Behavioural economics

aje on February 24, 2020

Lecture handout: Behavioural economics*

Textbook Reading: Chapter 11

“A science that claims to interpret demand fails every time it explains consumer behaviour as irrational”

Douglas, M., and Isherwood, B., 1979, The World of Goods (1996, Routledge, p.xvi)

This session surveys the key findings of behavioural economics and explains how they relate to day-to-day management. Participants will receive a thorough understanding of how economic insights for decision making can be augmented with experimental economics.

After this lecture you should be able to: Apply a range of examples of behavioural anomalies to real business situations. Understand behavioural anomalies in light of an ecologically rational framework.

Here is an explanation of the Birthday Paradox. Notice that the probability calculation assumes a uniform distribution (i.e. that there’s a 1/365 chance of being born on any given day). In fact, birthdays in July, August and September are more common than other months.

This applet allows you to play multiple games of the Monty Hall problem. An article in the Smithsonian Magazine asks “When Did Girls Start Wearing Pink?”

Case: “Sun: A CEO’s Last Stand”, Business Week, July 26th 2004
Instructor Resource: A List of Behavioural Anomalies, March 2011
Activity: Complete this Sun Microsystems quiz

Here’s a nice poster of cognitive biases:

This is a nice illustration of the winner’s curse (h/t David Skarbek)

The UK government are so concerned with “excessive optimism” that they released guidance on how to mitigate it.

I used a pixelated image for an example of confirmation bias, and so I found it very interesting to see this example of bias contained within AI trained super resolution:

A nice example of attribution bias is provided in this article from The Economist, asking “what if executive memos were clear and honest?”:

We had a dreadful 2020. To be fair, nobody could have reasonably expected the executive team to predict a global pandemic which resulted in widespread economic shutdowns. But by the same token, if managers aren’t at least partly responsible during the bad times, they shouldn’t take full credit for the good times. Most executives are riding on the backs of central bankers who have slashed the cost of capital and on technology pioneers who have made it easier to transact and communicate… So, given that my fellow executives took bonuses in the boom years, we are slashing their salaries by half.

One of my favourite uses of behavioural economics is to reflect on the design of a menu when I am eating in a restaurant. This analysis by William Poundstone is truly fascinating. We should be very careful about believing too much of the highly disputed social priming literature, but framing effects are fun to think about. Apparently the second cheapest bottle of wine on a menu is actually good value for money, and here is an explanation of the decoy effect (note that this is different to the wine list example I use in class):

If you are familiar with the Amanda Knox case you should find this essay fascinating, where she identifies a wide range of behavioural biases that played a role in her wrongful conviction and ongoing reputational damage: “A Surprising Gift from my Wrongful Conviction“.

Although I take behavioural economics seriously, I don’t think it majorly restricts the usefulness Efficient Market Hypothesis:

The reason for this is (partly) explained in Vernon Smith’s Nobel prize address:

  • Smith, V. L. 2003, “Constructivist and Ecological Rationality in Economics†”. American Economic Review. 93 (3): 465–508

Further videos on the implication for stock picking are: “The psychology behind irrational decisions“, “Understanding Unconscious Bias” (Royal Society) and from Marginal Revolution University: “How expert are expert stock pickers?” (and subsequent videos such as “Can you beat the market?” “Investing: Why You Should Diversify” and “Who Is More Rational? You or the Market?“)

Recommended books:

  • Poundstone, William (2010) Priceless: The Hidden Psychology Of Value Oneworld
  • Kahneman, Daniel (2011) Thinking, Fast and Slow Farrar Straus and Giroux

Recommended articles:

    • Lambert, Craig “The Marketplace of Perceptions”, Harvard Magazine, March-April 2006 – A summary of chief insights from behavioural economics and neuroeconomics
    • Poundstone, W., (2011) “Prospect Theory” (Chapter 16) and “Ultimatum Game” (chapter 18) from Priceless: The Hidden Psychology of Value, One World – Good introductions to key concepts
    • Tabarrok, A., “A Phool and His Money” Review of PHISHING FOR PHOOLS: The Economics of Manipulation and Deception, by George A. Akerlof and Robert Shiller, Princeton University Press – A defence of standard economic theory against behavioural claims
    • Manne, H.G., (2005) “Insider trading: Hayek, virtual markets, and the dog that did not bark”, Journal of Corporation Law 31(1):167-185 – A defense of insider trading from the perspective of internal markets and corporate information flows
    • Smith, V. L. (2002) “Constructivist and Ecological Rationality in Economics” Nobel Prize Lecture – An explanation of the difference between constructivist and ecological rationality
Learning Objectives: Apply a range of examples of behavioural anomalies to real business situations. Understand behavioural anomalies in light of an ecologically rational framework.