TRUƯỜNG ĐẠI HỌC KINH TẾ QUỐC DÂN

BEHAVIORAL FINANCE & ECONOMICS 1

(NEU)

Introduction to behavioral economics

Chapter 2 – Introduction to
Behavioural Economics
OBJECTIVES
1. To know the definition and the history of behavioral
economics
2. To understand about the necessity of behavioral
economics
3. Understand how and why behavioral economics is
different from standard approaches.
4. To analyse the debates and controversies on behavioral
economics
Content

2.1. Irrational behavior and incentives

2.2. What is behavioural economics?
2.3. The history and evolution
2.4. Debate and controversy
2.1. Irrational behavior and
incentives
Irrational behavior and incentives (1)
EV1=250
1. Which option do you prefer? EV2=.25*1000+.75*
• A) will definitely win $ 250, compared to
• B) There are 25% of the chance of winning USD 1,000 and 75% of
the opportunity?to lose anything?

2. What option do you prefer?

• C) It will definitely lose 750 USD, compared to
• D) There are 75% of the chance to lose 1000 USD and 25% of the
opportunity to lose anything?

3. You like the doctor informed:

• E) The surgery has 99% of the likelihood of success
• F) The surgery has 1% of the likelihood of failure
Irrational behavior and incentives (2)
4. Binh is a musical fan, likes to visit the art museum on holidays.
Growing up he likes to play chess with family members and friends. What
situation is more likely to occur?
G. Binh play trumpet in a symphony orchestra
H. Binh is a farmer

5. An is a person who likes to read, like philosophical sentences in good

movies in the story. Growing up, she likes to talk and philosophy with
family and friends. What situation is more likely to occur?
I: An is a writer
J: An is at home or do nothing
Taxi in NewYork
Reading:
1. Vì sao taxi New York thường sơn màu vàng? - VnExpress Du lịch
2. Tại sao Taxi màu vàng "thống trị đường phố" New York? - Đất nước và xe - Tập 3
([Link])
Roosevelt's photo to become Governor of
NewYork in 1928
Why is behavioral economics
Reality:
• Individuals may be risk loving people or risk adverse people
• Some people are willing to sell their items to a neighbor with lower or higher price
than that of strangers
• Ready to sacrifice in some cases
• Buy milk with high price or low price
• The same kind of beer, but when closed into two bottle or can can sell different
prices? Right or wrong

Reality:
• The decision maker does not absolutely rational (smoking, using the phone when
driving ...)
• Buyers and sellers make the transaction even they lack of perfect information
• There are always uncertainties in any decisions

mặt hàng phễu: giá thấp để thu hút khách hàng, sau đó khách hàng sẽ mua sp chính
Why is behavioral economics
Behavioral economics studies options of
decision makers in the reality that
affected by psychological factors.
 Features of behavioral economics
• People do not always act because of personal
interests; do not maximize benefits and minimize
costs with stable hobbies.
• Human thinking depends on people knowledge,
people feedback ability and their limited handling
ability.
• Many options are not the result of careful
consideration and influence of the decision -making
context.
some
in4 • People are influenced by information available in
come
up in ur memories, automatic effects created, and
brain outstanding information in the environment.
• People tend to resist the change; and are the poor
predictors. the decisions depend on ability to predict
• People are members of society, influenced by social
practices such as trust, fairness, sensitive to social
standards and the need to express ourselves.
Features of behavioral economics
Two systems that drive the way we think
System 1 is fast, intuitive, System 2 is slower, more
and emotional deliberative, and more logical
Fast Slower
trực giác Intuitive More deliberate
Emotional More logical
associative Liên tưởng Suy diễn deductive

tiềm thức Subconscious Self-awareness

Flexible Follow rules
What should we think…

1. When driving a motorbike to an intersection? only good when ure professional

2. Before the information that the incidence of cancer What should

in rural areas is higher than that of urban areas? we think?
Think Fast or
3. If there is information that the incidence of rural Slow
cancer is lower than urban areas?
What should we think…
1. If a scientist is very good at a certain field (such as
awarded the Nobel Prize for Medicine), it is often
assumed that the scientist also knows all other issues,
even though the scientist himself does not himself. Is it What should
True or False? we think?
Think Fast or
2. I suddenly remembered a comment of musician Duc Huy that Slow
the singer could start the song failed, but when the end of the
song was successfully described, the audience would see it as
a performance. Is it True or False
Two systems that drive the way we think

1. (A Cane+ a baseball)= 1,1 USD; A cane is

more expensive than a baseball by $1.
What is baseball’s price?

