Chapter 8 - Behavioral economics: A closer look at decision making. In this chapter you will learn: What time inconsistency is and how it accounts for procrastination and other problems with selfcontrol, why sunk costs should not be taken into account in deciding what to do next, what types of opportunity cost people often undervalue and why undervaluing them distorts decision making,...
Trang 1© 2014 by McGraw-Hill Education 1
Chapter 8
Behavioral Economics: A Closer Look at
Decision Making
What will you learn in this chapter?
• What time inconsistency is and how it accounts
for procrastination and other problems with
self-control
• Why sunk costs should not be taken into account
in deciding what to do next
• What types of opportunity cost people often
undervalue and why undervaluing them distorts
decision making
• What fungibility is and why it matters in financial
decision making
Scenario 1: When are sunk costs sunk?
• Suppose you buy a ticket to attend a concert
for $20 Upon arriving, your ticket is not in
your pocket How do you react?
1 “Oh well, I’ll just buy another ticket for $20.”
2 “No way, I’m not going to spend $40 on this
concert! I’d rather go do something else instead.”
54% of people indicated they would react like 1
46% of people indicated they would react like 2
Trang 2© 2014 by McGraw-Hill Education 4
Scenario 2: When are sunk costs sunk?
you are missing $20 How do you react?
1 “Oh well, I’ll just buy a ticket for $20.”
2 “You know what? Forget the concert.”
88% of people indicated they would react like 1
12% of people indicated they would react like 2
When are sunk costs sunk?
• Scenarios 1 and 2 are identical.
– You arrive at a concert intending to see a concert.
– You have $20 less than you expected.
• If you are short on cash, it makes sense to skip the
concert.
• If you are not short on cash, why does it matter if you
lost a $20 bill before or after you’d converted it into a
concert ticket?
– This is not rational behavior.
– Emotionally, however, it seems to matter for some.
• Behavioral economics studies why individuals appear to
act irrationally by studying insights from psychology.
Dealing with temptation and procrastination
• Individuals struggle against procrastination and
temptation.
• They do not complete the actions they had planned to do.
– Does this reveal preferences of valuing less the activities not
performed?
– Or, that they weren’t acting rationally?
• Individuals feel conflicted when they know they want to
do one thing, but find themselves constantly doing
another.
– Actions revealing true desires
• These desires may go against understanding of self.
– Labelling conflicts irrational is giving up and suggests an inability
to model and predict individuals’ decisions.
Trang 3© 2014 by McGraw-Hill Education 7
Dealing with temptation and procrastination
• The conflict between plans and actions can be
better understood using time inconsistency,
competing selves, and commitment
• One theory on why individuals give in to
temptation is that individuals can hold two
inconsistent sets of preferences:
1 What we would like to want in the future.
2 What we will want in the future, when the future
comes.
• When individuals change their minds about what
they want simply because of the timing of the
decision, they exhibit time inconsistency.
Active Learning: Time inconsistency
You have a test tomorrow If your friends are
going to the movies now, would you go with
them and study after the movie?
Time inconsistency
• Time inconsistency helps to explain behaviors like
procrastination and lack of self-control It is as if
there are two selves inhabiting our thoughts
– Future-oriented self: Clear-sighted preferences to get
things done.
– Present-oriented self: Backslides when faced with
alternative choices now.
• No matter how wise the decisions about the
future are that the future-oriented self makes,
when that future becomes the present, the
present-oriented self will be in charge again
Trang 4© 2014 by McGraw-Hill Education 10
Time inconsistency
• Individuals who are aware of their
time-inconsistent preferences often seek out ways
to remove temptation
• A commitment devicecan be used to help
fulfill a plan for future behavior that would
otherwise be difficult
– Increasing the cost of engaging in certain activities.
– Blocking that activity from your choice set.
© 2014 by McGraw-Hill Education 11
Active Learning: Time inconsistency
What commitment devices can be used to assure
that you will study when the movie ends?
Thinking irrationally about costs
• People weigh the trade-off between costs and
benefitsto arrive at a decision
– If the benefits of doing something are greater than the
opportunity cost, rational people are assumed to do it.
– If the benefits are smaller than the opportunity cost,
they won’t choose to do it.
• In reality, people don’t always weigh costs and
benefits rationally
– Failing to ignore sunk costs.
– Undervaluing opportunity costs.
• This erroneous decision making is an example of
cognitive bias
Trang 5© 2014 by McGraw-Hill Education 13
Sunk-cost fallacy
activity even though the benefit of continuing
is less than the opportunity cost, especially if a
cost was incurred to engage in the activity
– This is referred to as the sunk-cost fallacy.
• It is hard for individuals to accept losses
• Costs that cannot be recovered are irrelevant
to whether an individual should remain
engaged in the activity or select a new activity
© 2014 by McGraw-Hill Education 14
Active Learning: Sunk costs
Suppose you are almost failing a class but the
deadline to drop and receive a tuition refund has
passed
considered when deciding whether to drop the
class?
Undervaluing opportunity cost
alternative is not readily apparent
• This causes individuals to overvaluethe
benefits and undervaluethe opportunity cost
of the not selected alternative
• People tend to undervalueopportunity costs
when they are nonmonetary:
– Individuals’ time cost.
– Implicit cost of ownership: Overvaluing items that
are owned.
Trang 6© 2014 by McGraw-Hill Education 16
Forgetting about fungibility
• Many individuals commit to a specific purchase by
setting money aside for that purchase
– Using envelopes to mark money for certain purchases.
– Depositing money into separate bank accounts.
• Separating money into mental categories helps
individuals commit to buying what they thought
was right during categorization
• However, money is fungibleand thus can be easily
substituted between purchases
– May derail individuals from staying on their budget.
© 2014 by McGraw-Hill Education 17
Forgetting about fungibility
• Forgetting that money is fungible can lead
individuals to make poor choices
• For example, suppose that an individual has a
$2,000 credit card balance and $5,000 in the
bank
• Net wealth is identical whether the individual pays
off the balance or not:
– With balance: $5,000 - $2,000 = $3,000.
– Without balance: $3,000.
• However, the individual pays interest when
carrying a credit card balance, but doesn’t if the
balance is paid off
Forgetting about fungibility
• Forgetting that money is fungible can also
make individuals riskier
• For example, gamblers typically play riskier
once they win a sum of money
– Many think that they are “playing with the house’s
money,” even though it is their own.
Trang 7© 2014 by McGraw-Hill Education 19
Summary
• For many decisions, individuals act rationally
• For some decisions, it appears that individuals
are not acting in what is in their best interest
• Many of these irrationalities are due to pitfalls
in the way that humans think
help individuals avoid common
decision-making pitfalls