with
r as a third letter, as it is easier to imagine the words for the former)

▪ Imaginability. Considering that if something is easy to imagine, it is also more probable

(i.e., vividly imagining the risks of a mountain expedition can make such expedition to appear very
dangerous)

▪ Illusory correlation. Associating two events very strongly leads to a conclusion that there is a relationship
between the two
(i.e., thinking that suspect is more likely to commit a crime because of the features of his appearance)
 Question 5

What is the third heuristic they discuss, and to what kind of biases could it lead?
▪ Anchoring: probabilities are evaluated by starting from an initial value or starting point
(different starting points will yield different estimates of a probability, which are biased towards such
points)
Consider a car salesman who offers a very high price
to start negotiations. The price is arguably well Question: how do people
above the fair value of the car. The customer might negotiate the final price?
be aware about the approximate price of such cars.

▪ The probability estimate is influenced by an anchoring point, so the negotiated price will tend to be
higher than if salesman had offered a lower price to start with
 Question 5

What is the third heuristic they discuss, and to what kind of biases could it lead?
▪ Insufficient adjustments. Making insufficient adjustment from the starting point
(i.e., using information that comes to mind – valuing a $100 t-shirt to be cheap as compared to one for
$1,200)

▪ Evaluations of conjunctive and disjunctive events. Assigning incorrect probability to the events as
those are compared to simple events (i.e., betting on the least likely of the provided events)

P[getting heads 3 times in succession] < P[getting heads in one coin toss] < P[getting heads at least once
in three successive tries])

▪ Assessment of subjective probability distributions. Constructing verry narrow probability

distributions
(i.e., investors will make mistakes in assessing the chance of very low or high values of the Dow-
Jones industrial index)
 Question 6

What are the consequences of the existence of heuristics and biases for rational choice theory?
▪ Although everyone is exposed to life situations where heuristics are used, very few people realize the
principles of statistics and probability on their own; and do not detect the biases in their judgments of
probability

▪ As a result, their probabilities are subjective as different individuals have different probabilities for the
same event (rational theory allows this: subjective probabilities are inferred from your preferences)

▪ However, a person bets on team A rather than on team B because he believes that team A is more
likely to win (bias); he does not infer this belief from his betting preferences (rationality)

▪ Thus, subjective probabilities determine betting preferences, but are not derived from them
 Question 6

What are the consequences of the existence of heuristics and biases for rational choice theory?
▪ Consider a person whose is subject to gambler's fallacy: his estimate of the probability of tails on a
particular toss increases with the number of consecutive heads that preceded that toss
(such judgment is internally consistent and thus in accordance with the rational theory)

▪ But a coin has no memory and is incapable of generating sequential dependencies (so the probabilities
that you determine are incompatible with the generally held belief about the coin)

▪ Rationality requires compatibility: your judgments must be compatible with your knowledge about
the subject matter, the laws of probability, and your own judgmental heuristics and biases

▪ Yet, rational theory can’t assess compatibility of your probability judgments with your other beliefs
 Question 7

What is a ‘straw-man argument’? And what is the straw-man with which Duflo starts her lecture?
▪ A straw-man argument is a type of fallacy, where someone creates a simplified, perhaps more extreme
version of their opponent’s stance, in order to refute that (rather than refuting the true, more nuanced
position, which is more difficult)

▪ Critics of Randomized Control Trial experiments create a straw-man out of Duflo’s work. She re-
creates their simplified version of how a controlled experiment can be done inappropriately, in order
to gain unhelpful policy advice:
“Run a small, well-controlled experiment → get the results → prepare a shine policy brief → get full-scale adoption”

▪ Duflo is showing that critics of RCT aren’t refuting her real work, but only fighting a simplified
caricature (so called “gold-plated” experiments), whereas the actual RCT work is more nuanced and
complex
 Question 8

What are the arguments against this strawman?

There are several failings of the straw-man version of economic experiments “in the field”:
External validity
▪ Results are highly context dependent (e.g., it is impossible to design one-size-fits-all policy for a whole country,
based on one study with a sample of 100 schools, as local contexts could change policy outcomes and efficacy).
▪ Large-scale implementation can create effects unforeseen in smaller experiments (e.g., price shifts, spillovers,
political side-effects)

Internal validity
▪ Carefully controlled experiments can still have validity issues (e.g., sample size too small to draw precise
conclusions, incorrect assignment of treatment, losing subjects in the experiment follow-ups)

Other issues
▪ Selection bias arising form the fact that experiments with negative results are shelved (and never go to the field),
and only “lucky” experiments with positive results are promoted to policymakers
▪ Politicians pay attention to studies that already match their policies
▪ Pursuing just the“gold-plated” small experiments can be a waste of money, not a source for change
 Question 9

To argue against the strawman arguments is to show that it is a misrepresentation. What is the first flaw Duflo
discusses? And what example does she use to discuss this flaw?

