💰Psychology of Economic Decision-Making Unit 1 – Psychology of Economic Decisions

Key Concepts and Theories

• Bounded rationality recognizes humans have limited cognitive abilities and often make satisficing rather than optimizing decisions
• Prospect theory proposes people make decisions based on potential gains or losses relative to a reference point rather than absolute outcomes
  • Includes concepts of loss aversion (losses loom larger than gains) and diminishing sensitivity (marginal impact decreases further from the reference point)
• Mental accounting involves separating financial decisions into non-fungible mental budgets (rent, entertainment, savings) which can lead to irrational behavior
• Intertemporal choice examines how people make tradeoffs between costs and benefits occurring at different points in time (present bias, hyperbolic discounting)
• Heuristics are mental shortcuts or rules of thumb used to simplify complex decisions (availability, representativeness, anchoring and adjustment)
  • While often useful, heuristics can lead to systematic biases and suboptimal choices in certain contexts
• Dual-process theory distinguishes between fast, automatic, intuitive thinking (System 1) and slow, deliberate, rational thinking (System 2) in decision-making
• The endowment effect causes people to value items they own more highly than identical items they do not own due to loss aversion

Cognitive Biases in Economic Decisions

• Confirmation bias leads people to seek out, interpret, and recall information in a way that confirms their preexisting beliefs or hypotheses
• Anchoring bias occurs when individuals rely too heavily on an initial piece of information (the "anchor") when making decisions or estimates
  • Insufficient adjustment away from anchors can skew judgments and valuations
• Framing effects cause people to draw different conclusions from the same information depending on how it is presented (positive vs. negative, gain vs. loss)
• Overconfidence bias involves overestimating one's abilities, knowledge, or chances of success, leading to excessive risk-taking and poor planning
• Hindsight bias is the tendency to perceive past events as more predictable than they actually were and can distort evaluations of decision quality
• The sunk cost fallacy encourages throwing good money after bad by investing further in projects with unrecoverable past costs
• Herd behavior causes individuals to mimic the actions of a larger group, leading to speculative bubbles and suboptimal consensus
• Status quo bias favors maintaining the current state of affairs and can inhibit beneficial changes or reforms

Behavioral Economics Foundations

• Behavioral economics integrates insights from psychology, neuroscience, and sociology to understand economic decision-making
• Challenges the assumptions of perfect rationality, self-interest, and stable preferences in traditional economic models
• Focuses on how people actually behave rather than how they should behave according to normative theories
• Incorporates concepts such as bounded rationality, cognitive biases, emotions, and social influences into economic analysis
• Aims to develop more realistic and predictive models of individual and aggregate economic behavior
  • Prospect theory, mental accounting, and intertemporal choice are key behavioral economic theories
• Applies behavioral insights to improve public policy, business strategies, and personal finance (nudges, choice architecture)
• Complements rather than replaces traditional economic approaches by providing a more nuanced understanding of human behavior

Decision-Making Models

• Expected utility theory assumes people make choices to maximize their expected utility based on the probabilities and subjective values of outcomes
  • Relies on axioms of completeness, transitivity, independence, and continuity which are often violated in practice
• Prospect theory is a descriptive model that accounts for reference dependence, loss aversion, and probability weighting in decision-making under risk
  • Utility is defined over gains and losses relative to a reference point rather than final wealth states
• Bounded rationality models incorporate cognitive limitations and satisficing to explain deviations from perfect optimization
  • Includes concepts like aspiration levels, heuristics, and adaptive decision-making
• The Adaptive Toolbox proposes individuals use a repertoire of fast and frugal heuristics matched to specific decision environments
• Reason-Based Choice emphasizes the role of reasons, arguments, and justifications in shaping decisions beyond mere utility maximization
• Naturalistic Decision Making (NDM) examines how experts make decisions in real-world settings characterized by time pressure, uncertainty, and high stakes
• Multi-Attribute Utility Theory (MAUT) provides a framework for making trade-offs among multiple objectives or criteria in complex decisions
• Ecological Rationality investigates how heuristics can exploit the structure of information in natural environments to yield adaptive decisions

