Summary Economic Psychology
Assumptions of economic theory
- People have stable preferences over time and situations
- People are self-interested → Maximize own utility
- There are no cognitive limitations
- There is unlimited will-power
- There is complete information about choice alternatives (market transparency)
- Long-term perspective
- There is no role for emotion
- There is no role for fairness
Simple Psychological Principles
- Many choices are automatic (system 1)
- People are social animals
- People respond to mental models
- People are hard to mobilize
- Small changes can have big effects
What does psychology study?
- Physiology
- Thoughts/feelings
- Behavior
Economics Psychology
Assumptions about human behavior Research about human behavior
Aggregated behavior (errors cancel out) Individual behavior
Normative theory Descriptive theory
Deductive Inductive
Deviations (anomalies) from theory Separate theories (occasional theories) for deviations
Availability heuristic = 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
Cognitive heuristics = ‘short-cuts’ or rules of thumb to arrive at probability or frequency estimates. They often
lead to severe, systematic cognitive biases (e.g., errors in estimations likelihood and values of gains)
Bernoulli suggested you should consider expected utility instead of expected value
→ St. Petersburg paradox
→ 1st round: Tails pays out $2. Heads doubles and brings you to the next round
→ 2nd round: Tails pays out $4. Heads doubles and brings you to the next round
→ 3rd round: Tail pays out $8. Heads doubles and brings you to the next round etc.
EV = ½ * 2 + ¼ * 4 + 1/8 * 8 + ……
EV =1+1+1+1+…
= ∞ → Of course, no one would be willing to pay an infinitely large amount
Bentham came up with dome shaped prison (Panoptican); a prison that is as cheap as possible
Decision making = ‘Hedonic calculus’
→ Hedons: units of pleasure
→ Dolors: unit of pain
Simon came up with the concepts of bounded rationality and satisfycing (not optimising your utility, but
rather buying something that satisfies your wishes and not improving on that)
Thaler discovered that punishments may be counterproductive = Cobra effect
Examples are breeding the cobras, and the picking up children late from daycare. Instead of feeling ashamed,
more people were late after having to pay for being late
, Theory of Decision making (Riskless choice) by Edwards
Economic man =
- Completely informed
- Infinitely sensitive
- Rational
o Can order states (transitivity)
o Maximizes utility
Pareto’s Principle = A change should be considered desirable if it left everyone at least as well off as he was
before, and made at least one person better off
Compensation Principle = If it is possible for those who gain from an economic change to compensate the losers
for their losses and still have something left over from their gains, then the change is desirable
Risk = Known probabilities
Uncertainty = Unknown probabilities
People tend to:
- Prefer πL of losing large amounts over πH of losing small amounts
- Prefer bets involving π = 4/8 of winning
- Avoid bets involving π = 6/8 of winning
Subjective probability = People overestimate low probabilities and underestimate high ones with an indifference
point (where subjective equals objective probability)
Minimax loss = minimizing the maximum loss
Choices, values and frames by Kahneman and Tversky
EV = ∑ p × X
EU = ∑ p × U(X)
Prospect theory =
- Evaluated in terms of gains and losses PT = ∑ π(p) × V(X)
- Concave in the domain of gains, convex in the domain of losses
- Steeper for losses than for gains
Underweighting of moderate and high probabilities; Overweighting of low probabilities.
Highly likely and highly unlikely events are either ignored or overweighted
Expected utility: Outcomes are multiplied by probability
Prospect theory: Outcomes are multiplied by probability weights
Certainty Effect: People overweigh certain outcomes
Reflection effect: Risk aversion for choices with a sure gain, risk seeking for choices with a sure loss (S SHAPE!)
Dominance = If A > B, then A should be preferred over B
Invariance = Framing (description) of a choice problem should not affect the decision
This assumption is violated by Asian/Corona disease problem
Category boundary effect = 0% to 5% or 95% to 100% has a larger effect than any other
Pseudo certainty effect = When an uncertain event is treated like it was certain
Endownment effect = Ownership makes you overvalue things you own, feeling attached to it
Decision utility = Anticipated pleasure you feel at the time of decision
Experiences utility = Pleasure you actually feel from the consequences of your choice
Assumptions of economic theory
- People have stable preferences over time and situations
- People are self-interested → Maximize own utility
- There are no cognitive limitations
- There is unlimited will-power
- There is complete information about choice alternatives (market transparency)
- Long-term perspective
- There is no role for emotion
- There is no role for fairness
Simple Psychological Principles
- Many choices are automatic (system 1)
- People are social animals
- People respond to mental models
- People are hard to mobilize
- Small changes can have big effects
What does psychology study?
