I Lecture Introduction Standard economic theory predicts behavior based upon rational choices. A simple definition of a rational choice might be: a choice calculated to maximize the well-being (utility) of the individual. As a model of behavior, this is appealing. It seems reasonable that individuals would try to do the best they can for themselves. Suppose I wish to predict behavior in some situation using rational choice theory. I would need to know: the distribution of payoffs resulting from each possible action. I could then determine which action would result in the highest average payoff, and use this as a prediction. This is a simple way to predict actions, if I know everything. What does everything include? Suppose I am trying to predict the portfolio of stocks an individual would hold. I would need to know the risk and payoff of each possible stock, the enjoyment the individual would get from using their money for current consumption, the utility of money for future consumption, how long the individual expects to live, and the utility of bequeathing money to descendents. Beyond this, is it costless for the individual to determine the best portfolio for them? Certainly not. It takes time, effort and expense to arrive at a good decision. How does one model these costs? In the absence of good models of costs regarding learning, understanding and decision-making, models usually make simplifying assumptions like: perfect information, perfect learning, costless and perfect decision-making. These models require quite a lot of the individual. Even without these simplifying assumptions, rational choice may be very demanding. Lets examine this problem from the other perspective. Suppose I am an individual who wants to make good decisions. I need to:
1. Completely understand the distributions of payoffs from each possible action (as far as is optimal). 2. Know each possible action. 3. Have well formed and understood preferences. 4. Learn at an optimal rate (taking account of my costs of learning). 5. Not make mistakes Certainly this requires a lot also. Have you ever made mistakes? Ive graded students tests and homeworks before. While rational choice theory is a reasonable tool to use when the modeler and those being modeled can agree on payoffs, preferences and possible actions, there are many systematic and predictable behaviors that defy rational explanation. Have you ever done something you knew you would regret? Ever used a rule of thumb for a decision? The purpose of this course is twofold. First, you will need to manage or market to imperfect individuals. In this case it will be useful for you to understand individuals imperfections, and learn to use and manipulate them. Second, you are an imperfect individual, and also susceptible to deviations from rationality. Understanding your own tendencies toward mistakes, or misperceptions may help you to improve your own decisions. Your success will depend critically on your ability to make better decisions than the rest of the market. Several times in this course we will need to distinguish between different motives for modeling behavior. We may wish to model behavior as an accurate representation of how individuals thought processes and desires combine to lead to action. For lack of better terminology I will refer to this as the (social) scientists motive. A social scientist
will want a very accurate model of decision-making to allow them to predict the reaction of individuals to unprecedented changes in the system. On the other hand, one may wish to model behavior to understand how to manipulate the behavior in very specific ways. I will refer to this second motive as a manager s or marketer s motive. A manager will alter certain known parameters of a situation to improve the performance of individuals (maybe their own performance). A marketer will hope to manipulate the purchasing behavior of potential consumers. These motives require very different levels of abstraction (or detail and accuracy). Let us examine rational choice in the light of these two motives. Suppose we observe some behavior that does not fit with our current rational choice model. There may be several reasons for this. It could be that we have not accurately reflected the individuals preferences, information set, or consequences. If this is the case it may be possible to find another rational model that would explain the behavior. This may be a very difficult task, but it would allow us a better description of the motives behind behavior. Alternatively, if it is too difficult, or if no rational explanation exists, we could simply find a model of the deviation from what our rational model predicts. The new model may or may not have a basis in the individual s perceived motivation. This would tell us little to nothing of the underlying causes of the behavior, but might allow us to predict with greater accuracy what will happen in situations similar to those we have observed. Further, this method may be wholly unsatisfying to the scientist who wishes to have general models that allow for wide application and consistent explanations. However, this new method is perfect for the manager who knows the few parameters within her control and wishes solely to predict behavior within a very specific setting.
