Basic Concepts

Basic Concepts

Probability Judgment

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."