Behavioral Economics and Game Theory
INTRODUCTION
Behavioral Economics
“At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve economics on its own terms -- generating theoretical insights, making better predictions of field phenomena, and suggesting better policy.” --Colin F. Camerer, Behavioral Economics: Past, Present, Future
Traditional economists adhere to Homo economicus and believe that all humans are rational actors who make decisions based on their own well being. Although this belief if convenient for economic modeling, there is evidence that suggests otherwise. Behavioral economics is a discipline which tries to understand and model human decision making through cognitive-psychology. This field is primarily concerned with the bounded rationality of economics agents, and why and how they make decisions. Although homo economicus serves as a coherent framework to model human behavior, behavioral economists argue that actual human behavior deviates from this rational model in predictable way and by incorporating these features into economic models, it would improve our ability to explain observed behavior. (Levitt and List)
Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. (Levitt and List)
Game Theory
Game theory is a tool that is used to address social and economic problems. It is the study of strategic interactions among rational players to produce outcomes with respect to the preferences or utilities of those players, which may not have been intended by any of them. In a game, several agents strive to maximize their own utility by choosing particular courses of action, and each agent's final utility payoffs depend on the profile of courses of action chosen by all agents. Economists use game theory to capture an abundance of economic phenomena in order to better understand how economic actors make decisions. It is usually highly mathematical and bases on introspection and guesses rather that careful observation of how people actually play the games. (Camerer)
The power of game theory is in its generality and mathematical precision and the same basic principles are used to analyze all game. Although there are clear examples of some of the most prominent games listed below, it can be applied to a variety of situations. (Camerer) For example, say you are walking on a beach in Mexico and you see a vendor selling handmade bracelets with your name on them. Let’s assume they are worth anywhere between $10- $20 to you, and the vendor knows how impatient most tourists are but isn’t sure how much you value the bracelets. Game theory can tell you exactly what price the vendor should start out at and how quickly he should cut the prices that when you haggle with him.
GAMES
The Ultimatum Game
Prisoner's Dilemma
Trust Game
Kevin McCabe and his colleagues we able to provide an incentive for cooperative behavior by using a binary choice version of the Trust Game, where subjects can earn more money if they cooperate, but cannot communicate except by transferring money to each other through choices. Subjects DM1 and DM2 made sequential choices for the dollar amounts. DM1 makes the first decision and can
