Chapter 17 NOTBEHAVIORAL FOR ECONOMICS SALE he entire book so far has adopted the per- correct decision might have been to buy insur- T spective of neoclassical economics.An ance. In cases involving uncertainty, our previous economic agent—whether a consumer, firm, or analysis assumed that agents maximize expected player in a soccer game for that matter—was payoffs. assumed to make fully rational decisions. To the One of the major areas of active research in best of the agent’s knowledge, these decisions economics recognizes that economic agents may maximized the agent’s payoffs (utility, profit, or not behave as perfectly rational, calculating goal scoring in different instances). This is not to machines who maximize payoffs or expected say that we always assumed agents had perfect payoffs. They may sometimes make mistakes in information about the economic environment. A their calculations. They may have other psycho- homeowner who could foresee that his or her logical biases that may lead them to make deci- house would not suffer fire, flood, or other sions that do not maximize their payoffs (at least damage could have saved money by not purchas- if measured by monetary payoffs). This new ing homeowners’ insurance, but not knowing in area of research is called behavioral economics advance whether an accident would occur, the because, rather than taking fully rational beha- 613 614 PART SEVEN Input Market Neoclassical economics vior for granted, it tries to measure how rational behavior actually is and why it falls Assumes fully rational short of full rationality when it does. This branch of research seeks to integrate the maximizing behavior. insights and methods of psychology into economics. Two of the pioneers in this area of economics, Daniel Kahneman and Amos Tversky, were in fact psychologists Behavioral economics by training, although the economics profession claimed them as their own with the Study of economic 1 behavior that departs awarding of the Nobel prize in economics in 2002. This chapter will provide an from full rationality. introduction to the work of Kahneman, Tversky, and other contributors to this young but exploding area of research. SHOULD WE ABANDON NEOCLASSICAL ECONOMICS? There is obvious appeal in seeking to understand how agents actually make decisions instead of assuming decisions are made in some idealized, perfectly rational way. Should we abandon the neoclassical economics entirely in favor of a behavioral perspective? Have we then wasted the past 16 chapters studying the rational model? We better have good answers to those questions, and the answers better be ‘‘no’’! First, neoclassical models, whether applied to consumers, firms, or soccer players, have provided adequate predictions of behavior, certainly better than no model at all. Of course, these models could always stand to be improved by the addition of realistic psychological elements. In the meantime, as these models are improved and integrated in the standard ones, the standard models will continue to be of value. Second, idealized rational behavior may provide a benchmark toward which actual decisions tend as the decision maker experiments over time with different decisions and learns more about the economic environment. The neoclassical model may fare poorly as a predictor of instinctive decisions made in unfamiliar NOTsurroundings FOR but may perform better asSALE a predictor of long-run behavior by experienced agents. Market forces may put some discipline on mistakes made by firms: those that make too many mistakes or are run by managers suffering from severe biases may go out of business after a while. However, it is a question for empirical research which models, neoclassical or behavioral, perform better and over which sort of time frame. Third, even if actual behavior falls short of the ideal in the long run, still the ideal of fully rational behavior can provide a standard against which we can compare actual behavior. It is hard to speak of a ‘‘bias’’ unless one has a standard of comparison. Fourth, the neoclassical model provides considerable discipline in modeling economic situations. Just as a test question might have a million wrong answers but just one right one, so there may be a million possible biases but just one way to act rationally. Rather than looking for a deep explanation for a particular behavior, the tendency might be to attribute the behavior to a bias that fits that particular circum- stance but cannot be generalized beyond. Of course, as behavioral economics 1Tversky died before receiving the Nobel prize. CHAPTER 17 Behavioral Economics 615 continues to mature, this disadvantage will continue to be reduced as the knowledge gained about the psychology of economic decisions continues to be consolidated into a few general propositions with predictive power across different settings. LIMITS TO HUMAN DECISION MAKING: AN OVERVIEW The general theme that connects the findings in behavioral economics is that the