Behavioral Economics For Dummies

Morris Altman, PhD, is a professor of behavioral economics at Victoria University of Wellington in New Zealand and a professor of economics at the University of Saskatchewan in Canada. He is on the board of the Society for the Advancement of Behavioral Economics and is a former president of that organization. He also edited the Handbook of Contemporary Behavioral Economics.

Introduction 1

About This Book 1

Conventions Used in This Book 2

What You’re Not to Read 2

Foolish Assumptions 3

How This Book isOrganized 3

Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 4

Part II: Understanding Choice 4

Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 4

Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 5

Part V: The Part of Tens 5

Icons Used in This Book 6

Where to Go from Here 6

Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 7

Chapter 1: Decoding Behavioral Economics 9

Making Wise Assumptions 9

Why reality matters 10

Why incentives matter — even in behavioral economics 10

Making Sense of Choice 11

Maximizing versus satisficing 11

The effect of emotions 12

The avoidance of loss 12

How options are framed 12

Paternalism versus free choice 13

The role of social context in decision making 14

Relative positioning 14

Growing the Economic Pie 15

Deciphering Bubbles and Busts 15

Inefficient markets and investment behavior 16

Emotions, intuition, animal spirits, and business cycles 16

Understanding Happiness: Money Isn’t Everything 17

Chapter 2: Getting Real about Assumptions 19

Defining an Economic Model 20

Explaining economic phenomena 21

Making simplifying assumptions 21

Discovering the irrelevance of facts 22

Understanding the role of math in model building 23

Considering cause and effect 26

Watching out for spurious correlations 26

Contemplating Conventional Economic Assumptions and Real-World Alternatives 27

Conventional assumption #1: People’s preferences are stable and consistent 27

Conventional assumption #2: People are solitary decision makers 28

Conventional assumption #3: How people form preferences doesn’t matter 28

Conventional assumption #4: People have the same preferences 29

Conventional assumption #5: People are all maximizers 30

Conventional assumption #6: People have perfect knowledge 32

Conventional assumption #7: People have unbounded computational capabilities 33

Conventional assumption #8: People have willpower 34

Conventional assumption #9: People are capable of acting upon their preferences 35

Understanding Rational Economic Behavior 36

You can do no wrong: Errors and biases in decision making 37

Selfishness and the smart society 38

Getting to Know the Behavioral Economics Actor 39

Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis 41

Where Neuroeconomics Fits in the Behavioral Economics

Perspective 43

The Brain and Economics 45

The evolution of the human brain 45

The division of labor in the human brain 48

The Emotional Brain 49

Descartes’ error: The somatic marker hypothesis 49

Phineas Gage and the social and emotional side of rational decision making 50

How Emotions Affect Decision Making 53

Fear and decision making 53

Happiness and decision making 54

The Limits of the Human Brain and Homo Economicus 54

The brain isnot a calculating machine 55

The brain isa scarce resource 55

What Brain Sciences Confirm for the Behavioral Economist 57

People prefer the present to the future 57

People’s aversion to loss affects their decision making 58

What people feel isn’t always what they experience 58

People care about keeping up with — and beating —the Joneses 60

People’s brains evolve over their lifetimes 61

People value fairness 62

People like to trust and be trusted 63

Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything 65

The Role of Economic Incentives for Economic Behavior 66

Why money isall that matters in conventional economics 67

Opportunity costs for Homo economicus 69

Decision Making and Opportunity Costs 71

Using up your mind: Bounded rationality 71

Considering costs other than money: Psychological costs 72

Reducing opportunity costs in the real world: Satisficing behavior 73

Weighing the opportunity cost of altruism 75

Supply and Demand and Behavioral Economics 75

Introducing the bandwagon effect 76

Investigating the snob effect 77

Interjecting morals and ethics 78

Introducing sociology to supply and demand 79

Economic Psychology: How Thoughts and Feelings Impact Decisions 84

Loss aversion: How framing, ownership, and control affect economic behavior 85

How the fear of uncertainty influences decisions 85

The warm glow: Why people sacrifice money for fairness or justice 87

Forfeiting money for status 88

Part II: Understanding Choice 89

Chapter 5: Exploring the Limits to Free Choice 91

Free Choice in Economic Decision Making 92

What conventional economics says 92

What behavioral economics says 93

Revealed Preferences: When Choices Reveal Your Inner Self 94

The narrative about preferences 95

False preferences versus true preferences 96

The limits of revealed preferences and free choice 98

The Illusion of Free Choice 99

Advertising and preference distortions 99

Self-control and free choice 101

Defaults as a determinant of choice 102

Herding, the bandwagon effect, and free choice: Are followers irrational? 103

Constraining Choice versus Freedom of Choice 104

Information 104

Education 105

Consumer rights 105

Chapter 6: Quick and Simple Heuristics and Real-World Decision Making 107

A Bird’s-Eye View of Smart Decision Making in Conventional Economics 108

Decision-making norms in conventional economics: The human calculating machine 109