- Physiology
- Thoughts/feelings
- Behavior
Economics Psychology
Assumptions about human behavior Research about human behavior
Aggregated behavior (errors cancel out) Individual behavior
Normative theory Descriptive theory
Deductive Inductive
Deviations (anomalies) from theory Separate theories (occasional theories) for deviations
Availability heuristic = 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
Cognitive heuristics = ‘short-cuts’ or rules of thumb to arrive at probability or frequency estimates. They often
lead to severe, systematic cognitive biases (e.g., errors in estimations likelihood and values of gains)
Bernoulli suggested you should consider expected utility instead of expected value
→ St. Petersburg paradox
→ 1st round: Tails pays out $2. Heads doubles and brings you to the next round
→ 2nd round: Tails pays out $4. Heads doubles and brings you to the next round
→ 3rd round: Tail pays out $8. Heads doubles and brings you to the next round etc.
EV = ½ * 2 + ¼ * 4 + 1/8 * 8 + ……
EV =1+1+1+1+…
= ∞ → Of course, no one would be willing to pay an infinitely large amount
Bentham came up with dome shaped prison (Panoptican); a prison that is as cheap as possible
Decision making = ‘Hedonic calculus’
→ Hedons: units of pleasure
→ Dolors: unit of pain
Simon came up with the concepts of bounded rationality and satisfycing (not optimising your utility, but
rather buying something that satisfies your wishes and not improving on that)
Thaler discovered that punishments may be counterproductive = Cobra effect
Examples are breeding the cobras, and the picking up children late from daycare. Instead of feeling ashamed,
more people were late after having to pay for being late
, Theory of Decision making (Riskless choice) by Edwards
Economic man =
- Completely informed
- Infinitely sensitive
- Rational
o Can order states (transitivity)
o Maximizes utility
Pareto’s Principle = A change should be considered desirable if it left everyone at least as well off as he was
before, and made at least one person better off
Compensation Principle = If it is possible for those who gain from an economic change to compensate the losers
for their losses and still have something left over from their gains, then the change is desirable
Risk = Known probabilities
Uncertainty = Unknown probabilities
People tend to:
- Prefer πL of losing large amounts over πH of losing small amounts
- Prefer bets involving π = 4/8 of winning
- Avoid bets involving π = 6/8 of winning
Subjective probability = People overestimate low probabilities and underestimate high ones with an indifference
point (where subjective equals objective probability)
Minimax loss = minimizing the maximum loss
Choices, values and frames by Kahneman and Tversky
EV = ∑ p × X
EU = ∑ p × U(X)
Prospect theory =
- Evaluated in terms of gains and losses PT = ∑ π(p) × V(X)
- Concave in the domain of gains, convex in the domain of losses
- Steeper for losses than for gains
Underweighting of moderate and high probabilities; Overweighting of low probabilities.
Highly likely and highly unlikely events are either ignored or overweighted
Expected utility: Outcomes are multiplied by probability
Prospect theory: Outcomes are multiplied by probability weights
Certainty Effect: People overweigh certain outcomes
Reflection effect: Risk aversion for choices with a sure gain, risk seeking for choices with a sure loss (S SHAPE!)
Dominance = If A > B, then A should be preferred over B
Invariance = Framing (description) of a choice problem should not affect the decision
This assumption is violated by Asian/Corona disease problem
Category boundary effect = 0% to 5% or 95% to 100% has a larger effect than any other
Pseudo certainty effect = When an uncertain event is treated like it was certain
Endownment effect = Ownership makes you overvalue things you own, feeling attached to it
Decision utility = Anticipated pleasure you feel at the time of decision
Experiences utility = Pleasure you actually feel from the consequences of your choice
