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Behavioural Economics

What is behavioral economics?

Behaviorial economics studies the effects of insights from psychology on economic decisions.

Daniel Kahneman, a psychologist, was awarded the Nobel prize in economics in 2002, for his work in judgment and decision making. Kahneman’s work is the subject of his 2011 book, titled Thinking, Fast and Slow. He is the only non-economist to receive the Nobel prize in economics.

Kahneman in his book refers to intuition as operating automatically and quickly with little or no effort. In contrast, are effortful mental activities demanding attention, including complex computations. Two plus two requires no effort, but 17 times 24 requires attention and some thought. Kahneman in his book makes the case that at times a person’s intuition must be modified or corrected by a thought process.

A summary of subjects from Kahnerman’s book is as follows:

- Circumstances can have material effects on individual decision making. In the supermarket signs and product placement on shelves affect decisions by buyers;

- In organ donation, some countries have very high participation rates by requiring a negative choice on driver’s licenses. That is, the default choice is to donate organs;

- Our minds are susceptible to systematic errors ;

- We now understand the marvels as well as the flaws of intuitive thought;

- The accurate intuitions of experts is explained by the effects of prolonged practice, e.g. chess masters;

- Emotion is a part of intuitive judgment;

- We are prone to overestimate, and we underestimate the role of chance in events;

- Attentive thinking, including self control, takes over when things get difficult;

- Biases cannot always be avoided because attentive thinking may not recognize the error;

- Jumping to conclusions is risky when the situation is unfamiliar;

- Uncertainty and doubt are part of attentive thinking;

- From a single observation, we tend to like (or dislike) everything about a person, called the Halo Effect;

- Answering very difficult questions, such a predictions, can be impractical;

- It is error to regard a random sample from a population as highly representative of the total population (part of the law of large numbers);

- In labour negotiations the existing wage level is used as a base to demand a wage increase. Psychologists refer to this amount as an anchor. Also the seller of a house when fixing the asking price is aware of the price she paid for the house two years before and that price affects the buyer’s asking price. Kahneman suggests that if you are faced with an outrageous proposal, that you should refuse to continue to negotiate with that number on the table;

- Persons tend to ignore probabilities and consider only the possibilities when buying lottery tickets (Adam Smith offered the same advice in 1760);

- A person should adopt risk policies such as “always take the highest possible deductible when purchasing insurance” and “never buy extended warranties”;

- People overestimate the probabilities of unlikely events;

- Estimates of the causes of death are warped by media coverage;

- Probability neglect plus media coverage leads to risk exaggeration;

- Intuitive predictions need to be corrected because they are not regressive and therefore are biased;

- We have an illusion of understanding of the past. We assign a larger role to talent and stupidity than to luck;

- We have an almost unlimited abilty to ignore our ignorance;

- We refuse to acknowledge the uncertainties of our existence;

- A CEO’s influence is exaggerated because luck plays a large role in any firm’s success;

- The evidence that we cannot forecast success is overwhelming;

- Professional investors fail a basic test of skill, persistent achievement;

- Valid predictions are an illusion because the world is unpredictable;

- Experts tend to develop an enhanced illusion of their skill and become unrealistically overconfident;

- Humans are inconsistent in making summary judgments of complex information, e.g. reading of X-rays;

- Use of formulas or algorithms maximizes predictive accuracy;

- Intuition can only be trusted in an environment of stable regularities, e.g. bridge and poker;

- Overly optimistic forecasts of the outcome of projects are found everywhere;

- Optimists adapt well to hardships and take care of their health and live longer;

- Intuition includes overconfidence that can be tamed but not vanquished;

- Mental accounting affects behavior; e.g. keeping score while playing golf;

- The sunk-cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects;

- Except for the very poor, the main motivators of money-seeking are not necessarily economic.

- Bad news. The brains of humans and other animals contain a mechanism that gives priority to bad news. For example, an animal’s ability to detect a predator improves the animal’s chances of survival.

The psychological insights described above are at odds with an economist’s view of an agent of economic theory: “rational, selfish and his tastes do not change”. To a psychologist it is self-evident that people are not fully rational nor completely selfish, and their tastes are anything but stable.

The concept of loss aversion is a significant contribution of psychology to behavioral economics. Professional golfers putt more accurately when putting for par than for birdie. Loss aversion is a force that favors minimal change in our lives and institutions.

Several videos of Daniel Kahneman and his work are available on YouTube.

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