Lecture 1:
Economic psychology: how individuals affect the economy and how the economy affects individuals. It is a
better understanding of people behaving in their economic lives, and explores the way economic issues in
society affect people’s behavior.
International association for research in economic psychology: economic psychology is an emergent discipline,
informed by both disciplines, that leads to a better understanding of people’s behavior in their economic lives,
and that explores the way economic issues in society affect people’s behavior (IAREP).
- Topics IAREP: concerned with issues of choice and decision-making. Economic psychologists are also
interested in such diverse areas as encironmental issues, token economies, experimental gaming, and
time preferences, furthermore it deals with the impact of external economic phenomena upon human
behavior and wellbeing. These studies may relate to different levels of aggregation: from household
and individual consumer to the macro level of whole nations.
Economics is a behavioral science
Edwards (1954) was the first to introduce economic models of decision making into psychology.
At the core of behavioral economics is the conviction that increasing the realism of the psychological
underpinnings of economics will improve the fields of economics on its own terms.
Examples of defaults:
- Enrollment rate is close to 100% when enrollment is automatic, but if action is required to enroll, only
about 50% joins the plan even though it is free.
- Fly in urinals to reduce cleaning costs
Some simple psychological principles:
( 2015 world bank, how psychology can inform policy making)
1. Many choices are automatic
2. People are social animals
3. People respond to mental models
4. People are hard to mobilize
5. Small changes can have big effects (and these are not always easy to predict)
,Lecture 2
What is rationality?
- How should people make decisions?
o Normative/descriptive theories
- How do people make decisions?
o Descriptive theories
Small changes can have big effects
- Rewards may be counterproductive the cobra effect, trying to make it better makes it even worse
- Punishment may be counterproductive zorg voor nepbaby werkt niet preventief
Psychology & economics: history
Adam Smith: father of modern economics
- Rational economic man
- Self-interest = good
- The invisible hand: a metaphor that describes the unseen forces of self-interest that impact the free
market.
1776: wealth of nations:
- It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but
from their regard to their own interest.
- Every individual is continually exerting himself to find out the most advantageous employment for
whatever capital he can command. It is his own advantage, indeed, and not that of the society which he
has in view. But the study of his own advantage, naturally, or rather necessarily leads him to prefer that
employment which is most advantageous for society (aligns with demands of the market)
1759: moral sentiments
- How selfish man may be supposed, there are evidently some principles in his 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.
- Smith critically examines the moral thinking of his time and suggests that conscience arises from social
relationships. Smith proposes a theory of sympathy, in which the act of observing others makes people
aware of themselves and the morality of their own behavior.
- The basic idea of the theory is not original with me. A relationship between empathic concern and
altruism was proposed earlier by social psychologist Dennis Krebs (1975) and by developmental
psychologist Martin Hoffman (1976), much earlier by psychologist William McDougall (1908) and
even earlier by philosophers David Hume (1740) and Adam Smith (1759).
The value of a future gain should be directly proportional to the chance of getting it:
Expected value: EV = P * X
Jeremy Bentham (1748-1832)
- To maximize, we need to be able to quantify and compare the amount of happiness/pleasure of possible
acts
how we measure pleasure
1. Hedons: units of pleasure
2. Dolors: units of pain
- Decision making = hedonis calculus
John Stuart Mill (1806-1873): utility or the greatest happiness principle, holds that actions are right in
proportion as they tend to promote happiness, wrong as they produce the reverse of happiness. By happiness is
intended pleasure, and the absence of pain, by unhappiness, pain and the privation of pleasure.
Carl Menger (1840-1921): founder of the Austrian school of economics: ‘Grundsätze’
- Utility
- Hierarchy of motives
1. Self-actualization
, 2. Esteem
3. Love/belonging
4. Safety
5. Psychological needs
Economics vs. psychology
- Economics became more mathematical
o Development of mathematical models
o Testing models with public data
o Plausibility of the theory did not matter, but the predictive value did
- Psychology became more experimental
o Creation of artificial conditions in a lab to mimic reality
o Control of variables
o Recruitment of participants
Economics Psychology
Assumptions about behavior Research about behavior
Aggregated behavior Individual behavior
Normative theory Descriptive theory
Deductive (general to specific) Inductive (specific to general)
Deviations from theory Separate theories for anomalies
George Katona (1901-1981)
- Hungarian born, PhD, founder of survey research
- Index of consumer sentiment
- 1975: psychological economics: the basic need for psychology in economic research consists in the
need to discover and analyze forces behind economics processes, the forces responsible for economic
actions decisions and choices
Herbert Simon (Nobel Price economics, 1978)
- Bounded rationality
- Satisficing: good enough instead of optimal perfect solution
- Study of cognitive processes leading to decisions
Daniel Kahneman (Nobel price economics, 2002)
- Heuristics (mental shortcuts or rules of thumb) and biases in judgement
- Prospect theory
- Risk aversion for losses
Richard H. Thaler (Nobel price economics, 2017)
- Mental accounting: way individuals categorize, evaluate, and manage their money by separating it into
‘accounts’ in their mind, often based on subjective criteria rather than rational economic logic.
