Behavioural economics

Cognitive systems

Cognitive System 1: Answer to 2+2; drive your car in an empty street, understanding simple sentences in a language you know. Decision processes (fast, almost automatic, effortless). Automatic actions, observed impressions, insights. System 1 gives these inputs to system 2 (system 2 transforms inputs into actions for elaborations). If system 1 gets in trouble, system 2 takes a more active role.

Cognitive System 2: Give your phone number; answer to 24x17; parking in a limited space; read <behavioral economics>. Decision processes (slow, deliberate, effortful). System 1 and system 2 are always active in humans. Dual system (efficient, saves cognitive costs). System 1 leads to good decisions and actions but also to biases (systematic errors): errors are predictable when biases are made by consumers, firms can exploit them. Sometimes the two systems can conflict: system 1 can give distorted information (visual illusion). System 2 may be lazy.

Traditional and dual economic models

The traditional model of economics is concerned with system 2 (model of deliberate reason, people make decisions in a fully rational way). Also, system 1 (perceptions, impressions, intuitions) impacts how people make decisions. The dual system influences our behavior.

Preferences and rational behavior

Preferences (fully rational approach of consumer): Consumers may have preferences about two goods: A and B (in different quantities); E is the basket containing the two goods. Given two baskets: E’ and E’’ (consumer can have preferences (>, <, =) or be indifferent). When consumers have preferences between baskets, they have complete preferences. Preferences are transitive. Non-satiation: consumers are happier with a higher quantity of a good.

Consumer with complete transitive preferences: rational. We can express our preferences (rational: complete and transitive) through utility function: U(E) > U(E’’). If a consumer can choose within a set of baskets, they prefer the basket given their preferences: maximizing utility. In order to buy a good, you have to pay p with your limited income (you get the basket you can afford). Budget constraint: consumer is limited in consumption by a certain income.

Indifference curves and optimal choice

Indifference curves: Set of baskets giving the same utility (baskets judged indifferent by the consumer): utility is the same only if the consumer is indifferent between the two baskets. For every level of consumer, you have a different indifference curve (the more you move upwards, the higher is the utility): consumers prefer higher indifference curves. Optimal choice: full rational behavior, given prices and income, optimal choice is the point of budget constraint lying on the highest indifference curve. Full rational consumer chooses easily, maximizing utility.

Demand function and elasticity

Demand function: relation between the quantity demanded of a particular good by the consumer and the price of the good. Different prices show how the quantity is changing. The lower is the price, the lower is the quantity. Demand for Giffen good rises when the price rises. Comparing two prices: we are comparing optimal choices for different prices.

Demand elasticity (measures how demand is sensitive to price variation): through optimal choice given preferences is something we can observe. If you have information about prices and quantities, you can estimate demand. Elasticity: percentage variation of demand and percentage variation of price, causing percentage variation of demand, usually with a minus in front. Once we estimate the demand function, demand elasticity can be measured.

Demand elasticity is affected by preferences: existence of substitute goods (positively affects elasticity); fraction of income spent on a good (positively). Demand elasticity is elastic when elasticity is greater than 1. Demand elasticity is un-elastic when elasticity is lower than 1.

Utility and decision processes

Gain and losses, reference points: role they have in the decision process. Utility is defined on wealth (money you have), for people, absolute and relative valuation are important. Value function: the higher the value of the function, the happier the consumer. Value function: measures the utility of an outcome with respect to reference point r (reference-dependent utility function). Reference point is affected by different factors (also system 1): history of a person (post-purchase experience); expectation (former products); framing effects (equivalent description of the same problem lead to different choices).

Framing effect: important to define the reference point: if you have two alternatives they can be framed in different ways. Plan A and B expressed as gains, C and D as losses. Reference points are important for distinguishing gains and losses. Individuals tend to be loss averse: they dislike losses more than they like gains. The dislike associated with a loss tends to be higher than the increasing utility associated with a gain of the same level.

