Behavioral Economics & Finance
Lecture 1 – Introduction, Standard Economic Model &
Expected Utility
1. What is Behavioral Economics?
Behavioral economics (BE) studies how and why people make economic
decisions.
It aims to:
Understand actual economic behavior
Test the assumptions of the standard economic model
Apply insights from psychology, laboratory experiments, and other social
sciences
BE is not new: Adam Smith already incorporated psychological insights in The Theory
of Moral Sentiments (1759).
However, at the end of the 19th century, Vilfredo Pareto argued that economics
should focus only on choices, not on desires or psychology. This led to dominance of
rational choice models.
In the late 20th century, BE re-emerged:
Herbert Simon introduced bounded rationality: rationality is limited by
cognitive capacity, information, and time.
Kahneman & Tversky showed systematic deviations from rationality
(cognitive biases, framing effects, reference dependence).
Key Nobel Prizes:
Simon (1978): decision-making in organizations
Kahneman & Smith (2002): psychology and experiments in economics
Thaler (2017): behavioral economics
2. What is Behavioral Finance?
Behavioral finance applies psychological insights to financial decision-making:
Investor behavior
Financial markets
Corporate finance and managerial decisions
It is a subfield of behavioral economics.
,Traditional finance relies on:
Expected utility maximization
Rational investors
Efficient Market Hypothesis (EMH)
Behavioral finance emerged because traditional models failed to explain:
Market anomalies
Bubbles and financial crises
Persistent deviations from rational pricing
3. The Standard (Neoclassical) Economic Model
Core assumptions:
Agents maximize utility (or profits)
Full information and ability to process it
Stable, known preferences
Pure self-interest
Rational choice
This implies:
Full external knowledge
Full internal knowledge
Rational decisions
However:
People satisfice rather than maximize (Simon)
Information is often unavailable or costly
Cognitive limitations prevent full optimization
Systematic deviations exist for individuals and firms
Normative vs Descriptive
Normative theories: how people should behave (e.g. maximize utility)
Descriptive theories: how people actually behave
Behavioral economics focuses on the gap between the two.
,4. Risk, Uncertainty and Notation
Risk: probabilities are known
Uncertainty: probabilities are unknown
Probability:
Number between 0 and 1
Sum of probabilities equals 1
Binary prospect notation:
(x, p; y) where x > y
Preferences:
≻ strict preference
∼ indifference
5. Expected Value Theory (EVT)
The value of a prospect equals its mathematical expectation:
EV (x , p ; y )= px+(1− p) y
Examples:
Rain/no rain income example
Multiple outcome gambles
IPO investment example
A gamble is fair if its cost equals its expected value.
Limitation: St Petersburg Paradox
Game with infinite expected value, yet people are only willing to pay a finite amount.
This contradicts EVT.
6. Expected Utility Theory (EUT)
Proposed by Daniel Bernoulli (1738) to solve the paradox.
Key idea:
Value depends on utility, not monetary value
Utility increases with wealth, but at a decreasing rate
, Utility function:
U ' (x)> 0
U (x)<0 (concavity)
''
Example: U ( x )=ln (x)
Expected utility:
EU (x i , pi )=∑ pi U (x i)
EUT is a normative theory of rational choice under risk.
7. Axioms of Expected Utility Theory
A decision maker follows EUT if preferences satisfy:
1. Completeness: can always compare options
2. Transitivity: consistent ordering
3. Continuity: indifference possible via mixing
4. Independence: irrelevant alternatives do not affect preferences
Violations of these axioms imply EUT fails descriptively.
8. Risk Attitudes
Risk averse: prefers certainty to a fair gamble
Risk neutral: indifferent
Risk seeking: prefers gamble
Certainty Equivalent (CE)
Sure amount that makes a person indifferent to a gamble:
U (CE)= pU ( x )+(1− p) U ( y )
CE < EV → risk aversion
CE = EV → risk neutrality
CE > EV → risk seeking
Risk Aversion Measures
Absolute Risk Aversion (ARA)
−U ' ' ( w)
ARA= '
U (w)
Relative Risk Aversion (RRA)
Lecture 1 – Introduction, Standard Economic Model &
Expected Utility
1. What is Behavioral Economics?
Behavioral economics (BE) studies how and why people make economic
decisions.
