08 Prospect Theory Feb 4

Behavioral
Theories
History
and
Research Evidence
PSYCHOLOGY MEETS ECONOMICS
What Is Behavioral
Economics?
The study of choices actually made by
economic decision makers in an effort to
assess the strengths and weaknesses of the
rational choice model that is the mainstay of
modern economics.
The Rational Choice Model
A decision makers choice is rational if it is a most
preferred choice from the choices that are
available to the decision maker.
By most measures the rational choice model is
very successful when applied to choice problems
without uncertainty. For these problems it
predicts well how people choose.
But there are some predictions that are incorrect.
It suggests that people are sometimes irrational.
The Journey Begins
Let us begin
our journey!!
The Value of Behavioral
Economics
Behavioral economists have demonstrated
that the rational choice model systematically
predicts behavior less well in certain
circumstances.
These demonstrations suggest that
economists must improve on the rational
choice model.
What are these circumstances?
And how can we improve?
Behavioral Economics
:Framing Effects
How a choice is framed (i.e., presented)
strongly affects the choice that results.
Behavioral Economics:
Framing Effects
Would you pay $10 for a bottle of hair
shampoo in an expensive hair salon?
Framing Effects
shampoo in a discount supermarket?
Framing Effects
shampoo in a discount supermarket?
Typically, such shampoos are almost identical
apart from packaging.
Framing Effects
The rational choice model with full
information predicts that the consumer would
pay the lower price for shampoo since
packaging is less important than the hair-
cleaning agents.
But many people prefer to buy the more
expensive shampoo.
Framing Effects
600 lives are threatened.
Action (a) saves 200 lives.
Action (b) saves all 600 lives with
probability 1/3 and saves nobody with
probability 2/3.
Which action would you choose? (a) or (b)?
Framing Effects
Action (c) causes 400 to die.
Action (d) causes 600 to die with
probability 2/3 and causes nobody to die
with probability 1/3.
Which action would you choose? (c) or (d)?
Action (a) saves 200
lives.
Action (b) saves all 600
lives with probability 1/3
and saves nobody with
probability 2/3.
Action (c) causes 400 to
die.
Action (d) causes 600 to
die with probability 2/3
and causes nobody to die
with probability 1/3.
Framing Effects
These are identical problems, apart from how they are framed.
Yet the most common (highlighted) choices are different.
Framing Effects
These problems are identical, apart from how they
are framed.
Yet the most common (highlighted) choices are
different.
Why?

People overweight outcomes that they view as
certain or near certain, relative to outcomes that
are merely probable.
Certainty Effects Maurice Allais (1953)

Problem 1:
Choose Between the following two risky bets A or B:

A. $2,500 with probability of 0.33, $2,400 with a probability of
0.66, 0 with a probability of .01

B. $2,400 with certainty

Out of 72 people, 18% chose A and 82% chose B

People preference suggests the following:
U(2,400) > 0.33U(2,500) + 0.66U(2,400)

Problem 2:
Choose Between the following two risky bets A or B:

A. $2,500 with probability of .33, $0 with probability of 0.67

B. $2,400 with probability of 0.34, $0 with probability of 0.66

Out of 72 people, 83% chose A and 17% chose B

Peoples preference suggests the following:
0.33U(2,500) > 0.34U(2,400)

The choices in problem 1 implies
U(2,400) > 0.33 U(2,500) + 0.66 U(2,400)
Therefore,
0.34U(2,400) > .33U(2,500)

The choices in problem 2 implies
0.33U(2,500) > 0.34U(2,400)

This is a clear violation of the principle of
transitivity!
What is the difference between problem 1 and
problem 2?
Problem 2 is just Problem 1 without the 0.66
chance of winning $2,400.

The presence of an alternative and the
certainty of one of the options changed the
problem.
It seems that a reduction in probability of
winning, say from 80% to 20%, creates a
psychological distaste to individuals. They
interpret or perceive this as a loss (relative to
the original probability) and therefore tend to
favor a risk-averse decision.

