Behavioral Economics For Dummies

Morris Altman, PhD, is a professor of behavioral economics at Victoria University of Wellington in New Zealand and a professor of economics at the University of Saskatchewan in Canada. He is on the board of the Society for the Advancement of Behavioral Economics and is a former president of that organization. He also edited the Handbook of Contemporary Behavioral Economics.

• Introduction 1About This Book 1Conventions Used in This Book 2What You’re Not to Read 2Foolish Assumptions 3How This Book isOrganized 3Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 4Part II: Understanding Choice 4Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 4Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 5Part V: The Part of Tens 5Icons Used in This Book 6Where to Go from Here 6Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 7Chapter 1: Decoding Behavioral Economics 9Making Wise Assumptions 9Why reality matters 10Why incentives matter — even in behavioral economics 10Making Sense of Choice 11Maximizing versus satisficing 11The effect of emotions 12The avoidance of loss 12How options are framed 12Paternalism versus free choice 13The role of social context in decision making 14Relative positioning 14Growing the Economic Pie 15Deciphering Bubbles and Busts 15Inefficient markets and investment behavior 16Emotions, intuition, animal spirits, and business cycles 16Understanding Happiness: Money Isn’t Everything 17Chapter 2: Getting Real about Assumptions 19Defining an Economic Model 20Explaining economic phenomena 21Making simplifying assumptions 21Discovering the irrelevance of facts 22Understanding the role of math in model building 23Considering cause and effect 26Watching out for spurious correlations 26Contemplating Conventional Economic Assumptions and Real-World Alternatives 27Conventional assumption #1: People’s preferences are stable and consistent 27Conventional assumption #2: People are solitary decision makers 28Conventional assumption #3: How people form preferences doesn’t matter 28Conventional assumption #4: People have the same preferences 29Conventional assumption #5: People are all maximizers 30Conventional assumption #6: People have perfect knowledge 32Conventional assumption #7: People have unbounded computational capabilities 33Conventional assumption #8: People have willpower 34Conventional assumption #9: People are capable of acting upon their preferences 35Understanding Rational Economic Behavior 36You can do no wrong: Errors and biases in decision making 37Selfishness and the smart society 38Getting to Know the Behavioral Economics Actor 39Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis 41Where Neuroeconomics Fits in the Behavioral EconomicsPerspective 43The Brain and Economics 45The evolution of the human brain 45The division of labor in the human brain 48The Emotional Brain 49Descartes’ error: The somatic marker hypothesis 49Phineas Gage and the social and emotional side of rational decision making 50How Emotions Affect Decision Making 53Fear and decision making 53Happiness and decision making 54The Limits of the Human Brain and Homo Economicus 54The brain isnot a calculating machine 55The brain isa scarce resource 55What Brain Sciences Confirm for the Behavioral Economist 57People prefer the present to the future 57People’s aversion to loss affects their decision making 58What people feel isn’t always what they experience 58People care about keeping up with — and beating —the Joneses 60People’s brains evolve over their lifetimes 61People value fairness 62People like to trust and be trusted 63Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything 65The Role of Economic Incentives for Economic Behavior 66Why money isall that matters in conventional economics 67Opportunity costs for Homo economicus 69Decision Making and Opportunity Costs 71Using up your mind: Bounded rationality 71Considering costs other than money: Psychological costs 72Reducing opportunity costs in the real world: Satisficing behavior 73Weighing the opportunity cost of altruism 75Supply and Demand and Behavioral Economics 75Introducing the bandwagon effect 76Investigating the snob effect 77Interjecting morals and ethics 78Introducing sociology to supply and demand 79Economic Psychology: How Thoughts and Feelings Impact Decisions 84Loss aversion: How framing, ownership, and control affect economic behavior 85How the fear of uncertainty influences decisions 85The warm glow: Why people sacrifice money for fairness or justice 87Forfeiting money for status 88Part II: Understanding Choice 89Chapter 5: Exploring the Limits to Free Choice 91Free Choice in Economic Decision Making 92What conventional economics says 92What behavioral economics says 93Revealed Preferences: When Choices Reveal Your Inner Self 94The narrative about preferences 95False preferences versus true preferences 96The limits of revealed preferences and free choice 98The Illusion of Free Choice 99Advertising and preference distortions 99Self-control and free choice 101Defaults as a determinant of choice 102Herding, the bandwagon effect, and free choice: Are followers irrational? 