Lecture Economics - Chapter 8: Behavioral economics: A closer look at decision making

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,...

Chapter Behavioral Economics: A Closer Look at Decision Making © 2014 by McGraw-Hill Education What will you learn in this chapter? • 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 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 © 2014 by McGraw-Hill Education 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 you react? “Oh well, I’ll just buy another ticket for $20.” “No way, I’m not going to spend $40 on this concert! I’d rather go something else instead.” 54% of people indicated they would react like 46% of people indicated they would react like © 2014 by McGraw-Hill Education Scenario 2: When are sunk costs sunk? • Now suppose you arrive at the concert and you are missing $20 How you react? “Oh well, I’ll just buy a ticket for $20.” “You know what? Forget the concert.” 88% of people indicated they would react like 12% of people indicated they would react like © 2014 by McGraw-Hill Education When are sunk costs sunk? • Scenarios and 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 © 2014 by McGraw-Hill Education Dealing with temptation and procrastination • Individuals struggle against procrastination and temptation • They not complete the actions they had planned to – 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 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 © 2014 by McGraw-Hill Education 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: What we would like to want in the future 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 © 2014 by McGraw-Hill Education 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? â 2014 by McGraw-Hill Education Time inconsistency ã 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 © 2014 by McGraw-Hill Education Time inconsistency • Individuals who are aware of their timeinconsistent preferences often seek out ways to remove temptation • A commitment device can 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 10 Active Learning: Time inconsistency What commitment devices can be used to assure that you will study when the movie ends? © 2014 by McGraw-Hill Education 11 Thinking irrationally about costs • People weigh the trade-off between costs and benefits to arrive at a decision – If the benefits of doing something are greater than the opportunity cost, rational people are assumed to it – If the benefits are smaller than the opportunity cost, they won’t choose to 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 © 2014 by McGraw-Hill Education 12 Sunk-cost fallacy • Many times individuals remain engaged in an 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 13 Active Learning: Sunk costs Suppose you are almost failing a class but the deadline to drop and receive a tuition refund has passed • What factors should and should not be considered when deciding whether to drop the class? © 2014 by McGraw-Hill Education 14 Undervaluing opportunity cost • When making a decision, sometimes the alternative is not readily apparent • This causes individuals to overvalue the benefits and undervalue the opportunity cost of the not selected alternative • People tend to undervalue opportunity costs when they are nonmonetary: – Individuals’ time cost – Implicit cost of ownership: Overvaluing items that are owned © 2014 by McGraw-Hill Education 15 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 fungible and thus can be easily substituted between purchases – May derail individuals from staying on their budget © 2014 by McGraw-Hill Education 16 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 © 2014 by McGraw-Hill Education 17 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 â 2014 by McGraw-Hill Education 18 Summary ã 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 • Understanding these human tendencies can help individuals avoid common decisionmaking pitfalls © 2014 by McGraw-Hill Education 19 ... act irrationally by studying insights from psychology © 2014 by McGraw-Hill Education Dealing with temptation and procrastination • Individuals struggle against procrastination and temptation... up and suggests an inability to model and predict individuals’ decisions © 2014 by McGraw-Hill Education Dealing with temptation and procrastination • The conflict between plans and actions can... separate bank accounts • Separating money into mental categories helps individuals commit to buying what they thought was right during categorization • However, money is fungible and thus can