The optimizing decision-making machine in conventional economics 110

Core conventional benchmarks for rational choice: To dream an impossible dream 111

The limits of conventional rationality 112

Rethinking Bounded Rationality and the Limits of the Mind 113

Bounded rationality and satisficing: Rationality within reason 114

The two blades of the decision-making scissors: Ecological rationality 114

Prospect Theory: Describing Average Decision-Making Behavior 116

Introducing prospect theory: Real-world decision making under uncertainty 117

Thinking about prospect theory and conventional norms 118

Exploring emotions as a hot bed of irrationality 118

The fundamentals of prospect theory: Understanding the value function 119

Unveiling Some Implications of Loss Aversion 122

Loss aversion and the certainty effect 122

Risk seeking in losses 123

The endowment effect: Explaining attachment to possessions 124

Uncovering Errors and Biases in Decision Making 125

Overconfidence 125

Herd behavior 125

Confirmation bias 126

Anchoring 126

Generalizing 127

Less isBest in Decision-Making: Fast and Frugal Heuristics 127

Exploring the superiority of heuristics 128

Understanding human rationality: New benchmarks built on human capabilities 130

Chapter 7: How the Framing of Choices Affects Decision Making 131

The Framing Effect 131

Framing and the economic schools of thought 132

The effect of framing on preferences and choices 133

Appreciating the objective unimportance of frames: The errors and biases approach 133

Understanding frames as heuristics 134

Framing in Pictures: The Possibility of Cognitive Illusions 134

Framing the Mona Lisa 135

Distorting the line illusion 135

Framing faces 136

Framing automobiles: Surface beauty versus substance 137

The letter illusion 138

We’re All Framed: Framing and Decision Making 139

Framing and loss aversion: The classic Asian disease experiment 140

When money isn’t everything 142

Saving a penny to lose a bundle: Framing prices through relative positioning 143

Frames as Defaults: How Anchors Sway the Course of Decision Making 144

Changing default options and choices 144

Revisiting choice architecture 146

Framing isimportant, but so are income and prices 147

The Inescapable Frame and Rational Decision Making 148

Understanding frames as an information-generating machine 148

Repairing frames and rational decision making 148

Introducing product labels into the framing arsenal 149

Market Failure and the Framing Effect 149

Chapter 8: How Norms, Peers, History, and Culture Influence Choice 153

Making Decisions in a Bubble, the Conventional Economics Way 154

Making decisions as if other people don’t matter 155

Making decisions as if history doesn’t matter 155

Making decisions as if society doesn’t matter 157

Introducing Social Norms to Decision Making 157

Looking at some norms 158

Identifying how trust impacts economic development 161

Seeing how discriminating norms can lead to a slow economy 162

Studying the role of education in the formation of norms and the shaping of preferences 163

The carrot and the stick: Exploring the enforcement of social norms 163

Peer Pressure: Seeing How Peers Affect Decision Making 164

How History and Culture Affect Choice 165

Rooting choice in history 165

Culture club: How culture affects the formation of preferences and choices 166

Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis 167

How Gender Affects Choice 167

Not tonight, honey: Conventional choice theory 168

Household bargaining power and women’s rights 169

Understanding household choices when women have a voice 171

Exploring population growth when women’s preferences count 172

Understanding why women go on welfare even if they want to work 174

Identifying why women are more risk averse than men 175

Exploring women’s altruistic preferences 176

Examining labor market discrimination 177

The Role of Children in Economic Decision Making 179

News Flash! Preferences Change with Age 179

Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 181

Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law 183

Why Most People Pay Taxes: The Big Stick versus the Warm Glows 183

How the big stick induces tax payments 184

The niceness effect 185

Social norms and taxes 186

A sense of fairness and tax compliance 186

Different Perspectives on Reducing Pollution 187

Exploring the economics of pollution control 187

Thinking about the green corporation 188

Understanding the links between green consumption and green production 189

Studying social norms and the greening of the world 189

Understanding the mix of economic and non-economic variables in determining green production 190

Crime and Punishment 190

The calculating criminal 191

Addiction and criminal behavior 193

The role of identity and social networks in determining criminal behavior 193

Why most people don’t commit crimes even when crime pays 194

Chapter 11: Labor Supply in the Real World 197

An Introduction to Labor Supply 197

Decoding the reality of labor supply 197

Mapping out changes to labor supply 198

Uncovering what people do when they aren’t working 201

Labor Supply When People Prefer Leisure: The Conventional Economics Perspective 202

The income-leisure trade-off: Bribing people to work 203

Why economics predicts that more income reduces labor supply: Work as an inferior good 206

How to increase the labor supply when people dislike work: Using the big stick 207

