Ch9. Behavioral Economics — Why Do People Act Irrationally?

The Assumption of Traditional Economics

Traditional economics assumes that humans are rational economic agents (Homo Economicus):

They process complete information
They always maximize their utility
They have consistent, stable preferences

But in reality, humans violate these assumptions constantly.

Behavioral Economics combines psychology and economics. It studies how people actually make decisions and explains phenomena that traditional economics cannot account for.

System 1 and System 2

Daniel Kahneman’s core distinction:

System 1 (Fast Thinking):

Automatic, fast, intuitive
Emotion-driven, effortless
Used for most everyday judgments
Prone to errors

System 2 (Slow Thinking):

Deliberate, slow, analytical
Requires effort and focused attention
Used for complex calculation and reasoning
Accurate but tiring

Key insight: Most human decisions are made by System 1. This is why systematic errors (biases) occur.

Heuristics and Biases

Heuristics: Mental shortcuts that simplify complex problems. Generally useful, but they create systematic errors in certain situations.

Representativeness Heuristic

Judging probability based on how closely a case resembles a typical category.

Classic example: “Linda is 31, single, outspoken, and very bright. She majored in philosophy. As a student she was deeply concerned with social justice. Which is more probable: Linda is (A) a bank teller, or (B) a bank teller who is active in the feminist movement?” → Most people choose B. But mathematically, A is always more probable (conjunction fallacy).

Availability Heuristic

Judging probability by how easily an event comes to mind.

Example: Plane crashes are covered extensively in the media. As a result, people feel flying is more dangerous than driving — but statistically, the opposite is true.

Anchoring and Adjustment

Over-relying on the first piece of information encountered.

Example: “Does the African continent make up more or less than 65% of the United Nations membership? What is your best estimate?” → Groups shown 65% first give significantly higher estimates than groups shown a lower number.

Prospect Theory

Introduced by Kahneman and Tversky in 1979. Kahneman received the Nobel Prize in Economics in 2002.

Loss Aversion

The pain of a loss is approximately twice as powerful as the pleasure of an equivalent gain.

Joy of gaining $100 < Pain of losing$ 100

Why this matters:

People avoid options with losses even when the expected value is identical
Stock investors hold losing positions too long (selling would make the loss “real”)
People devote more effort to preventing losses than to achieving equivalent gains

Properties of the Value Function

Reference point dependence: Feelings are based on changes relative to a baseline, not absolute levels
Diminishing sensitivity in gains: The jump from $1,000 to$ 10,000 feels less thrilling than from $100 to$ 1,000
Diminishing sensitivity in losses: As losses grow larger, additional pain diminishes
Asymmetry between gains and losses

The Certainty Effect

People prefer a certain small gain over a larger but uncertain gain, even when expected value favors the gamble.

100% chance of $300 vs. 80% chance of$ 450
Expected values: $300 vs.$ 360 — rational choice is the gamble
In practice: most people choose the certain $300

Status Quo Bias and the Default Effect

Status Quo Bias: The tendency to prefer the current state over change.

Loss aversion + the uncertainty of change → a powerful tendency to stick with the default option.

Empirical evidence on the default effect:

Country	Organ Donation System	Consent Rate
Germany	Opt-in (must register to donate)	~12%
Austria	Opt-out (must register to not donate)	~99%

The policy content is identical; changing only the default setting produces a dramatic difference in outcomes.

Nudge

Concept developed by Richard Thaler and Cass Sunstein. Thaler received the Nobel Prize in Economics in 2017.

Nudge: Changing the choice architecture — without removing options or using financial incentives — to steer people toward better decisions.

Libertarian Paternalism: Helping people make better choices without coercion.

Nudge examples:

Placing fruit at eye level and fries at the back in a cafeteria → healthier food choices increase
Automatic enrollment in a pension plan with automatic escalation of contributions → savings rates jump dramatically
Showing households their energy use versus their neighbors’ average → conservation behavior increases
Adding “X% of taxpayers have already paid on time” to tax notices → compliance rates rise

Time Inconsistency

Humans place excessive weight on immediate benefits relative to future benefits.

Hyperbolic Discounting: Future rewards are discounted more sharply as they get closer rather than at a constant exponential rate.

Example: “ $100 today vs.$ 110 tomorrow” — even though tomorrow’s offer is 10% higher, many people choose today. But “ $100 in one year vs.$ 110 in one year and one day” — most people are willing to wait.

Practical implications:

Deciding to go on a diet but not resisting today’s temptation
Choosing consumption over saving
Promising to change in the future, but deferring again when the future arrives

Behavioral Economics in Policy

Health:

Mandatory calorie labeling on food (improving availability of information)
Automatic scheduling of health checkups (setting a beneficial default)

Finance:

Automatic pension enrollment (opt-out design)
Showing total interest paid if only minimum payments are made on credit card statements

Environment:

Showing home energy use relative to neighbors (leveraging social norms)
Charging for plastic bags (exploiting status quo bias — behavior changes when the free default becomes costly)

Taxation:

Including social norm messages in tax reminder letters (“X% of your neighbors have already paid”)

Learning Checklist

Explain the difference between System 1 and System 2
Describe three major heuristics with examples
Explain loss aversion and the properties of the value function in Prospect Theory
Explain the default effect’s influence on behavior with an empirical example
Describe the principle of nudge policy and at least two applications

Key Concept Cards

The Phillips Curve ★★★★★ : Short run: inverse relationship (trade-off) between inflation and unemployment. Long run: vertical at the natural rate of unemployment → no trade-off between inflation and unemployment. Stagflation: simultaneous high unemployment and high inflation → shifts the Phillips Curve to the right.

Types of Unemployment ★★★★★ : Frictional: temporary, during job transitions. Structural: technological/industrial change (solution: retraining). Cyclical: insufficient demand during recessions. Natural rate of unemployment = frictional + structural (the unemployment rate at full employment).

Types and Causes of Inflation ★★★★ : Demand-pull inflation: excess aggregate demand → prices rise (AD shifts right). Cost-push inflation: rising supply-side costs (AS shifts left) → risk of stagflation. Hyperinflation: triggered by a sharp increase in money supply.

Practice Quiz

Q. Why is the long-run Phillips Curve vertical?

In the long run, expected inflation aligns with actual inflation, and unemployment returns to the natural rate. Raising inflation does not reduce long-run unemployment (monetary neutrality).

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