Behavioral Economics custom-MADE

Michał Krawczyk

University of Warsaw

Homo oeconomicus: the extinct species?

• Choices maximize certain objective function…• … which is stable• Expected value maximized under uncertainty• Such rationality is „common knowledge”• The theory is mute about:

–Capacity constraints–Cognitive limitations–Emotions–Biases–Heuristics–Impact of labels…

Behaviorial Economics

• A booming industry

• Aiming at descriptive accuracy…

• …yet in-keeping with rigorous economic modeling standards

• Allows for a number of deviations from the mainstream model of a rational decision maker…

• … but assumes that these deviations follow certain patterns

A handfull of key ideas

1. Heuristics and biases2. Framing3. Myopia4. Overconfidence5. Fairness/reciprocity

NB: not that incentives do not matter!

Behavioral Economics: Some research tools

He? Isn’t it just psychology?

• Different methods:– Rigorous mathematical modeling– Experimentation with monetary incentives

and without deception– Econometric analysis of field data

• Different philosophy:– At least aimed at arriving at a single paradigm

• Different focus/research questions– Ultimately, focus on policy applications

ExampleBeauty contest: an experiment

• Write down any integer between 1 and 100

• 2/3 of the mean will be computed

• Whoever is closest to this number is the winner

Beauty contest: analysis

• The mean cannot be higher than 100

• So the winning number cannot be higher than 67

• So nobody should pick any number above 67

• So the mean cannot be higher than 45

• So nobody should pick any number above 30 etc.

• Everybody should pick 1!

Beauty contest: analysis

• Everybody should pick 1!

• But that never happens

• So it’s a bad idea to do that!

• John Maynard Keynes’ allegory of the stock market

• Participants asked to choose the ``most beautiful’’ face out of 6 pictured.

• Those who picked the most popular face are eligible for a prize

• So you should not pick the prettiest but what you think others think that other think…

• Stock price can be far away from the fundamental because the assumption that rationality is kommon knowledge fails

For Starters: Heuristics and biases (Kahneman and Tversky)

• heuristics and biases: – Heuristics: easy solutions to complex problems– (ABC group: „fast and frugal”)– Biases: systematic errors

Experiment

• Write down a ``random’’ series of 20 zeros and ones (as if it resulted from tossing a fair coin)

• Now, count the number of ``runs’’ (e.g. 1,1,0,1,0,0,1 has 5 runs)

• Statistically, there should be about (n-1)/2 runs in a series of length n.

• Typically, there are many more runs

Why is it so? Representativeness

• An object should be representative of its class or process that generated it

• 1,0,1,0,0,1 looks ``more random’’ than 1,1,0,0,0,1 although they are equally likely

• Gives rise to ``gambler’s fallacy’’• „Steve is shy and withdrawn…helpful…need for order…

passion for detail…” Is Steve more likely to be a farmer or a librarian?– Base rate neglect

• Sample size neglect• Insensitivity to predictability

Representativeness on the market

• Efficient market hypothesis: no extra systematic profit

• Empirical puzzle: companies with low P/E yield higher returns (are underpriced)

• Explanation using RH: Investors overreact to current information

• For instance, low present-day earnings make people think that this will continue

Availability heuristic

• Judging frequency by the ease of retrieval

• Famous men vs non-famous women & vv

• Are „r........” or „..r……..” words more common?

• Bias of imaginability

Anchoring

• Insufficient adjustment: roulette wheel and African countries in the UN

• 1x2x3x…x8 greater than 8x7x6x…x1

• Miscalibration & overconfidence: give a confidence interval for Dow Jones

• Is the Nile more or less than 200 (2000) miles? How long is it? Results 300 (1500)

Anchoring and adjustment

• conjunctive events (A B) are overestimated;

• disjunctive events (AB) are underestimated

(how many people are needed for the probability that they share a birthday to be > 50%?)

mini-summary– Judgment is based on a limited set of

heuristics (just as perception)– leads to biases which are systematic and

hence predictable (at least in principle)– Imperfect or irrational they may be, but still

useful, most of the time– Some biases may be adaptive in

combination with other ones

Overconfidence

• Overtrading (Barber, Odean: ``Boys will be boys’’)

• Excessive entry (Camerer, Lovallo, AER `99)

• Overshooting in corporate investments (Malmendier and Tate, JoF `05)

• Stock picking

– On average, US workers report that their own employer’s stock is less risky than a diversified mutual fund.

– Enron employees thought so, too

Status Quo Bias

• Decision-makers generally prefer to stick with the status quo

–even when this means foregoing large profits

–even when told that the default is suboptimal

• Examples: retirement savings, insurance deductibles, organ donation…

The Harvard Know-It-Alls are Status Quo-Biased too

• Samuelson and Zeckhauser (1988) • In the 1980s, Harvard University added

several plans to its choice of health plans,• Existing employees “chose” the older plans

app. 3 times more often than the new ones. • In other words, incumbent employees made

the easiest choice of all: to do nothing.

