Behavioral Economics.pdf
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The first edition of this resource came about from teaching a course called ‘Strategy and
games’ for first-year undergraduates. The idea of the course was to illustrate through
classroom experiments some of the basic ideas of economics and game theory. In
teaching that course my interest and knowledge of behavioral economics grew a lot;
as did my frustration at the limited resources available to students wanting to learn
more about this fascinating area of economics. Eventually, I decided it was time to
write a resource.
My basic objective when writing the resource was to convey both the excitement
and the importance of behavioral economics. I wanted to explain the basic principles,
ideas and results of behavioral economics and show how fascinating they are. I also
wanted to illustrate through applications why behavioral economics is fundamentally
important in understanding the world around us. Finally, I wanted a resource that was
accessible to a general reader, not just those trained in economics and comfortable
with algebra.
This fourth edition builds on the previous three. Behavioral economics is an
evolving subject, and so there is always new material to add and updates to take note
of. In this edition I have added more applications, including on cryptocurrency, fraud
and cybercrime, the COVID-19 vaccine and misinformation, as well as mental health.
There are also more general updates to the content, including the further reading at
the end of each chapter.
This resource would not have been possible without those who have contributed
to the literature on behavioral economics and given me such great material to work
with. Particular thanks are due to those who made my job so easy by writing papers
over many years that, when put together as a whole, gave very clear insights into eco-
nomic behavior. I would also like to extend a sincere thanks to very many people who
have given me useful feedback on the first three editions of the resource. It is important
to make clear, though, that the opinions expressed in this resource are mine, and not
necessarily those of the researchers whose work I refer to.
A lot of thanks is due to my wife, Anna, who has helped so much in writing this
and the earlier editions of the resource. On a personal level, she has been patient and
supportive while I wrote them. On a practical level, she is my greatest critic, never
happy until everything is explained as fully and clearly as possible; she is also a great
source of new ideas and new ways of thinking about old ideas. I should also thank
all the students and colleagues connected with the Strategy and Games course, for
teaching me so much. Finally, I want to give a big thanks to Myrna Wooders, who, as
well as being a fantastic person to know, has long been, and continues to be, a great
inspiration and mentor.