Loss aversion (property of individual): the reduction in value is more important than the increase in value: disliking losses more than liking gains. Sales in Italy are very regulated, compulsory to express the initial price as a percentage of variation. It is perceived as an advantage for the consumer but in some cases, the consumer does not know the percentage of variation, so the gain. Posting the initial price or not can have an impact on preferences. Rational consumer gives importance just to the discounted price, no importance to the initial price. Initial price: reference.

Choice with risk

In many economic situations, uncertainty (individual is unaware of all possible outcomes and cannot assess how likely are the different outcomes) about the consequences of actions and realized outcome. 1) Good quality or bad quality; 2) Holiday can be good or not; 3) Financial investment: profitable or not. Probability for individual is likely: roulette.

Three important situations (attitude towards risk):

• Concave utility function (risk-averse): individual prefers a certain amount of money to a prospect with the same expected value.
• Convex utility function (risk lover): individual prefers risky prospect to its expected value for sure.
• Linear utility function (individual is indifferent, so is risk neutral).

Risk averse: you avoid the risk not accepting expected value to an amount of money which is sure. Risk lover: you have a probability of 0.5 of flipping a coin with the probability of getting 2 or 0. Often individuals tend to give much importance to small probability events (overestimating events): buying lottery tickets. Expected utility: decision process of individual under risk (example of insurance of a car (you do not know the risk—is better a full insurance or not?)). Idea of expected utility: utility of a prospect (random variable) is the expected utility of the wealth outcomes.

If you want to associate a number to a prospect which is a random variable: compute the expected value of the utility associated with each outcome. Idea: rational individual chooses the prospect with the highest expected utility; compare expected utility to expected value of a prospect.

Time and decision making

Time is an important part of decision (benefits and costs are spread over time, also in future). Study or not? Eat healthy or not? (decision in which time is important). In each period t, an individual can get utility (u)t. --> individual wants to transform a sequence of utility over time into a single number which is a measure of intertemporal utility (way in which preferences are represented). Quantity which summarizes all the relevant info. Negative utility: cost; positive utility: benefits.

Intertemporal utility function: Ut function of utility in each period. The standard way is to use exponential discounting: utility in each period is multiplied by a number (which is the discount), given by discount factor (parameter of delta) for the number of the period from today up to the moment utility is obtained. Delta is from 0 to 1. U1 (utility today, no discount) + deltaU2 (utility tomorrow in 1 period from now).

Delta: relative importance the consumer is attaching to the future. 10 euro today is equivalent to delta10 euro tomorrow? If we consider 2 periods, utility is u3 (delta²): delta to the power of 2 because there are 2 periods from today to consider. Since delta is smaller than 1 or equal to 1= delta² smaller than delta. The more distant is the future, the less importance is given to the utility in that specific period.

Discount rate p (interest rate the individual would like to delay the utility from today up to the next period): the higher is the discount factor delta, the lower is the discount rate p. When you have to take an action that is a cost: patience: cost immediately, impatience: later, the more distant because you suffer a cost (postponing).

Real-world discount factor

1) Postpone receipt: you earned 200 euro, but you have the possibility to delay this amount by 1 year. How much money would you need to get after one year in order to delay the payment? Depends on discount factor. Impatience: you want to get more money. 2) Postpone payment: you need to pay a debt of 200 euro, you have the possibility to wait 1 year. How much money would you be willing to pay back after one year if payment is delayed? You are willing to pay more tomorrow (impatient). If delta=1 (payment closer to 200); if delta<1 (payment much higher).

3) Expedite receipt: you will get 200 euro in 1 year, but you can receive it immediately. How much money are you willing to accept now? Smaller quantity depending on discount factor. 4) You need to pay back a debt in 1 year. How much would you pay now? If you are impatient you want to pay less.

Discount factor: on average low, it is higher the longer it is necessary to wait. (short-term impatience): different ways to decline discount factor (deviation from standard model). The larger is the money involved, the larger is the estimated discount factor (absolute magnitude effect). Estimated discount factor: smaller for gains than for losses. Higher to postpone than to expedite payment (people are less impatient about expediting rather than postponing).