Example: Brigitte Madrian and Dennis Shea (2001)

• Design: A Fortune 500 Company Switched 401(k) default on April 1, 1998. Madrian and Shea examine behavior of new hires.

OLD• Default Contribution:

Must actively sign up• Default Allocation:

None

NEW• Default Contribution:

3 percent of compensation deducted for plan

• Default Allocation: Money Market Fund

401(k) Participation IncreasesPercent at Specified Contribution Rate

0%

20%

40%

60%

80%

0% 1-2% 3% 4-5% 6% 7-9% 10% 11-14% 15%

Before AutomaticEnrollment

After AutomaticEnrollment

Source: Madrian and Shea (2001).

Contribution Rate

401(k) Asset Allocation Also Changed

0%

20%

40%

60%

80%

100%

Before AutomaticEnrollment

After AutomaticEnrollment

Money Mkt

Stocks

Bonds

Source: Madrian and Shea (2001).

Per

cen

t o

f A

sset

s

Impact of Automatic Enrollment in 401(k) Before, During and After

401(k) participation by tenure at firm

0%

20%

40%

60%

80%

100%

0 6 12 18 24 30 36 42 48

Tenure at company (months)

Fra

ctio

n o

f em

plo

yees

eve

r p

arti

cip

ated

Hired before automatic enrollment Hired during automatic enrollment

Hired after automatic enrollment ended

Source: Choi, Laibson, Madrian, Metrick (2004)

Is More (Choice) Always Better?

Adding more complex options:

• delays choice, strengthens the Status Quo bias (O’Donoghue and Rabin, 2004).

• biases choice, complex options avoided (Shafir and Tversky, 1994; Iyengar and Kamenica, 2006).

• 1/N rule – Add a second fund and many investors divide portfolio 50-50; add a third fund and 1/3 placed in each.

• (several other examples of menu dependance)

Myopia

• Would you rather have:

$100 right now or $101 in a week?

• How about

$100 a year from now or $101 in a year+a week from now

• We are impatient in the short run, patient in the long run.• (referred to as „(quasi)hyperbolic discounting”)• U=u0+βδu1+ βδ2u2+βδ3u3+…• McClure et al. (Sci. 2004) claim to have found separate neural

circuits primarily associated with, resp., β and δ

Real Consequence of Hyp. Discounting

• A typical American has an outstanding credit card debt of $6,000

• Pretty costly

• Yet few people can pay off such amounts

• And immediate pleasure of purchase hard to resist

Inconsistent Choices Due to Impatience

• Eat chocolate today with delayed health consequences but immediate gratification, or eat fruit today with less gratification but better long-term health consequences.

• What do you choose today for you to eat next week? What do you choose today to eat today?

• Research by Daniel Read and Barbara van Leeuwen (1998)

Choosing fruit vs. chocolate

TimeChoosing Today Eating Next Week

If you were deciding today,would you choosefruit or chocolatefor next week?

Patient choices for the future:

TimeChoosing Today Eating Next Week

Today, subjectstypically choosefruit for next week.

74%choosefruit

Impatient choices for today:

Time

Choosing and Eating

Simultaneously

If you were deciding today,would you choosefruit or chocolatefor today?

Impatient choices for today:

Time

Choosing and Eating

Simultaneously

For Today, theygenerally go forchocolate

70% choosechocolate

Impatience: education in developing countries

Probe report on basic education in India: • 85 percent of the parents agreed that it was important for

children to be educated. • 57 percent of parents responded that their sons should

study “as far as possible.”

In fact, only a small minority obtains substantial education

levels. This is becuase education requires instant sacrifice

and offers delayed rewards

Sporadic attendence: enrollment, attendence, drop-out,

renewed enrollment etc. Salience matters (Akerlof 1991):

e.g. beggining of the school year

Policy implications

• Continuous low fees

• Efforts to make schooling more attractive to students

• Properly timed information campaigns

Do you know that you’re biased? Sophisticates and naives

(O’Donoghue, Rabin; AER ‘99)

• Suppose that β=.5, δ=1 (everything that does not happen now is discounted 50%

• Naives think that their β is 1. • Suppose you have to do the assignment on one of

the four days: Mon, Tue, Wed, Thu• The costs are 3, 5, 8, 13• Temp. Cons: (Y, Y, Y, Y) → will work on Mon• Naives: (N, N, N, Y) → will work on Thu• Sophisticates: (N, Y, N, Y) → will work on Tue

Does sophistication always pay?

• β=.5, δ=1

• Suppose now you can go for a party on one of the four days

• The rewards are: 3, 5, 8, 13

• Temp. Cons: (N, N, N, Y) → will party on Thu

• Naives: (N, N, Y, Y) → will party on Wed

• Sophisticates: (Y, Y, Y, Y) → will party on Mon

• Sometimes it’s better to be naive!

