The Rise of Behavioral Economics

The Rise of Behavioral Economics
by: Amos Koh Khin Phong

Modern-day economics has been widely debated about and criticized because they lack the element of human psychology when it comes to decision making. Thus, Behavioral Economics partially solves this problem through the integration of economics and psychology, so that economists can analyze how people make decisions under uncertainty; not just through mathematical models, but with elements of psychology and empirical evidence as well.

 

In 2002, Daniel Kahneman won the Nobel Memorial Prize in Economics for his works in integrating psychology and economic sciences to analyze decision making. Earlier this year, Prof. Richard Thaler won the Nobel prize for his major contributions in the field of Behavioral Economics.

 

In my research, I have conducted experiments with the members in the SIM Economics Society (SIMES) in a classroom setting and the results show a relatively good amount of empirical evidence on the basis that humans do not necessarily make economically rational decisions, as opposed to conventional economic theory.

 

Russian Roulette
In the first experiment, I asked two questions adapted from the economist Richard Zeckhauser’s version [1] of the Russian Roulette experiment:

  1. In a gun with 100 chambers and 4 bullets, what is the maximum you are willing pay to remove a bullet (making it 3 bullets)?
  2. In a gun with 100 chambers and 4 bullets, how much is the minimum you would accept to add a bullet (making it 5 bullets)?

 

The responses I received to the second question were much more interesting. After posting that question, all the subjects had the same question in mind: “What is the maximum I can get?” After stating that it was up to their imagination, I received many responses that stated that they wanted the maximum possible compensation.

 

There were several ways to make these calculations. One could try discounting his/her lifetime earnings and decide how much their lives are worth at that point in time, taking into consideration the odds of a bullet being fired. Another way would be based on his/her current wealth. Whichever method that person used to calculate, one common answer would be that the value that he/she answers both questions with should be approximately equal.

 

In this case, the answers given were not even close to one another. The results I received on average was that for every $1 paid to remove the bullet, $38 must be paid to him/her to add another bullet. This translates to a 3,800% premium to accept an undesirable consequence!

 

Economically, it is rational to be only willing to accept and pay the same amount. But this is a case where we value our lives so much so that most of us would want the maximum payout to take the extra risk. However, when asked to pay for the same risk, we were not willing to pay as much. Thus, we can see that the value we place on the willingness to accept an unpleasant outcome is usually more than our value that we are willing to pay for a pleasant outcome.

 

The Ultimatum Game

I conducted another experiment called the “Ultimatum Game”, which has been adapted from a German economist, Werner Guth [2]. Players were chosen at random to play the roles of the proposer or the responder. The proposer is given $10, and he decides how to split this money with the responder. The proposer can split as he/she wishes, from offering none of the money to even possibly offering all the money. The responder then decides whether to accept or reject the offer. If the offer is accepted, then they get their proposed share of the money. However, if the offer is rejected, both the proposer and responder gets nothing. They filled in a form as shown:

 

The results of the game conducted were as such: the maximum amount the proposers were willing to offer, on average, was $5 and the minimum amount the responders were willing to accept on average, was $3.50.

 

If players were economically rational, then the responders should have accepted any amount more than zero and proposers should give away a minimal amount for both parties to be better off. Hence, the results show our consideration of fairness when it comes to decision making.

 

After the game, I talked to some of the responders to understand why they would not accept the smallest possible amount. The common answer I got was that most of them felt that they deserved at least close to half ($5), because without them accepting the offer, the proposers would get none of it. On the other hand, the proposers felt the same way since they would not get anything if the responder rejected the offer. Thus, they were willing to offer close to half, to be fair to them.

 

Conclusion
Behavioral Economics is a relatively new field of study. However, it’s applications can have a significant impact on the analysis of decision making. In my opinion, decision making in economic theory is logical, and will prove to be asymptotically right; but one aspect that some economists did not take enough into their consideration was the psychological constraint of decision making into their models. Hence behavioral economists have conducted numerous experiments over the years to show empirical evidence that we indeed do not necessarily make economically rational decisions, and our own psychology and emotions justify these decisions as the best responses under uncertainty.

 

Professor Thaler is not just someone who proved that humans do not always make rational decisions [3], but instead what he and the other pioneers of behavioral economists have done is to give us a new perspective on the we look at how we make decisions under uncertainty; not just the mathematical aspects, but the psychological aspects as well.

 

References:

  1. R. Zeckhauser et al. 2009: “Virgin VS Experienced Risks” Discussion paper, Page 7, Para 2 Available at: https://heep.hks.harvard.edu/files/heep/files/dp4_zeckhauser-kousky-pratt.pdf
  2. W. Guth et al. 1998: Journal of Mathematical Psychology, Volume 42, Issues 2-3: Pages 227-247 Available at: http://www.sciencedirect.com/science/article/pii/S0022249698912123
  3. R. Thaler, 2015: Misbehaving: The Makings of Behavioral Economics: Page 9 “We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses.”