Managerial Economics

BEHAVIOURAL ECONOMICS

Introduction Exercise
You work for Department of Disease control and you need to keep Bihar safe.
There is a sudden and usually flu-like disease that breaks out.
Your best estimate is that 600 people will die from the disease if no government
action is taken.
You are given a choice between 2 programs to address the crisis:
Pick what you would do for each program. There are 2 possible responses to the crisis for
each program and each cost the same amount, but can only choose one due to resource
constraints.

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Introduction Exercise (Framing Effects)

Programme 1
Response A will save 200 people.

Programme 2
Response C 400 people will die for
certain.

Response B is risky. It has a one-third Response D there is a one-third

chance to save all 600 people but a
chance that no one will die and a twotwo-thirds chance to save no one.
third chance that everyone will die.
Which do you choose?

Which do you choose?

Experiment, 73% picked response A for program 1 while 78% choose response D for
program 2.
Why? Framing. By manipulating how alternatives were framed researchers could alter
choices dramatically.
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Anchoring Effects
A simple gambling game is two-up. Two coins are placed on a stick and then
tossed up in the air. You win a bet if the coins fall with either two heads or two
tails showing; otherwise you lose. Thus on each toss you win with chance
and lose with chance . Each toss is an independent event. Yet a player who
has just won is more likely to continue to bet than is a player who has just lost.
Anchoring effects are the effects on choices of seemingly irrelevant information.

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Increased Choice
Can you be worse off if the number of options for you to choose from is
increased?
The rational choice model says No.
How many options do you want on a restaurant menu? How hard do you want
to have to work at ordering a meal?

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Learning about Preferences

Have you ever tried a new food, or a new drink? Was it to learn more about
your preferences?
If a cocaine addict could go back in time to the moment when he first
experimented with cocaine but knew then what he now knows about the drug
and addiction, would he consume the drug?
The rational choice model says such experiments never occur because it
assumes that you already completely know your preferences. Hence, there is
nothing to learn.

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Uncertainty
The Law of Large Numbers says that the mean of a large sample drawn
randomly from a population is very likely to be very close to the mean of the
whole population.
Kahneman and Tverskys Law of Small Numbers says that an individuals
choices are overly influenced by the outcomes in a small sample, especially if
the sampling is personally experienced by the individual.

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Uncertainty
Why do people gamble at casinos when they know that casinos make large
profits because, on average, gamblers lose money?
Many people who buy a new appliance (e.g. a refrigerator or a TV) also buy
insurance against its failure in the early part of its life, even though the
probability of a failure is very low and the expected value of the insurance is far
less than its price.
The evidence is that people assign larger weights to very low probability events
than is consistent with the expected utility model of choice.

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Economic Basis
The workhouse of economic modeling is economic man or homoeconomicus, an agent who:
is infinitely self-interested,
infinitely capable of processing information
solving optimization problems, and
infinitely self-disciplined or
self-consistent when it comes to having the willpower to execute ones plans
whether those plans concern how much junk food to eat or how much to save
for retirement.

This approach has yielded fantastic insight, but

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Behavioural Economics
In contrast, it is,
bounded self-interest,
bounded information-processing capacity,
and bounded willpower.
Bounded self-interest enjoys widespread

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Behavioral Economics
Behavioral economics is concerned with systematic departures from
rational choice
Behavioral economists attempt to identify systematic biases
Departures from rational choice can inform the development of more general,
descriptive models of economic behavior
A decision maker with social preferences cares about the material or monetary
payoffs of others as well as his or her own, although the manner in which
concern for others payoffs is expressed can take a variety of forms.

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Systematic Biases
Some systematic departures from rational choice are:
Bias 1: Generosity and Selflessness (Altruism, Parent-Child, dividing $1?
$100? $1,000,000?)
Bias 2: Paying Attention to Sunk Costs (Sunk Cost Fallacy, Discount Tickets)
Bias 3: Overconfidence (men over women in decision making, Gym
memberships)
Bias 4: Self-Control Problems (New Year Resolution)
Bias 5: Falling Prey to Framing (introduction example)

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What it does?
It adds to the standard model of economics some reality about how
humans behave. In particular, it adds,
bounded rationality,
biases in interpreting information,
interdependent preferences,
emotions,
Learning,
.

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Thinking, Fast & Slow Human Judgment & Decision-Making

System 1 operates automatically and quickly, with little
or no effort and no sense of voluntary control
fast, intuitive and emotional
detecting that one object is more distant than another

System 2 allocates attention to the effortful mental

activities that demand it, including complex
computations
slower, more deliberative and logical
parking in a narrow space

Kahneman
Illustration by David Plunkert, via The New York Times

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