Ulysses and the Sirens:Commitment devices

Commitment devices

• Gym memberships• Christmans clubs• Fat farms• Voluntary casino bans• Disulfiram: „[with even small amounts of alcohol]

produces flushing, throbbing in head and neck, throbbing headache, respiratory difficulty, nausea, copious vomiting, sweating, thirst, chest pain, palpitation, dyspnea, hyperventilation, tachycardia, hypotension, syncope, marked uneasiness, weakness, vertigo, blurred vision, and confusion”

Commitment devices: cont’d

• „Quitting Smoking is Easy, I’ve Done It Hundreds of Times”

• Taxes on cigarettes can play the role of a commitment device

• Gruber and Mullainathan (2002) find that higher taxes on cigarettes make those prone to smoking better off

• Ariely and Wertenbroch (2002): students volunteered to self-impose essay submission deadlines

Commitment devices in developing countries

• Roscas: – Small contributions, large pay-out– Self-imposed social pressure to continue contributing– Helps overcome self-control problems

• Holding wealth in non-liquid assets• Less access to banking makes it more difficult to

overcome temptation

Researchers go bankers

• Ashraf, Karlan, and Yin (2005) • Offered an account with a commitment device to 842

households in the Philippines• Access constrained to reaching a self-specified savings

goal or a self-specified time period. • A control group of 466 households from the same

sample is offered a verbal encouragement to save but with no commitment.

• A sizeable demand for commitment observed• And an impact of commitment on savings.

Time inconsistence in maize farmers

• Duflo, Kremer, and Robinson (2005)• savings for fertilizer use for maize crop in

Western Kenya• many farmers plan to use fertilizer in the

next season but very few end up doing it • SAFI: Saving and Fertilizer Initiative—safi

means “pure” in Swahili) • Each season at harvest a farmer is offered

to buy a voucher for fertilizer• Transportation costs saving is the only

advantage

SAFI: results

• SAFI offered to a group of 420 farmers. • In addition, 293 farmers visited at fertilizer application

time, made an offer equivalent with SAFI or 50% discount

• Results: acceptance:– SAFI: 40 percent – Subsidy: 45 percent– No subsidy, no commitment: 21 percent

Loss Aversion

• Losses loom larger than equivalent gains

• Kahneman, Knetsch and Thaler’s (1990) mug experiment: WTP/WTA discrepancy

• Attributed to loss aversion: owners’ loss of the mug loomed larger than buyers’ gain of the mug.

• cf: „Endowment effect”

Additional Evidence on Endowment Effect

• John List’s field experiment with sports card collectors

• Endowment effect seems to go away with experience

Field evidence of loss aversion

• Odean (1998) showed the disposition effect:• (small) investors in the stock market tend to sell

stocks they have made money on… • … and keep the ones they have lost money on. • Inconsistent with standard theory and actually

contrary to tax incentives. • Genesove and Mayer (2001) found that

individuals who have taken a loss on their house set far higher prices when it comes time to sell.

Loss aversion? A field experiment (submitted to Econoics Letters)

• Run during a mid-term Microeconomics test• Two supposedly different scoring rules used:

3 points for each correct answer

1 point for no answer

0 for each incorrect answer

55 points to pass• OR:

2 points for each correct answer

0 point for no answer

-1 for each incorrect answer

45 points to pass

A field experiment on LA: findings

• Hypothesis: less risk taking with explicit penalty points less

• In fact, with N=93 we see little evidence of loss aversion • Re-run with app. 400 subjects, no evidence again

Examples of policy implications

• Favor policies that preserve benefits, rather than compensate for the loss thereof

• Ensure property rights are well defined: it may deter violence becuase the owner will be more motivated to prevent a loss than the challenger to pursue a gain

• (A new view on the well-known problem pertinent to many developing countries)

Combining it all together: SMaRT

• A program created by Thaler and Benartzi (2003)• Aimed at nudging people to save more • The crucial idea: people commit to saving more out of

their pay next pay rise

Why is it smart?

Foregone gain, not in an effort to get people• Lack of free will → precommitment • Loss aversion → foregone gain rather than loss• Status quo bias → opt-out rather than opt-in

SMaRT: results

• In one firm more than 75 percent of those offered the Save More Tomorrow plan participated

• Less than 20 percent later opted out

• Savings rates increased sharply

• Many major firms and pension fund providers thinking of adopting the plan

The philosophy behind the approach:``Libertarian paternalism’’

• The goal: help people make better decisions

• Main assumptions– People react to incentives– People exhibit biases– Freedom of choice must be respected

• The tools– Defaults– Information– Commitment devices– Social pressure– packages

Further readings

• Ariely, Banerjee, Camerer, Duflo, Kahneman, Laibson, Mullainathan, Rabin, Thaler…