103Constraining Choice versus Freedom of Choice 104Information 104Education 105Consumer rights 105Chapter 6: Quick and Simple Heuristics and Real-World Decision Making 107A Bird’s-Eye View of Smart Decision Making in Conventional Economics 108Decision-making norms in conventional economics: The human calculating machine 109The optimizing decision-making machine in conventional economics 110Core conventional benchmarks for rational choice: To dream an impossible dream 111The limits of conventional rationality 112Rethinking Bounded Rationality and the Limits of the Mind 113Bounded rationality and satisficing: Rationality within reason 114The two blades of the decision-making scissors: Ecological rationality 114Prospect Theory: Describing Average Decision-Making Behavior 116Introducing prospect theory: Real-world decision making under uncertainty 117Thinking about prospect theory and conventional norms 118Exploring emotions as a hot bed of irrationality 118The fundamentals of prospect theory: Understanding the value function 119Unveiling Some Implications of Loss Aversion 122Loss aversion and the certainty effect 122Risk seeking in losses 123The endowment effect: Explaining attachment to possessions 124Uncovering Errors and Biases in Decision Making 125Overconfidence 125Herd behavior 125Confirmation bias 126Anchoring 126Generalizing 127Less isBest in Decision-Making: Fast and Frugal Heuristics 127Exploring the superiority of heuristics 128Understanding human rationality: New benchmarks built on human capabilities 130Chapter 7: How the Framing of Choices Affects Decision Making 131The Framing Effect 131Framing and the economic schools of thought 132The effect of framing on preferences and choices 133Appreciating the objective unimportance of frames: The errors and biases approach 133Understanding frames as heuristics 134Framing in Pictures: The Possibility of Cognitive Illusions 134Framing the Mona Lisa 135Distorting the line illusion 135Framing faces 136Framing automobiles: Surface beauty versus substance 137The letter illusion 138We’re All Framed: Framing and Decision Making 139Framing and loss aversion: The classic Asian disease experiment 140When money isn’t everything 142Saving a penny to lose a bundle: Framing prices through relative positioning 143Frames as Defaults: How Anchors Sway the Course of Decision Making 144Changing default options and choices 144Revisiting choice architecture 146Framing isimportant, but so are income and prices 147The Inescapable Frame and Rational Decision Making 148Understanding frames as an information-generating machine 148Repairing frames and rational decision making 148Introducing product labels into the framing arsenal 149Market Failure and the Framing Effect 149Chapter 8: How Norms, Peers, History, and Culture Influence Choice 153Making Decisions in a Bubble, the Conventional Economics Way 154Making decisions as if other people don’t matter 155Making decisions as if history doesn’t matter 155Making decisions as if society doesn’t matter 157Introducing Social Norms to Decision Making 157Looking at some norms 158Identifying how trust impacts economic development 161Seeing how discriminating norms can lead to a slow economy 162Studying the role of education in the formation of norms and the shaping of preferences 163The carrot and the stick: Exploring the enforcement of social norms 163Peer Pressure: Seeing How Peers Affect Decision Making 164How History and Culture Affect Choice 165Rooting choice in history 165Culture club: How culture affects the formation of preferences and choices 166Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis 167How Gender Affects Choice 167Not tonight, honey: Conventional choice theory 168Household bargaining power and women’s rights 169Understanding household choices when women have a voice 171Exploring population growth when women’s preferences count 172Understanding why women go on welfare even if they want to work 174Identifying why women are more risk averse than men 175Exploring women’s altruistic preferences 176Examining labor market discrimination 177The Role of Children in Economic Decision Making 179News Flash! Preferences Change with Age 179Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 181Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law 183Why Most People Pay Taxes: The Big Stick versus the Warm Glows 183How the big stick induces tax payments 184The niceness effect 185Social norms and taxes 186A sense of fairness and tax compliance 186Different Perspectives on Reducing Pollution 187Exploring the economics of pollution control 187Thinking about the green corporation 188Understanding the links between green consumption and green production 189Studying social norms and the greening of the world 189Understanding the mix of economic and non-economic variables in determining green production 190Crime and Punishment 190The calculating criminal 191Addiction and criminal behavior 193The role of identity and social networks in determining criminal behavior 193Why most people don’t commit crimes even when crime pays 194Chapter 11: Labor Supply in the Real World 197An Introduction to Labor Supply 197Decoding the reality of labor supply 197Mapping out changes to labor supply 198Uncovering what people do when they aren’t working 201Labor Supply When People Prefer Leisure: The Conventional Economics Perspective 202The income-leisure trade-off: Bribing people to work 203Why economics predicts that more income reduces labor supply: Work as an inferior good 206How to increase the labor supply when people dislike work: Using the big stick 207How Economic Necessity, Norms, and