Psychological Factors Influencing Financial Choices

• Risk attitudes (risk aversion, risk neutrality, risk seeking) shape individuals' willingness to take financial risks
  • Can vary across domains (investing vs. insurance) and change with age, wealth, and life circumstances
• Time preferences (patience vs. impatience) determine how individuals trade off between short-term and long-term financial outcomes
  • Hyperbolic discounting can lead to inconsistent choices and self-control problems
• Emotions (fear, greed, regret) can override rational financial calculations and fuel boom-bust cycles
  • Emotional goals (avoiding regret, seeking pride) influence investment and spending decisions
• Personality traits (conscientiousness, extraversion, neuroticism) are associated with distinct financial behaviors and outcomes
• Social comparison and relative income concerns can drive excessive consumption, debt, and financial risk-taking
  • "Keeping up with the Joneses" effect
• Financial literacy and numeracy skills affect the quality of financial decisions and long-term economic well-being
• Self-control and delayed gratification are crucial for saving, budgeting, and resisting temptation
  • Strategies like mental accounting and commitment devices can boost self-control
• Trust in financial institutions, advisors, and the overall economy impacts individuals' willingness to participate in markets and take appropriate levels of risk

Real-World Applications and Case Studies

• Retirement savings: Automatic enrollment, default investment options, and Save More Tomorrow plans can harness inertia and status quo bias to increase participation and contributions
• Insurance: Extended warranties and low deductibles are often overpriced due to loss aversion and probability neglect
  • Framing coverage in terms of potential gains rather than losses can encourage better decisions
• Marketing: Scarcity appeals, anchoring with high initial prices, and framing as gains vs. losses are common persuasion tactics
  • Partitioning product features or breaking payments into smaller amounts can increase perceived value and purchase intentions
• Investing: Naive diversification (1/n rule), disposition effect (selling winners too soon, holding losers too long), and home bias are common investor mistakes
  • Encouraging longer-term perspectives, rebalancing, and objective criteria can improve outcomes
• Credit cards: Teaser rates, minimum payments, and cash-back rewards can exploit present bias and mental accounting to encourage overspending
  • Providing timely feedback, budgeting tools, and alternative payment mechanisms can reduce debt
• Organ donation: Opt-out (presumed consent) policies result in much higher donation rates than opt-in policies due to status quo bias
• Energy conservation: Providing social comparisons (how your energy use compares to neighbors) and timely feedback can significantly reduce consumption

Research Methods in Economic Psychology

• Experiments (lab, field, online) enable researchers to isolate causal effects by manipulating specific variables while controlling for others
  • Randomized controlled trials (RCTs) are the gold standard for causal inference
• Surveys and questionnaires can measure attitudes, beliefs, preferences, and self-reported behaviors in large samples
  • Potential issues include response biases, demand characteristics, and hypothetical scenarios
• Observational studies analyze real-world data to identify correlations and patterns in economic behavior
  • Cannot definitively establish causality due to potential confounding variables and endogeneity
• Neuroimaging techniques (fMRI, EEG) can reveal the neural mechanisms underlying economic decision-making
  • Neuroeconomics combines neuroscience, psychology, and economics to study the biological basis of economic behavior
• Computational modeling can formalize theories, generate predictions, and fit models to empirical data
  • Includes agent-based models, decision trees, and machine learning algorithms
• Big data analytics leverage large-scale datasets (social media, online transactions, smartphone sensors) to uncover behavioral insights
  • Raises issues of privacy, consent, and generalizability
• Qualitative methods (interviews, focus groups, ethnography) provide rich, in-depth accounts of individuals' financial experiences, motivations, and challenges
  • Useful for exploratory research, hypothesis generation, and understanding cultural contexts

Ethical Considerations and Implications

• Autonomy: Behavioral interventions (nudges, defaults) can be seen as paternalistic and infringing on individual freedom of choice
  • Transparency and the ability to opt-out are important safeguards
• Fairness: Some psychological tactics (framing, anchoring) can be used to manipulate or deceive consumers
  • Regulators need to ensure a level playing field and protect vulnerable populations
• Privacy: The collection and use of personal data for behavioral targeting raises concerns about surveillance, control, and consent
  • Clear data rights, governance frameworks, and security measures are essential
• Responsibility: Encouraging individuals to make better choices can obscure the role of structural and systemic factors in shaping economic outcomes
  • Need to balance individual agency with collective action and policy reforms
• Unintended consequences: Behavioral interventions can sometimes backfire or have negative spillover effects in other domains
  • Careful design, piloting, and evaluation are necessary before wide-scale implementation
• Reproducibility: Many behavioral economics findings have failed to replicate, raising questions about the robustness and generalizability of the field
  • Improving research practices (pre-registration, open data, larger samples) is crucial for scientific integrity
• Inclusivity: Behavioral research has historically focused on WEIRD (Western, Educated, Industrialized, Rich, Democratic) populations
  • Greater diversity in samples, researchers, and cultural perspectives is needed to ensure global relevance and impact