This is the motivation behind what is called decision theory (or behavioral theory). The goal of decision theory is a description of behavior, and the rationale for the behavior. While the behavior might not be rational, we may find a procedurally rational model explaining the behavior, a description of the factors that are leading away from a rational decision. Decision theory recognizes that individuals are not completely rational. As such, a decision theoretic model does not tell us what we ought to do, but attempts to predict what we will do. Decision theory most often uses a rational choice model as a point of departure. Hence, the model describes somewhat the difference between what a rational individual would do, and what a real individual would do. Typically, we try first to explain behavior using rational choice theory. This will often be the best explanation, as people very often do something very close to what is best for them. If we cannot find a good rational explanation for a behavior we observe repeatedly, may we have discovered a behavioral anomaly. At that point we will try to find decision-theoretic explanations for why individuals cannot, or choose not to, behave as a rational choice model says they should. Behavioral economics seeks to use decision-theoretic models to predict behavior that has otherwise eluded economic explanation. Richard Thaler (formerly of Cornell) was instrumental in developing behavioral economics as a line of inquiry. Throughout this course we will present students with experimental situations designed to reveal anomalies within their own behavior. We will be playing for money (your money). Because anomalous behavior by definition leads to lower payoffs, you will have direct incentives to improve your behavior and learn to make better decisions. Why do we use these experiments? It is much cheaper to learn lessons in an experimental setting than in the real world. Lecture time will be used to examine class performance in
experiments, and to discuss anomalies and the models that try to explain them. The true value of the class, however, is in learning to apply the concepts to real decisions and the behavior of individuals in the marketplace. We hope you will learn how not to be a sucker. For example, imagine you were very pressed for time and needed both a new car and a new TV. Both of the things that you want are on sale today and you have only enough time to drive across town and buy one of them. Both of the sales end today, and thus these are the best prices available in the near future. The car is advertised at 10% off the normal price and the TV is advertised at 50% off the normal price. Most people when faced with this quandary in experimental settings reply, 50% off that s better than 10%, I m going to go get the TV, what a deal!! What s wrong with that? A discount of 10% on a cheap car is close to $2,000.00, while 50% off an expensive TV these days is not likely to save you more than $500.00. This suggests that individuals can be mislead in a very simple way using percentages. What are the implications in the marketplace? Have you ever seen automobiles advertised at some percentage off? Never. Every person in marketing knows this, they don t want people to think about percentages when the price is relatively large. Instead, they want to express the savings in dollars. Lower cost items will most often have discounts expressed in percentage terms. (This is usually not the case for coupons. Know why?) This brings up the question of ethics. It seems perfectly reasonable for you to understand your own tendencies to make mistakes in judgment, and to learn to correct them. It is quite another thing for you to understand other people s errors and take advantage of them. Many of the ethical issues surrounding the use of these psychological
tricks we shall discuss are unexplored. But it is well known that many criminal ventures involve using psychological phenomenon to trick individuals. We will try to focus some of our discussion on ethical issues and the appropriate use of behavioral models. Review of the syllabus: Please read the syllabus! The course homepage at XXXXX will be your textbook for the course. I will post my lecture notes, any homeworks and other course materials on the web. You will find that I like to script my lectures, meaning my lecture notes will follow my presentation nearly word for word. The advantage of this is that I stay on track in lectures. The disadvantage is that if you don t understand my lecture, you are not likely to get any help from the lecture notes. Grading: three homeworks, a midterm and a final. I will talk a bit more about these as we move closer to them. These will consist mostly of essays based on the principles of the course. Essays are fun to grade. My advice: be short and concise, and only include things you are familiar with. If you reveal a misconception or a gap in your knowledge, I must lower your grade (no matter what else appears in the same essay). I list my office hours as XXXX. Please feel free to stop by if you have questions. Because of the nature of this course, I don t expect a rush of people. Don t be shy if you have questions or comments about my lecture style. Etc. A short note about me: this is my first time teaching this course. My background in behavioral economics is strong, but I have zero experience with experimental economics. This means: be patient with me during sections. We have made some revisions in the curriculum from last year. There were some experiments that either did not go well, or did not have great value. I have tried to inject some experiments
and material from my own expertise. Pray that the experiments work out! The topics that I expect to cover include:
In order to run the experiments, individuals require proper motivation. In other words, we need to pay you a reward for your actions. For this reason, we collect a $40 lab fee from each student. If this is a particular hardship for you please come see me. This money is given out as a reward during the experiments for good decisions. We have tried to design it so that you will win back $40 on average throughout the semester. Those of you who do well will win back something greater than $40. Those of you who do not do well will win back something less than $40. We will need to receive each of your payments prior to the beginning of the first lab. You will receive a receipt. I should mention that we are all imbeciles. All of us make errors in judgment. Many people will have different reactions to being put under the microscope (as we do in this course). Feel free to say what you think even if you are afraid of being wrong. We like it when you are wrong in this class. Because each of you knows ahead of time that we are trying to expose common errors, you may try to figure out how to avoid them, and be on your guard. For this reason, not all experiments may work out. Despite this, the real world has no warning signs when you are about to make mistakes. We will try to learn from the experiments even if the students happen to beat them. There are 3 possibilities for the lab on Thursdays, XXXXXXX. The lab will run an hour and fifteen minutes, it s just like a class session. I will need each of you to sign up for a lab session. We must have around 20 students in each session.