How Economic Necessity, Norms, and Love of Work Determine Labor Supply 207

How target income affects labor supply 208

Why increasing income doesn’t reduce labor supply 209

Labor supply when market employment isa superior good 210

Social welfare programs and labor supply 210

Norms, anchors, default retirement age, and labor supply 213

Chapter 12: The Black Box of the Firm: Human Relationships and Productivity 215

Survival of the Fittest, the Firm, and Contemporary Economic Theory 216

Doing the best we can: From slave to free labor to the big boss 216

Determining industrial relations through market forces 217

Maximizing profits and minimizing costs in the calculating firm 218

Understanding why the behavioral firm wins out 221

When People Don’t Behave According to Conventional Economics: X-Inefficiency 221

Types of x-inefficiency 221

When product markets aren’t competitive enough 222

Increasing inefficiency, managerial slack, and the art of lobbying 223

Preferences, managerial slack, and x-inefficiency 223

How low wages produce x-inefficiency and high wages contribute to x-efficiency 224

Efficiency wages: Connecting wages, effort, and productivity 226

Exploring fairness and gift exchange inside the firm 227

Understanding the relationship between conventional, x-efficiency, and efficiency wage theories 227

Chapter 13: The Good Economy: How Ethical Behavior Can Grow the Economy 229

Ethical Behavior: An Introduction 229

The Conventional Perspective on Ethical Behavior and the Economy 231

The Good Company 233

The Compatibility between Ethics and Profits 236

Examining x-efficiency and the socially responsible firm 236

How ethical consumers sustain and grow ethical production 239

Chapter 14: Why Institutions Matter 243

What Behavioral Economics Has to Say about Institutions 244

The decision-making context 245

The theory of the firm 245

The New Institutional Economics 246

Institutions and Wealth Creation 250

Governance 251

Culture 255

Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 257

Chapter 15: Deciphering Behavioral Finance 259

What Behavioral Finance is259

The Efficient Asset Market Models and Their Limits 260

The efficient market hypothesis 261

The random walk hypothesis 262

Irrational Exuberance: Smells Like Animal Spirit 264

Bubbles and Busts: A Preface to Inefficient Markets 266

The Dutch tulip bulb bubble 266

Contemporary bubbles: Evidence of inefficient markets 268

The causes of financial bubbles 271

Chapter 16: Looking into Recessions and Depressions 275

Introducing Psychology in Business Cycle Narratives 276

Grasping the meaning of macroeconomics, recessions, and depressions 276

Understanding animal spirits 279

Deconstructing business cycles: The tango between psychology and “real” factors 284

Economic Psychology and Government Policy 285

How Fairness, Reciprocity, and Punishment Influence Wages, Effort, and the Business Cycle 286

How efficiency wages cause sticky wages and involuntary unemployment 287

Why businesspeople don’t like to cut wages over the business cycle 287

Insights on money illusion: Tricking workers into cutting their wages 288

Why high wages don’t necessarily cause higher unemployment 289

How unemployment undermines confidence and destroys productivity 289

Chapter 17: The Art and Science of Happiness: Can You Be Happy without More Money? 291

Happiness and Conventional Economics 291

How happiness ismeasured 292

The art of being happy 292

Why conventional economics assumes that money makes you happy 294

Diminishing returns for income and wealth 295

What increasing per-capita income ignores 295

Happiness and Behavioral Economics 296

What makes us happy: The individual versus the expert 297

Why money alone can’t make you happy (at least if you’re well off) 298

The new empirics of the happiness debate 301

What money can’t buy (at least not easily) 303

How Government Policy Affects Happiness 306

Part V: The Part of Tens 309

Chapter 18: Ten (Or So) Key Public Policy Implications of Behavioral Economics 311

Consumer Rights and Protection and the Framing of Information 312

Product Labeling and Consumer Choice 312

Financial Markets and Information Deceit 313

Saving for the Future 313

Organ Donations 314

Weakness of Will and Self-Control 315

Labor Market Regulation and Economic Efficiency 316

Big Brother and Behavioral Economics: Does Government Know Best? 316

Crime, Punishment, and Identity 317

Population Growth and the Empowerment of Women 318

Tax Compliance: The Carrot isas Important as the Stick 319

Trust and Economic Efficiency in an Imperfect World 319

Chapter 19: Ten (Or So) Experiments in Behavioral Economics 321

The Ultimatum Game: Fairness and Punishment 321

The Dictator Game: Being Fair Because It’s the Right Thing to Do 323

Fair Wage Experiments: Adventures into Labor Market Dynamics 324

Public Goods Games: Sacrificing for the Public Good 325

The Dark Side of Humanity: It Isn’t All about Lovingkindness 327

The Endowment Effect: How Ownership Affects Behavior 327

Market Games: Markets Work Even When They’re “Irrational” 329

Bubble Experiments: How Smart People Produce Economic Bubbles 330

Experiments on Bounded Rationality 331

Chapter 20: Ten Decision-Making Lessons from Behavioral Economics 333

Be Wary of Overconfidence 333

You Can’t Believe Everything You Read 334

Avoid Situations That Require More Self-Control Than You Can Muster 335

Don’t Blindly Follow the Herd 336

You Can’t Trust Everyone 336

Invest Simply 337

Pay Attention to Sample Size 337

Read the Fine Print 338

Being Nice Pays 338

Educate Yourself 339

Index 341