▪ The straw-man does not accurately describe the work of RCT/policy researchers: “one does not simply run an
experiment, write one’s policy brief, and disappear while the policy is being scaled up”

▪ The specific first flaw she refutes is that, “RCT researchers do not come to sweeping conclusions about the
potential impact of a program based on any single experiment. It is the accretion of results that makes sense and
justifies the whole enterprise”

▪ She uses the example of microcredit: the practice of giving out microloans to “lift” people out of poverty had a
low level of robust, empirical evidence behind it

▪ Self-reported positive case studies (i.e., “anecdotes”) were being used to bolster the success of microcredit
(particularly by microfinance institutions providing microcredits). In reality, there were cases farmers became
severely indebted through microfinance, and committed suicide as a result
 Question 9

To argue against the strawman arguments is to show that it is a misrepresentation. What is the first flaw Duflo
discusses? And what example does she use to discuss this flaw?

▪ Duflo explains in detail how researchers approached microcredit experiments (cross-country approach,
spanning several urban and rural contexts, with different levels of pre-existing micro-lending).

▪ Review articles were published on all this data, showing that microcredit was neither as wonderful nor as
terrible as people had claimed:
1. More businesses emerged through microcredit, but they were largely short-lived. Borrowers who already
had a business did use the loans to expand, but they were a small proportion of the eligible population and
some business were eventually shut down
2. Some durable goods were purchased more often (e.g. bikes, refrigerators), but there was no overall
improvement in household consumption, nor a significant increase in spending on health and education
3. Female empowerment wasn’t noticeably aided by these schemes
4. Spending on “temptation goods” (e.g., snacks, tea, tobacco) declined in some experiments but increased in
others
 Question 10

What was the big lesson from microcredit?

▪ In terms of the application of RCT findings to policy, there is no “one-size-fits-all” approach

▪ Local contexts and additional issues of scaling-up do matter, and it’s possible that only a small subsection of a
targeted population (e.g., prior small business owners) will be the only ones to receive true benefits of it

▪ Cooperation led to a “win-win” scenario both for policymakers and microfinance investors (e.g., in terms of
improving the policy stance towards microcredits)

▪ The issues with external validity and generalizability can be solved through coordination of independent research
teams who (re-)run experiments with the same methods, but in different national, cultural, regional contexts

▪ The findings about microcredit turned out to be neutral in terms of long-term outcomes for recipients. Yet, after
many experiments, reviews, and meta-analyses, the findings were methodologically robust
 Question 11

What is the first example of how the long chain from first experiments to the final adoption of policy was used to
tackle the many difficulties involved with scaling-up?

▪ Teaching at the Right Level intervention into education main idea was to create space in schools with very low-
income students in developing countries, to categorize students by their real “level” in basic reading and math, in
order to effectively get them to improve (which wasn’t possible under a strict national curriculum)

▪ The long chain of scaling-up the policy involved a lot of re-evaluation and tinkering of the intervention design:
1. Change in teaching staff. Paid assistants community members in schools, vs. volunteers, vs. different types of
training, materials and incentives provided to government teachers already at the school
2. Change in teaching approach. After-school sessions, vs. different durations of “learning camps”, vs.
implementation during typical classes
3. Government involvement. Purely NGO intervention, vs. government funding, vs. a mix of two

▪ Carefully looking at which interventions worked, and which failed helped to gather specific knowledge about the
educational system in India (e.g., time constraints experienced by government teachers, and their legal
requirement to teach the national curriculum first) and eventually implement the policy more efficiently
 Question 12

What is the role of the economist in relation to policy makers?

▪ Duflo sees the role of an economist as a “plumber” who tinkers at the specifics of a policy, constantly
looking at what exact problems need solving, while dealing with complex reality and uncertainty of
the real world

▪ Economist tries to find “general lessons” but also apply them in specific settings, with government
collaboration and “excellent knowledge of local institutions” (e.g., rice distribution program in
Indonesia)

▪ Direct collaboration with government comprises a very important way in which researchers and
economists play a role in the policy process. (e.g., auditing pollution-heavy manufacturers in India)
 Question 13, 14 and 15

What is the main theory which is criticized by behavioral economics?

Behavioral economists have shown over the past three decades that people:
▪ Do not exhibit rational expectations
▪ Use heuristics that lead them to make systematic errors
▪ Make different choices depending on the context, wording of the problem and monetary rewards

Duflo discusses external validity quite technically. How is it described in the lecture?
▪ External validity is a problem which in principle cannot be solved. One can only give an assessment of the scope
of the validity of the experimental results beyond the experiment itself

What is the changing relationship between psychology and economics during the 20th century?
• In the first decades of the 20th century, theories of choice attempted to expel all psychological notions from
economic theory. However, the emergence of the behavioral economics re-brought the topic onto the surface.