- Behavioral finance: acknowledges that human behavior often deviates from purely rational decision-
making due to emotions, biases and heuristics.
- Fairness
- Self-control
- Satisficing
Assumptions of economic theory
- Stable preferences
- Self-interest
- Maximization
- No cognitive limitations
- Unlimited will-power
- Complete information
- Long-term perspective
No role for emotions
No role for fairness
, Rationality:
- Very simple: when people decide what to do, they look at what it gives them, and how likely it is that
they get it.
- Value of future gains should be directly proportional of the chance of getting it.
EV: likelihood of gain (biased probability estimations) * value of the gain (biased value estimations)
Availability heuristics: assessing the frequency of a class or the probability of an event by the ease with which
instances or occurrences can be brought to mind (plane crash)
Paradoxes of gambling behavior Willem A. Wagenaar
- Lotteries are taxation of the stupid
Cognitive heuristics cognitive biases
Representativeness heuristics and the base rate fallacy
- Base rate fallacy: tendency to ignore relevant statistical information in favor of case-specific
information
Study of happiness after:
- Winning the lottery
- Becoming paraplegic after a car accident
Result: relatively little difference in quality of life and happiness
Positive vs. normative economics:
- Positive economics: describe and understand how consumers behave
- Normative economics: how consumers should behave
- Positive theory: advocated by thaler, grounded in real-world behavior, incorporating psychological
factors that affect decision-making.
Thaler criticizes the assumption of fully rational agents in traditional economic models, argues that consumers
do not always make decisions in the way that traditional models predict, thus, economists should expand their
models to account for psychological influences
Economic psychology: how individuals affect the economy and how the economy affects individuals. It is a
better understanding of people behaving in their economic lives, and explores the way economic issues in
society affect people’s behavior.
International association for research in economic psychology: economic psychology is an emergent discipline,
informed by both disciplines, that leads to a better understanding of people’s behavior in their economic lives,
and that explores the way economic issues in society affect people’s behavior (IAREP).
- Topics IAREP: concerned with issues of choice and decision-making. Economic psychologists are also
interested in such diverse areas as encironmental issues, token economies, experimental gaming, and
time preferences, furthermore it deals with the impact of external economic phenomena upon human
behavior and wellbeing. These studies may relate to different levels of aggregation: from household
and individual consumer to the macro level of whole nations.
Economics is a behavioral science
Edwards (1954) was the first to introduce economic models of decision making into psychology.
At the core of behavioral economics is the conviction that increasing the realism of the psychological
underpinnings of economics will improve the fields of economics on its own terms.
Examples of defaults:
- Enrollment rate is close to 100% when enrollment is automatic, but if action is required to enroll, only
about 50% joins the plan even though it is free.
- Fly in urinals to reduce cleaning costs
Some simple psychological principles:
( 2015 world bank, how psychology can inform policy making)
1. Many choices are automatic
2. People are social animals
3. People respond to mental models
4. People are hard to mobilize
5. Small changes can have big effects (and these are not always easy to predict)
,Lecture 2
What is rationality?
- How should people make decisions?
o Normative/descriptive theories
- How do people make decisions?
o Descriptive theories
Small changes can have big effects
- Rewards may be counterproductive the cobra effect, trying to make it better makes it even worse
- Punishment may be counterproductive zorg voor nepbaby werkt niet preventief
Psychology & economics: history
Adam Smith: father of modern economics
- Rational economic man
- Self-interest = good
- The invisible hand: a metaphor that describes the unseen forces of self-interest that impact the free
market.
1776: wealth of nations:
- It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but
from their regard to their own interest.
- Every individual is continually exerting himself to find out the most advantageous employment for
whatever capital he can command. It is his own advantage, indeed, and not that of the society which he
has in view. But the study of his own advantage, naturally, or rather necessarily leads him to prefer that
employment which is most advantageous for society (aligns with demands of the market)
1759: moral sentiments
- How selfish man may be supposed, there are evidently some principles in his 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.
