Basic Concepts

Basic Concepts

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.

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

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. Upredictability- in an efficient market it is not possible to predict future stock price movements based on publicly available information

Behavioral Life-Cycle Theory

Savings Economics

1. People have the temptation to spend more of their income now than in the future.

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

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.

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"
• Hindsight bias
  • "Because events which actually occurred are easier to imagine than counterfactual events that did not, people often overestimate the probability they previously attached to events which later happened"
• Curse of Knowledge bias
  • "people who know a lot find it hard to imagine how little others know
• Representativeness
  • "People judge conditional probabilities like P(hypothesis|data) or P(examples| class) by how well the data represents the hypothesis or the example represents the class.
  • 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.
• Barberis, Shleifer and Vishny model
  • "Earnings follow a random walk but investors believe, mistakenly, that earnings have positive momentum in some regimes and regress toward the mean in others. After one or two periods of good earnings, the market can't be confident that momentum exists and hence expects mean-reversion; but since earnings are really a random walk, the market is too pessimistic and is underaccting to good earnings news. After a long string of food earnings, however, the market believes momentum is building. Since it isn't, the market is too optimistic and overreacts."

---

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

---