Behavioral Economics: Irrationality and Anomalies in Individual Decision-making - Prof. Ep, Apuntes de Negocios Internacionales

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Behavioural anomalies and rationality

Based on: Frank (1991) and “Irrationality: Rethinking thinking” The Economist , 18 December 1999, pp. 69-71.

Individual Behaviour

— In economics we usually describe a person in terms of his or her preferences. — We usually put some additional structure on preferences: — More of each good is better — Utility only depends on individual consumption (no context) — The consumer then maximizes utility subject to some constraint.

o X prefers University P, costs 800 €/year o University E requests registration (8,000 €) before knowing admissions in P o X pays 8,000 € to E o Later, X gets in P o Will X continue in P or E?

Quick reminders

o It is costly to process information to optimise à “satisfice” § Play chess with a clock: 40 moves in 2.5 hours. § Satisfice = optimise with an information cost ü Gathering information is costly, cognitive capacity is limited o Systematic errors or biases = breaking the “rational” rules of decision-making. § Different reactions when realising at the cinema entry that we lost a 10€ bill or the ticket. § Shoes that do not fit: same if they are a gift or we bought them? § Pizza buffet experiment: 3€ price that some tables get back. § Bad investments in firms, not firing employees, continuing wars (Vietnam etc.)...

Quick reminders: Bounded rationality

o Explain using the value function: o You buy a 100 € ticket to go to Camp Nou. o When reaching the stadium you notice that you could sell it for 1,000 €. o You would have never paid 1,000 €. o Do you sell the ticket?

Prospect Theory & Asymmetric value function

o “Know the relevant facts but decide “badly” o Use heuristics (approx. rules) to select information and decide: § Availability § Representativeness § Anchoring § Perception § Irrelevant options § ...

Two types of “errors” or biases

o A Spanish speaking person, Peruvian or US citizen? o A shy person, an nuclear physicist or a salesman? o A top football player is more probably Brazilian or not? § 10,000 players in total, 100 are top players § 50 players are Brazilian, 25 of them are top players o We underestimate the “regression towards the mean” § Fans complain when their team plays badly after scoring or winning a game. § Remember Real Madrid vs. Alcorcón?

Representativeness

o X = % de African countries in the UN § Lottery à anchor = n = 10 ó 65 § People estimated X very differently: ü If n = 10 à E( X ) = 25% ü If n = 65 à E( X ) = 45% o Estimate multiplications: § 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 à 2. § 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 à 512 o Context: are these experiments artificial? unreal? irrelevant? tricks for our Bayesian mind designed for “producing” probabilities from very small clues, and not using frequencies from big samples. o Why do most new firms fail?

Anchoring

o Are A, B and C relevant options? o When adding C (after initially choosing only from A and B), more people choose B. Price Distance A B C o Even if C is dominated, is it really an irrelevant option in terms of information?

Irrelevant options

o disproportionately influenced by the fear of feeling regret o cognitive dissonance o status quo bias o tendency to compartmentalise o over-confidence o magical thinking and quasi-magical thinking o hindsight bias and memory bias o emotional responses

Some more biases – provide your examples