Basic Concepts

Basic Concepts

Basic Idea

The standard economic model of human behavior includes at least three unrealistic traits: unbounded rationality, unbounded will power, and unbounded selfishness. Behavioral Economics modifies these unrealistic traits.

• Depatures from unbounded rationality emerge both in judgments and in choice.
  • Judgment deals with the process people use to estimate probabilities.
  • Choice deals with the processes people use to select among actions, taking account of any relevant judgments they may have made.

Three Main Points

• Heuristics: People often make decisions based on approximate rules of thumb (trial and error), not strictly rational analyses. This deals with how judgments diverge from unbounded rationality.
• Framing: The way a problem or decision is presented to the decision maker will affect his action.
  • Ex. An example of a "positive frame" where people have the choice to choose the outcome of 600 citizens to an Asian Disease(A) saving 200 lives for sure or (B) a 1/3 chance of saving all 600 with a 2/3 chance of saving no one. Even though they both have the same risk, people tend to chose A over B.
• Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies. A condition in which current prices do not reflect all the publicly available information about a security, such as when some individuals get certain information before others, or when some individuals do not properly analyze the available information.

Behavioral Economics Theories

Prospect Theory

How people make choices under uncertainty. One needs to understand when indviduals faced with separate gambles treat them as separate gains and losses and when they treat them as one, pooling them to produce one gain or loss. This deals with how people make choice that diverge from unbounded rationality.

1. It is defined over change to wealth rather than levels of wealth to incorporate the concept of adaptation
2. The loss function is steeper than the gain function to incorporate the notion of "loss aversion"; the notion that people are more sensitive to descreases in their well being than to increases.
3. Both the gain and loss function display diminishing sensitvity (the gain function is concave, the loss function is convex) to reflect experimental findings.

Asymmetric Value Function

Behavioral Life-Cycle Theory

Savings Economics

1. People mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behaviour as the accounts are largely non-fungible and marginal propensity to consume out of each account is different. This is an example of both the heurstic mechanism and framing effects.

Rational efficient markets hypothesis

Finance Economics

1. Stock prices are "correct" in the sense that asset prices reflect the true or rational value of the security. (not tested because intrinsic values are not observable)
2. Unpredictability- in an efficient market it is not possible to predict future stock price movements based on publicly available information

Example

Two companies, Royal Dutch Petroleum and Shell Transport, merged together in 60:40 ratio. Royal Dutch trades mostly with US and Netherlands while Shell trades mostly with London. According to the rational model, they should trade 60:40.

Limits to arbitrage

1. The price of an asset may not equal its fundamental value – this represents a mispricing. However, this mispricing may persist for long periods of time because arbitraging it away may entail significant risks and costs

Example

Hedge funds do try to exploit this mispricing, buying the cheaper stock and shorting the more expensive one, but in the Summer of 1998, this was not the case. Hedge funds were trying to get more liquidity, the pricing disparity widened

The Methods of Behavioral Economics

• They define themselves, not on the basis of the research methods that they employ, but rather their application of psychological insights to economics. This is how they differ from experimental economics.

Heuristic Mechanism

• Availability Heuristic
  • people may judge the probabilities of future events based on how easy those events are to imagine or to retrieve from memory. This is where people base their prediction of an outcome on the vividness and emotional impact rather than on actual probability.
  • Example
  • After a news feature about a rape case, many women will be more nervous about going out alone at night. We have thus been primed by the news, increasing the accessibility of this information.
• Representativeness Heuristic
  • People tend to judge the probability of an event by finding a ‘comparable known’ event and assuming that the probabilities will be similar.
  • Law of Small Numbers
    • "Small samples are thought to represent the properties of the statistical process that generate them"
    • "Assuming that people mistakenly think a process generates draws from a hypothetical "urn", although draws are actually independent.

Behavioral Economics and Non-Random Walk Hypothesis

• Non-Random Walk Hypothesis
  • The people believe that there are trends and incremental changes in the prices and when looking at them, one can determine whether the stock is on the rise or fall.
  • Martin Weber observed the stock market for ten years. Over those ten years, he looked at the market prices and looked for any kind of trends. He found that stocks with high price increases in the first five years tended to become under-performers in the following five years.

This page designed by Lydia Gray

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Home Page | History of Behavioral Economics | Basic Concepts | Stock Markets | Gambling and Stocks | Gambler's fallacy and Law of Small Numbers |Hunting for Homo Sovieticus: Situational versus Attitudinal Factors | Criticism of Behavioral Economics | Behavioral Economics: Sources

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