Part I
Introduction
1
1
An introduction to behavioral economics
3
1.1
The history and controversies of behavioral economics
4
1.1.1 Behavioral economics is reborn
6
1.1.2 Behavioral economics and policy
9
1.1.3 The different faces of behavioral economics
11
1.1.4 Debate and controversy
13
1.1.5 Too far or not far enough
16
1.2
Some background on behavioral economics methods
18
1.2.1 Some background on experiments
19
1.2.2 Some background on theory
22
1.2.3 Some background on field studies and experimetrics
24
1.3
How to use this book
27
1.3.1 Chapter previews
28
1.3.2 Behavioral finance
29
1.4
Further reading
29
1.5
Review questions
30
Part II
Economic behavior
31
2
Simple heuristics for complex choices
33
2.1
Utility and search
34
2.1.1 How to search
35
2.1.2 Choice arbitrariness
40
2.2
Mental accounting and framing
47
2.2.1 Reference-dependent utility
48
2.2.2 The endowment effect
49
2.2.3 Willingness to pay or accept
51
2.2.4 Transaction utility
54
2.2.5 Narrow framing
55
2.2.6 Hedonic editing
57
2.2.7 Choice bracketing
57
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2.3
The role of emotions
59
2.3.1 Aversion to lying
60
2.3.2 Deception
61
2.3.3 Honesty and framing
66
2.4
Summary
68
2.5
Demand, supply and markets
69
2.5.1 Double-auction markets in the lab
71
2.5.2 Posted offer markets and market power
74
2.5.3 The law of one price
75
2.6
Labor supply and reference dependence
78
2.6.1 A target income and target wage
78
2.6.2 Taxicab drivers
80
2.6.3 Female labor supply
82
2.7
The housing market
84
2.7.1 Reluctance to sell
84
2.7.2 What are buyers willing to pay?
85
2.8
The behavioral life cycle hypothesis
87
2.8.1 Fungibility and mental accounting
89
2.9
Saving for the future
93
2.9.1 Let’s diversify
94
2.9.2 Let’s not diversify
94
2.10 Further reading
97
2.11 Review questions
98
3
Choice with risk
99
3.1
Expected utility
100
3.1.1 The Allais paradox
104
3.1.2 Risk aversion
105
3.1.3 Risk-loving for losses
109
3.1.4 When expected utility will work
110
3.2
Independence and fanning out
111
3.2.1 Disappointment
114
3.2.2 Rank-dependent expected utility
116
3.3
Reference dependence and prospect theory
118
3.3.1 Reference-dependent utility
121
3.3.2 The reference point and expectations
122
3.3.3 Combined gambles
125
3.3.4 Stochastic reference point
126
3.4
Preference reversals
128
3.4.1 Procedural invariance
133
3.4.2 Regret theory
134
3.4.3 Prospect theory and preference reversals
136
3.4.4 Why preference reversals matter
137
3.5
Summary
138
3.6
Financial trading
139
3.6.1 The equity premium puzzle
139
3.6.2 The disposition effect
141
3.6.3 The ostrich effect
144
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3.7
Insurance
146
3.8
Tax evasion
149
3.8.1 Standard model of tax evasion
150
3.8.2 Behavioral theories of tax evasion
152
3.8.3 Taxes and reference points
154
3.8.4 Tax evasion in the laboratory
155
3.9
Legal settlements
158
3.9.1 Fourfold pattern of risk attitudes
158
3.9.2 Frivolous litigation
160
3.10 Further reading
162
3.11 Review questions
163
4
Choosing when to act
165
4.1
Exponential discounting
166
4.1.1 The discount factor
168
4.1.2 The utility of sequences
171
4.2
Hyperbolic discounting
173
4.2.1 Quasi-hyperbolic discounting
175
4.2.2 The consequences of time inconsistency
177
4.2.3 Temptation and self-control
179
4.3
Loss aversion and sequences
182
4.3.1 Reference dependence
182
4.3.2 Preferences for sequences
185
4.4
Time and risk
187
4.5
Summary
193
4.6
Borrowing and saving
194
4.6.1 Saving equals growth or growth equals saving?
194
4.6.2 Why save when you have debts?
195
4.7
Firm pricing and membership fees
196
4.7.1 Time inconsistency and consumer behavior
196
4.7.2 Firm pricing
198
4.7.3 Choosing the correct calling plan
200
4.8
Fraud and cybercrime
202
4.8.1 Social engineering and persuasion
202
4.8.2 Time pressure, impulse and procrastination
205
4.9
Environmental economics
206
4.9.1 Inter-generational discount factor
206
4.9.2 Reducing CO2 emissions
209
4.10 Further reading
211
4.11 Review questions
211
5
Learning from new information
213
5.1
Bayesian updating and choice with uncertainty
214
5.1.1 Models of choice with uncertainty
215
5.1.2 The Ellsberg paradox
217
5.2
Two cognitive biases
219
5.2.1 Confirmatory bias
219
5.2.2 A model of confirmatory bias
221
5.2.3 Law of small numbers
223
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5.2.4 A model of the law of small numbers
