Behavioral Economics: Reunifying psychology and economics Colin Camerer Reading Notes

Economics- The science of how resources are allocated by individuals, and collective institutions. (firms and markets) individual behavioral psychology predicts and explains those behaviors and allocations. Standard Economic Model (SEM)- Grossly inconsistent with psychology. Assumption: All Else Constant. Behavioral Economics- Uses psychology to inform economics but with a mathematical structure unique to economics. ***Adam Smith, Theory of Moral Sentiments*** Theory to Economists- A body of mathematical rules and theorems Theory to Psychologists- A verbal construct or theme that organizes experimental regularity. Expression Divergence- The ways of expressing knowledge diverged and so split the early fields of psychology and mathematical-based economics. Economists and Legal Positivism (F-Twist after Milton Freedman)- Theories with false assumptions can make surprisingly accurate predictions. i.e. Those that assume that people are highly rational and willful, may judge probabilities accurately; those theories are proven false by psychology thought, people are not rational. The F-Twist relaxes rationality assumptions and allows economists to ignore psychology. 1970s- Cognitive psychologists study judgement and economic decision making. Taking maximizing utilities and logical rule of probability judgement as benchmarks and conformation or deviation from benchmarks used as a way to theorize cognitive mechanisms (like optical illusions and perception). Melding bounded rationality in terms familiar to economists.

One Goal of Behavioral Economics- To suggest mathematical alternatives with firm psychological foundations to rationality assumptions. Should be: As simple as possible, but no simpler-Einstein. Two Principles of Economic Behavior: 1.Expected Utility Theory (EU)- Assumes that people value risky gambles by weighing the utility of an outcome (x); by its probability (Pi), i Pi u(xi), where (u) is a function that measures the value of an outcome. (EU) assumes that if two gambles have a common probability of a common outcome, that outcome is canceled out when deciding among the two gambles. Theories assist pricing, purchases of insurance, corporate structure, and personal decisions like investments in education. 2.Behavioral Alternative to (EU)/Prospect Theory- i(Pi)u(xi-r). Incorporates psychology- People adapt to what they have experienced and weights probabilities nonlinearly. Adaption implies utilities are determined by gains and losses from some reference point (r), not overall wealth. Loss Aversion Studies- Losses disliked two times as much as gains equal in size are liked; people take risks when gambles involved only losses, at best break-even. Reflection Effect- People avoid risks when gambles all yield gains. Damage to the Environment- People ask two to ten times as much money to accept damage to the environment as they are willing to pay to clean up the same damage. (EU)- People weight possible outcome by its probability. Prospect Theory- People are assumed to weight a possible outcome by a decision weight, nonlinear. Overweighting- Explains the widespread desire to gamble on low probability events, i.e. lottery tickets. People tend to overweigh low probabilities. Exponential Discounting- Necessary for rational evaluation of future consequences. Future utilities u(xt) are discounted by a weight (t), and exponentially declining function of (t). Exponential discounting makes the strong prediction that the relative evaluation of two payments depends on only the amount of delay between the two payments. Hyperbolic Discounting- (t)- () reflects the preference for immediate rewards, () expresses the preference for rewards delayed (t) periods, relative to a delay (t+1) periods. Doesnt account for the desire to savor good outcomes by delaying them and the fact that people

prefer wage profiles that are ever-increasing. (e.g. people prefer $100 now over $110 in a week, but prefer $110 in 11 weeks over $100 in ten weeks) Social Utility, Reciprocation and Allocation Inequality- Mathematical theories of social utility assume people dislike allocations in which they can earn different amounts than others and/or people like to reciprocation. Learning by Reinforcement- People learn by reinforcing strategies that performed well or would have performed well had they been chosen. Experience Weighted Attraction Rule- two classes of learning rules: 1. Reinforcement Learning Rules- Studied by Psychologists. 2. Belief Learning Rules- Studied by Game Theorists. Economic Rules- Economists choose rational behavior principles/theories that are idealistic. Economic alternatives focus on how people should behave. Behavioral Rule Alternatives- focus on how people do behave and force economists to look at the psychological aspects. Utility Maximization- The assumption that people rank objects consistently enough to promote assignment of a unique utility number u(x) to object (x). Preference Construction- Utilities change depending on how the objects are described or on the way in which choices are made. Bayesian Probability Judgement- The order in which new information arrives should not affect judgement. Contrary to evidence- very old and very new information weighs heavier. Confirmation Bias- People see new information as more relevant or consistent with their beliefs than it really is. Heuristics- An alternative to Bayers Rule: Availability- easily retrievable information is overweighted. Representativeness- Hypothesis well represented by evidence are thought to be more likely. Resistance to Behavior Economics- Based on the fear that the psychological evidence is too fragmented to suggest formal alternatives to rationality. Policy Making- Rational people make fewer mistakes; relaxing rationality assumptions (a.k.a. Behavioral Economics) promotes reasoned argument about how people can be helped.

Cooling Off Policies- promote hot consumers to renege on purchases for a short time (e.g. three days) exemplifying conservative paternalism doing much good for people who act impulsively but little harm to those who do not.