Love of Work Determine Labor Supply 207How target income affects labor supply 208Why increasing income doesn’t reduce labor supply 209Labor supply when market employment isa superior good 210Social welfare programs and labor supply 210Norms, anchors, default retirement age, and labor supply 213Chapter 12: The Black Box of the Firm: Human Relationships and Productivity 215Survival of the Fittest, the Firm, and Contemporary Economic Theory 216Doing the best we can: From slave to free labor to the big boss 216Determining industrial relations through market forces 217Maximizing profits and minimizing costs in the calculating firm 218Understanding why the behavioral firm wins out 221When People Don’t Behave According to Conventional Economics: X-Inefficiency 221Types of x-inefficiency 221When product markets aren’t competitive enough 222Increasing inefficiency, managerial slack, and the art of lobbying 223Preferences, managerial slack, and x-inefficiency 223How low wages produce x-inefficiency and high wages contribute to x-efficiency 224Efficiency wages: Connecting wages, effort, and productivity 226Exploring fairness and gift exchange inside the firm 227Understanding the relationship between conventional, x-efficiency, and efficiency wage theories 227Chapter 13: The Good Economy: How Ethical Behavior Can Grow the Economy 229Ethical Behavior: An Introduction 229The Conventional Perspective on Ethical Behavior and the Economy 231The Good Company 233The Compatibility between Ethics and Profits 236Examining x-efficiency and the socially responsible firm 236How ethical consumers sustain and grow ethical production 239Chapter 14: Why Institutions Matter 243What Behavioral Economics Has to Say about Institutions 244The decision-making context 245The theory of the firm 245The New Institutional Economics 246Institutions and Wealth Creation 250Governance 251Culture 255Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 257Chapter 15: Deciphering Behavioral Finance 259What Behavioral Finance is259The Efficient Asset Market Models and Their Limits 260The efficient market hypothesis 261The random walk hypothesis 262Irrational Exuberance: Smells Like Animal Spirit 264Bubbles and Busts: A Preface to Inefficient Markets 266The Dutch tulip bulb bubble 266Contemporary bubbles: Evidence of inefficient markets 268The causes of financial bubbles 271Chapter 16: Looking into Recessions and Depressions 275Introducing Psychology in Business Cycle Narratives 276Grasping the meaning of macroeconomics, recessions, and depressions 276Understanding animal spirits 279Deconstructing business cycles: The tango between psychology and “real” factors 284Economic Psychology and Government Policy 285How Fairness, Reciprocity, and Punishment Influence Wages, Effort, and the Business Cycle 286How efficiency wages cause sticky wages and involuntary unemployment 287Why businesspeople don’t like to cut wages over the business cycle 287Insights on money illusion: Tricking workers into cutting their wages 288Why high wages don’t necessarily cause higher unemployment 289How unemployment undermines confidence and destroys productivity 289Chapter 17: The Art and Science of Happiness: Can You Be Happy without More Money? 291Happiness and Conventional Economics 291How happiness ismeasured 292The art of being happy 292Why conventional economics assumes that money makes you happy 294Diminishing returns for income and wealth 295What increasing per-capita income ignores 295Happiness and Behavioral Economics 296What makes us happy: The individual versus the expert 297Why money alone can’t make you happy (at least if you’re well off) 298The new empirics of the happiness debate 301What money can’t buy (at least not easily) 303How Government Policy Affects Happiness 306Part V: The Part of Tens 309Chapter 18: Ten (Or So) Key Public Policy Implications of Behavioral Economics 311Consumer Rights and Protection and the Framing of Information 312Product Labeling and Consumer Choice 312Financial Markets and Information Deceit 313Saving for the Future 313Organ Donations 314Weakness of Will and Self-Control 315Labor Market Regulation and Economic Efficiency 316Big Brother and Behavioral Economics: Does Government Know Best? 316Crime, Punishment, and Identity 317Population Growth and the Empowerment of Women 318Tax Compliance: The Carrot isas Important as the Stick 319Trust and Economic Efficiency in an Imperfect World 319Chapter 19: Ten (Or So) Experiments in Behavioral Economics 321The Ultimatum Game: Fairness and Punishment 321The Dictator Game: Being Fair Because It’s the Right Thing to Do 323Fair Wage Experiments: Adventures into Labor Market Dynamics 324Public Goods Games: Sacrificing for the Public Good 325The Dark Side of Humanity: It Isn’t All about Lovingkindness 327The Endowment Effect: How Ownership Affects Behavior 327Market Games: Markets Work Even When They’re “Irrational” 329Bubble Experiments: How Smart People Produce Economic Bubbles 330Experiments on Bounded Rationality 331Chapter 20: Ten Decision-Making Lessons from Behavioral Economics 333Be Wary of Overconfidence 333You Can’t Believe Everything You Read 334Avoid Situations That Require More Self-Control Than You Can Muster 335Don’t Blindly Follow the Herd 336You Can’t Trust Everyone 336Invest Simply 337Pay Attention to Sample Size 337Read the Fine Print 338Being Nice Pays 338Educate Yourself 339Index 341