Behavioural economics overview presented at the Malta Association of Risk Management (MARM) Conference of 15 March 2013 by Marie Briguglio

1. Behavioural Economics
An overview
Marie Briguglio

2. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

3. Economics...
Any aspect of human behaviour that involves the allocation of scarce
resources
…the study of choice
Like all science, economics
develops and applies theories,
applies assumptions.
The standard, or neo-classical, economic model is the dominant
framework for thinking about consumer welfare and consumer choice.
FOUNDATIONS

4. Practical men, who believe themselves to be quite
exempt from any intellectual influences, are usually
the slaves of some defunct economist.”
John Maynard Keynes
FOUNDATIONS

5. Example
Implicit assumption about how people make decisions
1. They perceive a situation.
2. They think of possible courses of action
3. They calculate which course is in their best interest.
4. They take action accordingly
STANDARD ECONOMIC MODEL

6. More specifically
•Is a Bayesian Information Processor
•With well-defined and stable preferences
•Who maximises expected utility
•Who applies exponential discounting rules
•Who is self-interested (narrowly defined)
•Who has preferences over outcomes not changes relative to a reference point
•Who has only instrumental tastes for beliefs and information
(Rabin: The “Dead Parrot” of Economics)
In short...
Individuals are assumed to be like computers
Can effortlessly process data and compute their optimal
choice
STANDARD ECONOMIC MODEL

7. If we assume decisions are made this way, we can believe in..
- Informing decisions to achieve behavioural change
- Using economic incentives to achieve behavioural change
- Limiting the scope for government
STANDARD ECONOMIC MODEL

8. Example:
How do we assume that people make decisions about savings?
They weigh up their consumption in the current and future periods.
They use all relevant information in making their savings choices;
They choose a level of consumption and saving that maximises their
lifetime utility.
STANDARD ECONOMIC MODEL

9. But we often observe people....
Paying for a gym they will never use....
Investing in lotteries rather than saving...
Leaving credit card bills outstanding ...
Taking up smoking...
Taking out a mobile phone contract with large upfront payments...
Buying cars they cannot afford to maintain...
Donating blood...
Reacting negatively to performance bonuses….
BEHAVIOURAL ECONOMICS

10. From initial doubts...
1. People are generally rational BUT
2. Emotions such as fear, affection, hatred explain most
departures from rationality.
...to the idea of “Satisfising” (Simon)
Information consumes the attention of its recipients.
..to ”heuristics” (Tversky & Kahneman)
Rules of thumb that can lead to systematic biases
…and behavioural economics
Relaxing the standard economic assumption that
everyone in the economy is rational and selfish.
SEM as a special case.
BEHAVIOURAL ECONOMICS

11. Behavioural economics increases the explanatory power of
economics by providing it with more realistic psychological
foundations
Camerer and Loewenstein 2004
BEHAVIOURAL ECONOMICS

12. Methodologically
Multiple Regression Models
Lab Experiments (e.g. Ariely)
Field Experiments (e.g. della Vigna)
Natural Experiments (Freakonomics)
Imaging Studies (e.g. Laibson)
BEHAVIOURAL ECONOMICS

13. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

14. Loss aversion
The phenomenon that people dislike losses more than they
like gains.
LOSS AVERSION

15. The endowment effect
occurs when a person’s preferences depend upon what they
already possess.
implies that a person’s preferences depend upon a certain
reference point, perhaps determined by the person’s
possessions.
ENDOWMENT EFFECT

16. Kahneman and Tversky (1979) PROSPECT THEORY
embodies both
The endowment effect
Loss aversion
is more complex than utility theory
has sharp implications for how markets function
Is useful when prospects (most) are mixed eg.
starting a company
running for elections
PROSPECT THEORY

17. PROSPECT THEORY

18. Anchoring and adjustment:
A process used when forming judgments: we first pick an initial estimate (an
anchor), then adjust up or down as necessary.
The estimate does not have to be related to the good.
Nor does the anchor have to be consciously chosen by the consumer.
ANCHORING AND ADJUSTMENT

