Basic Concepts
From Dickinson College Wiki
Basic Concepts
Basic Idea
- 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.
- It is defined over change to wealth rather than levels of wealth to incorporate the concept of adaptation
- 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.
- 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
- 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
- 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)
- 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
- 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"
- 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."