226
5.2.5 Generating random sequences
227
5.2.6 Do biases matter?
228
5.3
Learning from others
229
5.3.1 To conform or not
229
5.3.2 Cascade experiments
231
5.3.3 What happened to conformity?
234
5.3.4 Signaling games
235
5.4
Summary
238
5.5
Health care
239
5.5.1 Patients
239
5.5.2 Practitioners
242
5.5.3 Public health messaging
243
5.6
Asset price bubble and crash
247
5.6.1 Bubbles in the lab
248
5.6.2 Experience and bubbles
251
5.6.3 Explaining bubbles
254
5.6.4 Cryptocurrency
256
5.7
Voting in elections
257
5.8
Further reading
259
5.9
Review questions
259
6
Interacting with others
261
6.1
The beauty contest
262
6.1.1 Strategy and Nash equilibrium
263
6.1.2 Choice in a beauty contest
264
6.1.3 Learning in a beauty contest
266
6.2
Playing for the first time
267
6.2.1 Level-k thinking
267
6.2.2 Sophisticated beliefs
270
6.2.3 Focal points
272
6.2.4 Equilibrium refinement
276
6.2.5 Nash equilibrium with mistakes
279
6.3
Learning from experience
282
6.3.1 Reinforcement learning
283
6.3.2 Belief-based learning
285
6.3.3 Experience-weighted learning
287
6.3.4 Learning and prediction
289
6.4
Teams make decisions
293
6.4.1 Teams and the beauty contest
295
6.4.2 The sophistication of teams
298
6.4.3 Are teams smarter?
299
6.5
Summary
300
6.6
Auctions
301
6.6.1 Revenue equivalence
301
6.6.2 Winner’s curse
303
6.7
Learning to coordinate
307
6.7.1 Weakest link games
307
6.7.2 Threshold public good games
313
6.7.3 Coordinating on networks
315
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6.8
Monetary policy by committee
319
6.9
Industrial organization
321
6.9.1 Limit pricing
321
6.9.2 Market entry
324
6.9.3 Quantity leadership
326
6.10 Further reading
329
6.11 Review questions
330
7
Social preferences
331
7.1
The experimental evidence for social preferences
332
7.1.1 The nice side of social preferences
332
7.1.2 The nasty side of social preferences
337
7.1.3 Reciprocity
340
7.1.4 Fairness and competition
344
7.1.5 The terminology of reciprocity
345
7.1.6 Social preferences and teams
346
7.2
Inequality aversion
348
7.2.1 Inequality aversion with incomplete information
349
7.2.2 Inequality aversion with complete information
352
7.2.3 An evaluation of inequality aversion models
355
7.3
Intentions and social norms
356
7.3.1 A model of fairness based on intentions
357
7.3.2 What is fair?
359
7.4
Summary
363
7.5
Giving to charity
364
7.5.1 Crowding out
364
7.5.2 Who is watching?
366
7.5.3 Why do people give?
368
7.5.4 Social norms and crowding out
368
7.6
Price and wage rigidity
370
7.6.1 A model of worker reciprocity
371
7.6.2 Wage stickiness in the lab
372
7.6.3 How long to forget a wage change?
374
7.6.4 Firm pricing
374
7.7
Contract theory
375
7.7.1 Contracts for loss-averse workers
377
7.7.2 Exploitation of an overconfident worker
379
7.8
Further reading
379
7.9
Review questions
380
Part III
Origins of behavior
383
8
Evolution and culture
385
8.1
Evolution and economic behavior
385
8.1.1 Looking for food and finding a utility function
386
8.1.2 Choosing when to have children
388
8.1.3 Aggregate risk
389
8.1.4 Competing with others
392
8.2
Culture and multi-level selection
397
8.2.1 Cross-culture comparisons
397
8.2.2 Group selection
401
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8.2.3 Gene–culture coevolution
404
8.2.4 Reciprocity in children and chimpanzees
406
8.3
Summary
409
8.4
The gender gap
409
8.4.1 Attitudes to risk
410
8.4.2 Attitudes to competition
411
8.4.3 Social preferences
414
8.4.4 Why are men and women different?
415
8.5
The economics of family
416
8.6
Development economics
420
8.6.1 The education production function
421
8.6.2 Microfinance
424
8.7
Further reading
427
8.8
Review questions
427
9
Neuroeconomics
429
9.1
An introduction to the brain
429
9.1.1 An economist’s map of the brain
432
9.1.2 Brain processes
435
9.1.3 Executive control systems
437
9.1.4 Neurotransmitter and hormone
438
9.2
Valuing rewards and learning
439
9.2.1 Reward evaluation
440
9.2.2 Learning about rewards
443
9.2.3 Risk and uncertainty
446
9.2.4 Different types of reward
448
9.3
Making decisions
449
9.3.1 Choice and strategy
450
9.3.2 Framing effects
453
9.3.3 Strategic behavior
455
9.3.4 Fairness and norms
456
9.3.5 Punishment and inequality aversion
459
9.3.6 Present bias and a brain in conflict
461
9.3.7 Multiple-self models
466
9.4
Summary
467
9.5
Addiction
468
9.5.1 A model of rational addiction
469
9.5.2 Biases and addiction
471
9.5.3 Cues and addiction
474
9.5.4 Addiction and neuroscience
476
9.6
Further reading
477
9.7
Review questions
478
Part IV
Welfare and policy
479
10
Happiness and utility
481
10.1 What makes us happy?
481
10.1.1 Happiness is relative
484
10.1.2 Adaption and habituation
487
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10.2 Do we know what makes us happy?
489
10.2.1 Remembered utility
490
10.2.2 Projection bias
493
10.3 Choice and commitment
495
10.3.1 Does present bias matter?
497
10.3.2 Pre-commitment
499
10.3.3 Do people like having choice?
500
10.4 Summary
502
10.5 Health and happiness
502
10.5.1 Measuring the value of treatment
503
10.5.2 Improving the remembered utility of treatment
506
10.6 Mental health and life satisfaction
507
10.7 Saving and retirement
510
10.7.1 Projection bias in saving
510
10.7.2 Investor autonomy
511
10.8 Welfare trade-offs
513
10.8.1 The inflation–unemployment trade-off
513
10.8.2 Tax saliency
515
10.9 Further reading
519
10.10 Review questions
520
11
Policy and behavior
521
11.1 Designing good institutions
521
11.1.1 The tragedy of the commons
522
11.1.2 Matching markets
526
11.1.3 Spectrum auctions
529
11.1.4 Behavioral economics and institution design
534
11.2 Nudge and behavior change
534
11.2.1 Savings accounts
535
11.2.2 A default to save
536
11.2.3 Nudge
538
11.2.4 Nudge and behavior change
541
11.2.5 Consumer protection, health and the environment
543
11.3 Summary
546
11.4 Further reading
547
11.5 Review questions
547