Utility of sequences and hyperbolic discounting

Utility of sequences: preference for improving preference: when you have to take two actions closed in time, you first want to take away the negative one, and then the beneficial one. Preference for improving sequence not with exponential discounting: here when you have two actions: one with positive utility and one with negative utility. Positive action first because the negative one in the future is multiplied in your intertemporal utility function with a number less than 1. (discounted in the future).

Utility of sequences: what is happening 2 weekends away has an impact on what is chosen between this and next weekend. In terms of preferences individuals have not only preference for improving sequences, but also preferences for spreading evenly the events (you want to spread the positive things): short distance.

Hyperbolic discounting (wait for 10 euro in the future, when the moment comes you still want to wait): quantity multiplying utility in time t. it implies consistency in individual choices. (if Maria today prefers 110 euro in 31 days to 100 euro in 30 days, after 30 days she cannot prefer 100 euro today to 110 tomorrow: short-term impatience, time inconsistency in choice): payoffs in the future are treated very differently.

Present bias preference, beta (between 0 and 1, parameter which measures all future outcomes: with beta<1, present bias preference, individuals give less importance to future because it is future and treat different close future and distant future for parameter delta) (beta=1: standard exponential discounting model) and delta are the two parameters. (quasi-hyperbolic discount): present and future are treated differently because they are different in the mind of people.

Beta=1: time consistency, full rationality according to exponential discounting. Beta=0.8: time inconsistency (you make a plan about a moment in the future, but when the moment comes you take a different choice): naïve consumer: they are unaware of present-biased preference (you plan something, but you are unaware when the moment you planned to do some action comes and you do something different). Procrastination: you make a plan and then you do not respect the plan, projecting your decision in the future. Properation: if you take an action earlier with respect to the moment you planned to do it.

Individuals: sophisticated if they know they have present bias preferences. I know I make a plan today and I will think differently about the planned action. Sophistication vs. naivety: When you have to do homework: delayed benefits (the cost of doing homework is immediate but you have benefits in the future, the day after you have done homework: benefits). Sophistication is the solution of delayed benefits. When you have to watch a movie: the action generates benefits (delayed cost and immediate benefits): in this case sophistication can lead individuals to take even more worse actions (prooperate even more).

Commitment

Commitment: possibility of pre-ordering tickets for a movie. Possibility for individuals of restricting the set of future actions. Commitment allows you to have the highest value, solution of problem with time consistency. Commitment means restricting your future set of alternatives. Commitment can be a reasonable alternative when people are not fully rational.

Behavior in interaction with others: game theory

Situation where individual or profit of a firm depends on actions of other agents (not only by actions they choose). Agents here are aware of the interdependence. Strategy: try to predict what you are going to do, what affects my outcome. (a lot of economic situations: competitive markets). Manager-workers interaction, game of chess.

Game: set of players, actions, and strategy (relevant for decision-makers). Payoffs: outcome derived from the strategy of all players. Payoffs must be defined in terms of utility. Utility function which is capturing preferences.

Simultaneous and sequential games

Two games: simultaneous game and sequential game. Simultaneous: all players choose their actions without knowing the actions of the other players. Sequential game: a player chooses first and then other players for second. Equilibrium in sequential game is subgame. It is obtained through a procedure of backward induction (BI). BI: in order to get equilibrium, we start considering the choice of a player moving second, who chooses the action with the highest payoff for any action chosen by the player moving first. Then we consider the action of the first player, as optimal choice, given a correct prediction of the subsequent choice by the player moving second. Complete information game: players know all the possible set of strategies of the other players. Each player knows the alternatives of all players.

The prisoner's dilemma

The prisoner's dilemma: simultaneous game. Two suspects for a crime are put into separate cells. If they both confess, each player will spend 6 years in prison. If only one confesses he will be freed and his accusation is used against the other, who will receive a sentence of 7 years. If nobody confesses: 1 year in prison. For the combination of each strategy, you have the outcome, payoffs are measured by the number of years in prison.

Game solution: Nash Equilibrium: for a game of two players, pair of strategies such that each...