CONTENTS
PREFACE xv
1 RATIONALITY, IRRATIONALITY, AND RATIONALIZATION 1
Rational Choice Theory and Rational Modeling 2
Rationality and Demand Curves 4
Bounded Rationality and Model Types 8
Special Relationship between Behavioral Economics
and Experimental Economics 10
Biographical Note: Herbert A. Simon 12
Thought Questions 13
References 13
Advanced Concept: Deriving Demand Curves 13
PART 1 CONSUMER PURCHASING DECISIONS
2 TRANSACTION UTILITY AND CONSUMER PRICING 17
Rational Choice with Fixed and Marginal Costs 18
Fixed versus Sunk Costs 21
The Sunk Cost Fallacy 22
Theory and Reactions to Sunk Cost 25
History and Notes 28
Rational Explanations for the Sunk Cost Fallacy 28
Transaction Utility and Flat-Rate Bias 29
Procedural Explanations for Flat-Rate Bias 31
Rational Explanations for Flat-Rate Bias 33
History and Notes 33
Transaction Utility and Consumer Preferences in Reference 34
Theory and Reference-Dependent Preferences 35
Rational Explanations for Context-Dependent Preferences 36
Biographical Note: Richard H. Thaler 37
Thought Questions 38
References 38
Advanced Concept: Fixed Costs and Rational Choice 39
ix
3 MENTAL ACCOUNTING 41
Rational Choice with Income from Varying Sources 42
The Theory of Mental Accounting 45
Budgeting and Consumption Bundles 49
Accounts, Integrating, or Segregating 52
Payment Decoupling, Prepurchase, and Credit Card Purchases 55
Investments and Opening and Closing Accounts 57
Reference Points and Indifference Curves 60
Rational Choice, Temptation and Gifts versus Cash 61
Budgets, Accounts, Temptation, and Gifts 62
Rational Choice over Time 64
Rational Explanations for Source-Based Consumption and Application 66
Biographical Note: George F. Loewenstein 67
Thought Questions 68
References 69
4 STATUS QUO BIAS AND DEFAULT OPTIONS 70
Rational Choice and Default Options 71
Preference Formation, Framing, and the Default Option 72
Rational Explanations of the Status Quo Bias 76
History and Notes 76
Reference Points, Indifference Curves, and the Consumer Problem 77
An Evolutionary Explanation for Loss Aversion 81
Rational Choice and Getting and Giving Up Goods 83
Loss Aversion and the Endowment Effect 85
Rational Explanations for the Endowment Effect 87
History and Notes 88
Biographical Note: Amos N. Tversky 89
Thought Questions 89
References 90
Advanced Concept: The Shape of Indifference Curves with Constant Loss Aversion 91
5 THE WINNER’S CURSE AND AUCTION BEHAVIOR 93
Rational Bidding in Auctions 93
Procedural Explanations for Overbidding 97
Levels of Rationality 98
Bidding Heuristics and Transparency 99
Rational Bidding under Dutch and First-Price Auctions 101
History and Notes 105
Rational Prices in English, Dutch and First-price Auctions 105
Auction with Uncertainty 106
Rational Bidding under Uncertainty 107
x CONTENTS
The Winner’s Curse and Anchoring and Adjusting 110
History and Notes 116
Rational Explanations for the Winner’s Curse 117
Biographical Note: Matthew Rabin 117
Thought Questions 118
References 119
Advanced Concept: Bayesian Nash Equilibrium and Bidding
under Uncertainty 119
PART 2 INFORMATION AND UNCERTAINTY
6 BRACKETING DECISIONS 125
Multiple Rational Choice with Certainty and Uncertainty 126
The Portfolio Problem 133
Narrow versus Broad Bracketing 135
Bracketing the Portfolio Problem 139
More than the Sum of Its Parts 140
The Utility Function and Risk Aversion 140
Bracketing and Variety 144
Rational Bracketing for Variety 144
Changing Preferences, Adding Up, and Choice Bracketing 145
Addiction and Melioration 146
Narrow Bracketing and Motivation 149
Behavioral Bracketing 149
History and Notes 150
Rational Explanations for Bracketing Behavior 151
Biographical Note: Drazen Prelec 151
Thought Questions 152
References 152
Advanced Concept: The Portfolio Problem 153
Advanced Concept: Bracketing the Portfolio Problem 154
7 REPRESENTATIVENESS AND AVAILABILITY 156
Statistical Inference and Information 157