- Smith critically examines the moral thinking of his time and suggests that conscience arises from social
relationships. Smith proposes a theory of sympathy, in which the act of observing others makes people
aware of themselves and the morality of their own behavior.
- The basic idea of the theory is not original with me. A relationship between empathic concern and
altruism was proposed earlier by social psychologist Dennis Krebs (1975) and by developmental
psychologist Martin Hoffman (1976), much earlier by psychologist William McDougall (1908) and
even earlier by philosophers David Hume (1740) and Adam Smith (1759).
The value of a future gain should be directly proportional to the chance of getting it:
Expected value: EV = P * X
Jeremy Bentham (1748-1832)
- To maximize, we need to be able to quantify and compare the amount of happiness/pleasure of possible
acts
how we measure pleasure
1. Hedons: units of pleasure
2. Dolors: units of pain
- Decision making = hedonis calculus
John Stuart Mill (1806-1873): utility or the greatest happiness principle, holds that actions are right in
proportion as they tend to promote happiness, wrong as they produce the reverse of happiness. By happiness is
intended pleasure, and the absence of pain, by unhappiness, pain and the privation of pleasure.
Carl Menger (1840-1921): founder of the Austrian school of economics: ‘Grundsätze’
- Utility
- Hierarchy of motives
1. Self-actualization
, 2. Esteem
3. Love/belonging
4. Safety
5. Psychological needs
Economics vs. psychology
- Economics became more mathematical
o Development of mathematical models
o Testing models with public data
o Plausibility of the theory did not matter, but the predictive value did
- Psychology became more experimental
o Creation of artificial conditions in a lab to mimic reality
o Control of variables
o Recruitment of participants
Economics Psychology
Assumptions about behavior Research about behavior
Aggregated behavior Individual behavior
Normative theory Descriptive theory
Deductive (general to specific) Inductive (specific to general)
Deviations from theory Separate theories for anomalies
George Katona (1901-1981)
- Hungarian born, PhD, founder of survey research
- Index of consumer sentiment
- 1975: psychological economics: the basic need for psychology in economic research consists in the
need to discover and analyze forces behind economics processes, the forces responsible for economic
actions decisions and choices
Herbert Simon (Nobel Price economics, 1978)
- Bounded rationality
- Satisficing: good enough instead of optimal perfect solution
- Study of cognitive processes leading to decisions
Daniel Kahneman (Nobel price economics, 2002)
- Heuristics (mental shortcuts or rules of thumb) and biases in judgement
- Prospect theory
- Risk aversion for losses
Richard H. Thaler (Nobel price economics, 2017)
- Mental accounting: way individuals categorize, evaluate, and manage their money by separating it into
‘accounts’ in their mind, often based on subjective criteria rather than rational economic logic.
- Behavioral finance: acknowledges that human behavior often deviates from purely rational decision-
making due to emotions, biases and heuristics.
- Fairness
- Self-control
- Satisficing
Assumptions of economic theory
- Stable preferences
- Self-interest
- Maximization
- No cognitive limitations
- Unlimited will-power
- Complete information
- Long-term perspective
No role for emotions
No role for fairness
, Rationality:
- Very simple: when people decide what to do, they look at what it gives them, and how likely it is that
they get it.
- Value of future gains should be directly proportional of the chance of getting it.
EV: likelihood of gain (biased probability estimations) * value of the gain (biased value estimations)
Availability heuristics: assessing the frequency of a class or the probability of an event by the ease with which
instances or occurrences can be brought to mind (plane crash)
Paradoxes of gambling behavior Willem A. Wagenaar
- Lotteries are taxation of the stupid
Cognitive heuristics cognitive biases
Representativeness heuristics and the base rate fallacy
- Base rate fallacy: tendency to ignore relevant statistical information in favor of case-specific
information
Study of happiness after:
- Winning the lottery
- Becoming paraplegic after a car accident
Result: relatively little difference in quality of life and happiness
Positive vs. normative economics:
- Positive economics: describe and understand how consumers behave
- Normative economics: how consumers should behave
- Positive theory: advocated by thaler, grounded in real-world behavior, incorporating psychological
factors that affect decision-making.
Thaler criticizes the assumption of fully rational agents in traditional economic models, argues that consumers
do not always make decisions in the way that traditional models predict, thus, economists should expand their
models to account for psychological influences
