Summary Behavioral Economics
Lecture 1
Standard Economic Model
The ·u
no-classical
Neo-classical economic model is the way most economists think about consumer welfare
and consumer choice. This unified vision of the economy is based on some common
rationality assumptions.
Agents are assumed to:
• maximise their utility.
• to have complete information, and to be able to process such information.
• be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option available=> Rational choices
Behavioural Economics versus Standard Economic Model:
I
Herbert Simon
·
People often tend to satisfice rather than to maximise.
Information is not generally available (information about the existence of information may
also not be available.
Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.
Ultimately: Perceptions count for much more than facts.
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions if
they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain goal
(usually utility maximisation)
Descriptive theories: How people do really behave, and may or may not be the same
as the normative theory
,Basic set up and notation
A probability is a number between 0 and 1 that indicates a likelihood that a particular
outcome will occur.
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
We focus mostly on binary prospects with 2 outcomes x > y and probability p, we can write
this as (x, p;y). Choices can be represented using decision trees.
Expected Value
The first theory used to model decision making under risk was expected value theory (EVT).
Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble is the value of each possible outcome times the probability
of that outcome.
Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
ST Petersburg Paradox
EV = ∑ (1/2)k *2k = ∞
,Expected Utility Daniel Bernoulli
The expected utility theory was proposed as a solution to the St. Petersburg paradox. The
paradox is the discrepancy between wat people seem to be willing to pay to enter the game
↳ WTP
and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes. The determination of the value of an item
must not be based on the price but rather on the utility it yields.
Marginal utility of money decreasing: after a certain wealth level any additional € will be
worth less in utility terms.
Expected utility
We can represent the utility as:
The assumption is that U’(x) > 0 and U’’(x) < 0. Utility increases in outcomes (money), but at
a decreasing rate.
U(x) = ln(x) would solve the St. Petersburg paradox.
Certainty Equivalent
In order to measure the risk preferences of people, we generally need to elicit some kind of
preference relation.
One convenient way is to find the sure amount of money that makes a decision maker
indifferent between playing the prospect and obtaining that amount.
We call this the amount of certainty equivalent (CE). This relationship can be represented as:
, Nature of the standard model
Economic agents are motivated by expected utility maximization.
An agent’s utility is governed by purely selfish concerns, in the narrow sense that it does not
take into consideration the utility of other.
Agents are Bayesian probability operators.
Agents have consistent time preferences according to the discounted utility model.
Classroom experiment
Lecture 1
Standard Economic Model
The ·u
no-classical
Neo-classical economic model is the way most economists think about consumer welfare
and consumer choice. This unified vision of the economy is based on some common
rationality assumptions.
Agents are assumed to:
• maximise their utility.
• to have complete information, and to be able to process such information.
• be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option available=> Rational choices
Behavioural Economics versus Standard Economic Model:
I
Herbert Simon
·
People often tend to satisfice rather than to maximise.
Information is not generally available (information about the existence of information may
also not be available.
Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.
Ultimately: Perceptions count for much more than facts.
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions if
they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain goal
(usually utility maximisation)
Descriptive theories: How people do really behave, and may or may not be the same
as the normative theory
,Basic set up and notation
A probability is a number between 0 and 1 that indicates a likelihood that a particular
outcome will occur.
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
We focus mostly on binary prospects with 2 outcomes x > y and probability p, we can write
this as (x, p;y). Choices can be represented using decision trees.
Expected Value
The first theory used to model decision making under risk was expected value theory (EVT).
Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble is the value of each possible outcome times the probability
of that outcome.
Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
ST Petersburg Paradox
EV = ∑ (1/2)k *2k = ∞
,Expected Utility Daniel Bernoulli
The expected utility theory was proposed as a solution to the St. Petersburg paradox. The
paradox is the discrepancy between wat people seem to be willing to pay to enter the game
↳ WTP
and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes. The determination of the value of an item
must not be based on the price but rather on the utility it yields.
Marginal utility of money decreasing: after a certain wealth level any additional € will be
worth less in utility terms.
Expected utility
We can represent the utility as:
The assumption is that U’(x) > 0 and U’’(x) < 0. Utility increases in outcomes (money), but at
a decreasing rate.
U(x) = ln(x) would solve the St. Petersburg paradox.
Certainty Equivalent
In order to measure the risk preferences of people, we generally need to elicit some kind of
preference relation.
One convenient way is to find the sure amount of money that makes a decision maker
indifferent between playing the prospect and obtaining that amount.
We call this the amount of certainty equivalent (CE). This relationship can be represented as:
, Nature of the standard model
Economic agents are motivated by expected utility maximization.
An agent’s utility is governed by purely selfish concerns, in the narrow sense that it does not
take into consideration the utility of other.
Agents are Bayesian probability operators.
Agents have consistent time preferences according to the discounted utility model.
Classroom experiment