19. Choice paradox
Although increased choice is perceived as desirable, in some
circumstances, the provision of choice either inhibits decision
makers’ likelihood to make a choice or detrimentally affects
their experienced well-being after the choice is made….
CHOICE PARADOX

20. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

21. Gambler’s fallacy
Mistakenly believing two outcomes are dependent is the gambler’s
fallacy.
GAMBLER’S FALLACY

22. Availability
The availability heuristic refers to the assessment of
probability of an event by reference to its availability
AVAILABILITY

23. Framing effects
People’s choices are often affected by irrelevant
factors of presentation
FRAMING EFFECTS

24. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

25. Time Inconsistency
One’s behavior is time consistent if their preferences over two
options do not change just because time has passed.
The standard model of exponential discounting fails to capture the
manner in which people’s preferences appear to change over time.
TIME INCONSISTENCY

26. Preferences over Profiles
People might also have preferences over shapes of utility
profiles.
They might prefer increasing profiles, and/or like to end on
a high note.
PREFERENCES OVER PROFILES

27. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

28. Strategic interactions
Limited strategic thinking
Altruism – pure or impure
Envy
Fairness
Betrayal aversion
Reciprocity
Trust
Peer effects
Group Processes

29. Successful investing is anticipating the anticipations
of others.
John Maynard Keynes
STRATEGIC INTERACTION

30. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

31. Behavioural Economics has
found its way to the heart of
government
FT 2009.
INTERVENTION

32. Example of problems…
Savings too low to fund retirement
Obesity rates and chronic illness levels
Consumption patterns unsustainable
….ripe for BE solutions
simplified interventions
changing “default options”
mandating “cooling off periods”
application of “nudges” “choice architecture”
INTERVENTION

33. All errors which he is likely to commit against advice and
warning, are far outweighed by the evil of allowing others to
constrain him to what they deem his good.
JS Mill
It is impossible not to meddle. Given that we can’t avoid
meddling, let’s meddle in a good way.
R Thaler.
INTERVENTION

34. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

35. It's not a case of: 'Read this book and then you'll think
differently. I've written this book, and I don't think
differently.
Daniel Kahneman

36. Examples of empowering self
- Avoiding decisions when S2 is depleted
- Committing self to reach goals
- Choosing the right peer groups
- Changing default options
- Availability beats cognition

37. The Automatic Millionaire: #1 selling business book of 2004
Make savings automatic so that you don’t notice it (payroll
deductions, automatic withdraws from checking, mortgage
payment, etc.)
PRE COMMITMENT

38. 1. Background
2. How we really make choices
3. How we handle risk
4. Decisions about the future
5. Choice and other people
6. Influencing decisions
7. Making better decisions
8. Conclusion

39. Homo Economicus
Individuals make choices to maximize utility under constraints they face
In uncertainty, individuals maximize expected utility by assigning
probabilities to different states of the world
Vs Homo Sapiens
People are complicated
WAY FORWARD

40. “We are just at the beginning!”
Daniel Kahneman
WAY FORWARD

41. Resources
marie.briguglio@um.edu.mt
A Course in Behavioral Economics, by Erik Angner (Palgrave
Macmillan, 2012).
An Introduction to Behavioral Economics: A Guide for Students by
Nick Wilkinson (2008).
“Nudge” by Thaler and Sunstein;
Ariely’s “Predictably Irrational”;
"Exotic Preferences" by Lowenstein and
Frey and Stutzer’s economics and psychology.
Thaler, Richard and Cass Sunstein. Nudge: Improving Decisions about
Health, Wealth and Happiness. New Haven: Yale University Press,
2008.
Behavioural Economics
YOUTUBE CHANNEL
via www.mariebriguglio.com
Due acknowledgement to Liam Delaney and Russell James for some of the slide contents.