Social Norms
Think of the following game.
You, and only you, will decide how to divide
$1 between yourself and one other person.
This will happen only once. You dont know
who is the other person and other person
does not know who you are.
How would you divide the $1?
Social Norms
$100?
Social Norms
$100?
$1,000,000?
Social Norms
$1? $100? $1,000,000?
Strategic reasoning predicts that since the
other person must take what he is given, and
has no power to influence this, he will get
nothing; i.e., you take everything.
Social Norms
$1? $100? $1,000,000?
Strategic reasoning predicts that since the
other person must take what he is given, and
has no power to influence this, he will get
nothing; i.e., you take everything.
But most people give at least something to
the other person. The smaller is the amount
to be divided, the more likely it is to be
divided equally.
Social Norms
Think of a new game.
You make an offer on how to divide $1. If
the other person accepts then this is how the
$1 is divided. If the offer is rejected then
both get nothing.
Social Norms
Strategic reasoning predicts that you will offer
at most one cent to the other, since he gets
nothing if he refuses.
The evidence is that most offers of about 30
cents or less are refused as unfair. Most
offers are about 40 cents and are accepted.
Social Norms
The explanation is that the other person is
offended if you try to keep a large part of the
$1. Also, the cost to the other of refusing the
offer decreases as you keep more for
yourself. You understand this and so offer
close to, but less than, $.
The social norm of fair suggests a 50-50
share and results in a desire by the other to
punish you if you are unfair.
Status quo bias and defaults in organ
donation (Johnson-Goldstein Sci 03)
Status Quo Bias
The explanation is that people prefer the
status quo (or) the current option compared
to an option they can voluntarily choose.
Why?
One explanation is the people are cognitively
lazy. In other words, they dont want to take
the extra effort in analyzing the value of the
new option.
Status Quo Bias
Another explanation is that they trust that
the first option must be the best one.
Another explanation is that the first option is
already available, meaning that they almost
feel like they own it and do not want to
disown it. (akin to the endowment effect)
Another explanation is that they have doubts
about their own ability to compare and
analyze the two options.
Status Quo Bias
Lastly they are merely expressing an aversion
to loss, i.e., what if they choose the newer
option and it is worse. By choosing the status
quo they are preventing a potential loss.
People value a
thing more once
it becomes theirs
One of the
central themes
in a capitalist
economy
Ownership
increases ones
utility

The Endowment Effect: Value
of Ownership
Students who did not get
a mug reported the price
they would be willing to
pay to get one.
What do you think happened?
a) Did the students with mugs price them higher/lower than
students with no mugs?
b) Did both sets of students price them about the same?
Students in every other
seat were given
university mugs. Then
reported how much they
would be willing to sell
the mug for.
Students with the
mugs were willing to
sell them, on average,
for

$4.50
Students with no mugs
were willing to buy
them, on average, for
$2.25
Class B
At the beginning,
students given a
chocolate bar. At
the end, given
option to trade
for a coffee mug.

Class C
At the beginning,
students offered a
choice between a
chocolate bar or
coffee mug.

Class A
At the beginning,
students given a
coffee mug. At
the end, given
option to trade for
a bar of Swiss
chocolate.
?
?
?
Class B

10%
chose
coffee mug

Class C

59%
chose
coffee mug
Class A

89%
chose
coffee
mug
?
?
?
33 chimpanzees given frozen-juice popsicle or tube of
peanut butter (both familiar items) and then an
opportunity to trade.
?
?
When initially
given peanut
butter
89%
Chose peanut
butter
When initially
given popsicle
42%
Chose peanut
butter
The Endowment Effect: Value
of Ownership
So what is happening? Why does
ownership add value?
Investing in something increases ones sense of
attachment to a product and hence increase
perceived value. [IKEA effect]
Marketing Examples
Money back guarantees not only reduces downside
risk but also reduces chances of return
Good vivid ads will transport a consumer into a
world where they feel like they virtually own the
product, thus enhancing the value of the yet-to-be
purchased product(s).

Is too much choice bad?
Jams study (Iyengar-Lepper):
6 jams 40% stopped, 30% purchased
24 jams 60% stopped, 3% purchased

Assignment study:
Short list 74% did the extra credit assignment
Long list 60% did the extra credit assignment

Participation in 401(k) goes down 2% for every 10 extra funds
Shoe salesman: Never show more than 3 pairs of shoes
Medical
65% of nonpatients said they would want to be in charge of medical
treatmentbut only12% of ex-cancer patients said they would
Camerer conjecture: The curse of the composite
Paraphrased personals ad: I want a man with the good looks of Brad
Pitt, the compassion of Denzel Washington
Is there too much mate choice in big cities?

Choice-aversion
How to model too much choice?
Anticipated regret from making a mistake
grass is greener/buyers remorse
Direct disutility for too-large choice set (e.g. too complex)
Policy question:
Markets are good at expanding choicewhat is a good
institution for limiting choice?
Example: Bottled water in supermarkets
Limit useless substitution? What is the right amount?
Pro-govt example: Swedish privatized social security
Offered hundreds of funds
Default fund is low-fee global index (not too popular)
Most popular fund is local tech, down 80% 1
st
yr

Features of Prospect Theory
(1)Reference Dependence
(2) Loss Aversion
(3) Risk aversion in gains and risk seeking in the losses (strictly
speaking this is not correct: 4-fold pattern or risk).
Axiomatics: see al-Nowaihi, Bradley and Dhami (2008, Economics
Letters). Science Direct Top 25 Paper.

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Behavioral

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