ability of humans to make payoff-maximizing decisions may be limited. These limits fall into three areas: • limited cognitive/calculating ability • limited willpower • limited self-interest.2 The rest of the chapter will be organized around this classification. To provide a preview of what will come, the first limit relates to complex decisions or decisions that require some calculations. Decisions involving uncer- tainty, for example, require the person to be able to work with probabilities and expected values. Decisions about investments may require the person to understand formulas for present discounted values. When a person learns new information, whether and how much a person should alter his or her decisions actually involves some complex math if it is to be done in any sense optimally. A perfect calculating machine could quickly perform the required calculations and make the right decisions. A real person may make mistakes in performing complex calculations or may avoid the calculations entirely and instead rely on an educated guess. We will study whether the resulting decisions tend to be right on average, involving only infrequent and random mistakes, or whether the decisions are consistently biased in certainNOT directions.. Will self-aware FOR people realize their potential SALE for mistakes and take steps to reduce problems arising from them? Will market forces tend to amplify or reduce the consequences of cognitive mistakes? We will then go on to study the second limitation: limits to human willpower. These limits are important for dynamic decisions, that is, decisions involving some sort of timing element where actions taken up front may have longer term implica- tions. For example, at the beginning of the week, a student may make plans for how much he or she will study for a test at the end of the week. When the time comes, the lure of television or video games may be too strong, and he or she may abandon the plans to study. After, the student may even regret having not studied. Such 2This classification of behavioral economics is due to R. Thaler and S. Mullainathan, ‘‘Behavioral Economics,’’ in N. Smelser and P. Baltes, eds., International Encyclopedia of Social Sciences (New York: Elsevier, 2001): 1094– 1100. Other useful surveys include one focusing on the application of behavioral economics to financial markets: N. Barberis and R. Thaler, ‘‘A Survey of Behavioral Finance,’’ in G. Constandinides, M. Harris, and R. Stulz, eds., Handbook of the Economics of Finance (New York: Elsevier, 2003): 1051–1121, one providing a general overview that highlights evidence from field experiments: S. DellaVigna, ‘‘Psychology and Economics: Evidence from the Field,’’ Journal of Economic Literature, forthcoming, April 2008 working paper version available at http://elsa.ber- keley.edu/~sdellavi/wp/pefieldevid08-08-07Longer.pdf, and one looking at biological bases for behavioral eco- nomics: C. Camerer, G. Loewenstein, and D. Prelec, ‘‘Neuroeconomics: How Neuroscience Can Inform Economics,’’ Journal of Economic Literature (March 2005): 9–64. 616 PART SEVEN Input Market self-control problems may arise in many contexts including diet, exercise, smoking, saving, and so forth. We present one model of self-control problems in which people weigh their well-being more when they are living in the moment than when they were planning ahead for it. Finally, we will turn to the third human limitation: limits to human self-interest. Humans may not just care about their own payoffs, income, or consumption; they may care about others as well. Certainly, this is not a completely foreign concept for standard economics to handle. Economists have long been modeling and studying altruistic behavior, for example, the sacrifices that a parent may make for a child or other family member or acts of charity. This simple form of altruism is fairly easy to capture in standard models. Others’ well-being may be just another good that a consumer can purchase along with hamburgers, televisions, etc. There are more complex interpersonal values that may be difficult for standard models to capture, and here is where behavioral economics comes in. People may care not just about the income or consumption levels that they and others end up with. They may get direct utility from broader social goals such as fairness and justice. Whether you want to be kind or nasty to someone else may not be predetermined but might depend on whether they were kind or nasty to you previously. We will try to integrate these interpersonal values into our model of decision making. These values matter most in strategic settings—the purview of game theory. We will see at the end of the chapter then how these broader concerns might lead us to modify the game-theoretic analysis from Chapter 5. LIMITED COGNITIVE POWER An old story tells of a queen who wanted to reward a hero for slaying a dragon. Reflecting her interest in puzzles, the queen offers him the choice of one of two prizes.