Calibration Exercises 162
Representativeness 165
Conjunction Bias 167
The Law of Small Numbers 169
Conservatism versus Representativeness 178
Availability Heuristic 180
Bias, Bigotry, and Availability 181
History and Notes 183
Contents xi
Biographical Note: Daniel Kahneman 184
Thought Questions 185
References 185
8 CONFIRMATION AND OVERCONFIDENCE 187
Rational Information Search 188
Confirmation Bias 192
Risk Aversion and Production 203
Overconfidence 204
Self-Serving Bias 207
Is Bad Information Bad? 208
History and Notes 210
Biographical Note: Colin F. Camerer 211
Thought Questions 211
References 212
9 DECISION UNDER RISK AND UNCERTAINTY 214
Rational Decision under Risk 215
Modeling Intransitive Preferences: Regret and Similarity 220
Independence and Rational Decision under Risk 226
Allowing Violations of Independence 234
The Shape of Indifference Curves 236
Evidence on the Shape of Probability Weights 237
Probability Weights without Preferences for the Inferior 239
Practical Implications of Violations of Expected Utility 240
What to Do When You Don’t Know What Can Happen 242
History and Notes 246
Biographical Note: Maurice Felix Charles Allais 246
Thought Questions 247
References 248
Advanced Concept: The Continuity Axiom 249
10 PROSPECT THEORY AND DECISION UNDER RISK OR UNCERTAINTY 250
Risk Aversion, Risk Loving, and Loss Aversion 253
Prospect Theory 257
Prospect Theory and Indifference Curves 259
Does Prospect Theory Solve the Whole Problem? 267
Prospect Theory and Risk Aversion in Small Gambles 269
History and Notes 275
Biographical Note: Peter P. Wakker 276
Thought Questions 276
References 277
xii CONTENTS
PART 3 TIME DISCOUNTING AND THE LONG AND SHORT RUN
11 DISAGREEING WITH OURSELVES: PROJECTION AND HINDSIGHT BIASES 281
The Standard Models of Intertemporal Choice 282
Making Decisions for Our Future Self 287
Projection Bias and Addiction 290
The Role of Emotions and Visceral Factors in Choice 297
Modeling the Hot–Cold Empathy Gap 299
Hindsight Bias and the Curse of Knowledge 303
History and Notes 306
Biographical Note: Dan Ariely 307
Thought Questions 307
References 308
12 NAÏVE PROCRASTINATION 309
The Fully Additive Model 310
Discounting in Continuous Time 312
Why Would Discounting Be Stable? 313
Naïve Hyperbolic Discounting 318
Naïve Quasi-Hyperbolic Discounting 324
The Common Difference Effect 330
The Absolute Magnitude Effect 331
Discounting with a Prospect-Theory Value Function 336
History and Notes 343
Biographical Note: Robert H. Strotz 344
Thought Questions 345
References 345
13 COMMITTING AND UNCOMMITTING 347
Rationality and the Possibility of Committing 348
Commitment under Time Inconsistency 351
Choosing When to Do It 361
Of Sophisticates and Naïfs 368
Uncommitting 374
History and Notes 378
Biographical Note: David Laibson 378
Thought Questions 379
References 380
Advanced Concept: The Continuous Choice Problem
with Backward Induction 381
Contents xiii
PART 4 SOCIAL PREFERENCES
14 SELFISHNESS AND ALTRUISM 389
Rationality and Altruism 392
Rationally Selfless? 397
Selfishly Selfless 403
Public Goods Provision and Altruistic Behavior 409
History and Notes 413
Biographical Note: Robert H. Frank 414
Thought Questions 415
References 416
15 FAIRNESS AND PSYCHOLOGICAL GAMES 417
Inequity Aversion 420
Holding Firms Accountable in a Competitive Marketplace 425
Markets Might Not Clear When Demand Shifts 426
Prices and Wages Might Not Fully Reflect Quality Differences 426
Prices Are More Responsive to Cost Increases than Decreases 426
Fairness 427
Kindness Functions 432
Psychological Games 443
History and Notes 446
Biographical Note: Ernst Fehr 447
Thought Questions 448
References 449
16 TRUST AND RECIPROCITY 450
Of Trust and Trustworthiness 455
Trust in the Marketplace 460
Trust and Distrust 465
Reciprocity 466
History and Notes 469
Biographical Note: Paul Slovic 470
Thought Questions 470
References 471
GLOSSARY 473
INDEX 495