It aims to:
Understand actual economic behavior
Test the assumptions of the standard economic model
Apply insights from psychology, laboratory experiments, and other social
sciences
BE is not new: Adam Smith already incorporated psychological insights in The Theory
of Moral Sentiments (1759).
However, at the end of the 19th century, Vilfredo Pareto argued that economics
should focus only on choices, not on desires or psychology. This led to dominance of
rational choice models.
In the late 20th century, BE re-emerged:
Herbert Simon introduced bounded rationality: rationality is limited by
cognitive capacity, information, and time.
Kahneman & Tversky showed systematic deviations from rationality
(cognitive biases, framing effects, reference dependence).
Key Nobel Prizes:
Simon (1978): decision-making in organizations
Kahneman & Smith (2002): psychology and experiments in economics
Thaler (2017): behavioral economics
2. What is Behavioral Finance?
Behavioral finance applies psychological insights to financial decision-making:
Investor behavior
Financial markets
Corporate finance and managerial decisions
It is a subfield of behavioral economics.
,Traditional finance relies on:
Expected utility maximization
Rational investors
Efficient Market Hypothesis (EMH)
Behavioral finance emerged because traditional models failed to explain:
Market anomalies
Bubbles and financial crises
Persistent deviations from rational pricing
3. The Standard (Neoclassical) Economic Model
Core assumptions:
Agents maximize utility (or profits)
Full information and ability to process it
Stable, known preferences
Pure self-interest
Rational choice
This implies:
Full external knowledge
Full internal knowledge
Rational decisions
However:
People satisfice rather than maximize (Simon)
Information is often unavailable or costly
Cognitive limitations prevent full optimization
Systematic deviations exist for individuals and firms
Normative vs Descriptive
Normative theories: how people should behave (e.g. maximize utility)
Descriptive theories: how people actually behave
Behavioral economics focuses on the gap between the two.
,4. Risk, Uncertainty and Notation
Risk: probabilities are known
Uncertainty: probabilities are unknown
Probability:
Number between 0 and 1
Sum of probabilities equals 1
Binary prospect notation:
(x, p; y) where x > y
Preferences:
≻ strict preference
∼ indifference
5. Expected Value Theory (EVT)
The value of a prospect equals its mathematical expectation:
EV (x , p ; y )= px+(1− p) y
Examples:
Rain/no rain income example
Multiple outcome gambles
IPO investment example
A gamble is fair if its cost equals its expected value.
Limitation: St Petersburg Paradox
Game with infinite expected value, yet people are only willing to pay a finite amount.
This contradicts EVT.
6. Expected Utility Theory (EUT)
Proposed by Daniel Bernoulli (1738) to solve the paradox.
Key idea:
Value depends on utility, not monetary value
Utility increases with wealth, but at a decreasing rate
, Utility function:
U ' (x)> 0
U (x)<0 (concavity)
''
Example: U ( x )=ln (x)
Expected utility:
EU (x i , pi )=∑ pi U (x i)
EUT is a normative theory of rational choice under risk.
7. Axioms of Expected Utility Theory
A decision maker follows EUT if preferences satisfy:
1. Completeness: can always compare options
2. Transitivity: consistent ordering
3. Continuity: indifference possible via mixing
4. Independence: irrelevant alternatives do not affect preferences
Violations of these axioms imply EUT fails descriptively.
8. Risk Attitudes
Risk averse: prefers certainty to a fair gamble
Risk neutral: indifferent
Risk seeking: prefers gamble
Certainty Equivalent (CE)
Sure amount that makes a person indifferent to a gamble:
U (CE)= pU ( x )+(1− p) U ( y )
CE < EV → risk aversion
CE = EV → risk neutrality
CE > EV → risk seeking
Risk Aversion Measures
Absolute Risk Aversion (ARA)
−U ' ' ( w)
ARA= '
U (w)
Relative Risk Aversion (RRA)