2. 5 machines produce 5 products in What should

5 minutes. So, 100 machines produce
100 products in how many minutes? we think?
Think Fast
3 Each day the number of lotus flowers
or Slow
doubled. It takes 48 days for the lotus
to cover the surface of the lake. How
many days need to cover the lake half
by the lotus?
Two systems that drive the way we think
base of slow thinking
In a series of psychological
experiments, Kahneman and
Tversky proves that we
people often come to the
decision to follow the faster
thinking mechanism than to
think slowly

Knowing how the two systems

work together to shape our
judgments and decisions.
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2.2. What is behavioural
economics?
 Behavioural economics
A subject that brings together economic insights about preferences and
decision-making with broader principles of behavior from a range of other
social, behavioral and biological sciences.
• relaxes economists’ standard assumptions to give models in which people decide
quickly
quy tắc bất thành văn

• often using simple rules of thumb rather than rigorously but robotically calculating
the monetary benefits and costs of their decisions.
• explores how quick thinking leads people into systematic mistakes but also explains
how people can learn from their mistakes.
• people look to others when making decisions and when seeking happiness.
 Behavioural economics
• Behavioral economics combines elements of economics and psychology to
understand how and why people behave the way they do in the real world.
• Behavioral economics examines the difference between what people “should” do
and what they “actually do” and the “consequences” of those actions.
• Behavioral economics is based on empirical observations of human behavior, which
has demonstrated that people do not always make what neoclassical economists
consider “rational” decisions. ” or “optimal,” even when they have the information
and tools available to do so.
 Behavioural economics
• People aren’t necessarily good at planning systematically for future events and
particularly when immediate pleasures have emotional influences.
 people will be sensitive to impulsive decision-making which may be not good for
their long-term welfare, for example smoking and eating unhealthy food.
 Behavioral economics enriches economic analyses of behavior – grounded
as it is in theories about preferences, incentives, decision-making and strategy – with
insights from psychology, sociology, cognitive neuroscience and evolutionary
biology
 Behavioural economics
Behavioral economics takes on this approach
to develop a more realistic view of how real
people make their economic decisions and
choices, starting by exploring the non-
monetary incentives and motivations that drive
our behaviour

Standard economic models describe

people as robotic, mathematical
machines, and so understanding and
controlling behavior can be seen as, in
many ways, more similar to an
engineering problem than a socio-
psychological problem
2.3. The history and evolution
of behavioural economics
The history and evolution of
behavioural economics
David Hume (1711–1776)
• Early analyses of economic psychology focused on the moral dimensions
of decision making.
• Psychological forces of benevolence and philanthropy can be justified if
there are market failures
• Benevolence does imply some sort of interdependence amongst people’s
utility, and this is something that standard economic analyses of
independent, atomistic agents cannot capture but it is a theme that has
received a lot of attention in modern behavioral economics.
The history and evolution of
behavioural economics
Adam Smith (1723–1790)
• Famous for his rhetorical justification of free markets and the accompanying metaphor of the Invisible
Hand of the price mechanism coordinating individual behaviour in socially beneficial directions.

• the impact that social emotions have on our choices – foreshadowing a number of areas in modern
behavioural economics, particularly models of social influence.

• The Theory of Moral Sentiments (1759):

o “How selfish so ever man may be supposed, there are evidently some principles in his nature, which
interest him in the fortune of others, and render their happiness necessary to him” (Smith 1759, p. 9).

o Emphasize he importance of sentiment in modern behavioural economics, with his emphasis on

social, unsocial and selfish passions – focusing on the importance of vividness in events in
determining how strongly we respond to them.

o Linking with modern analyses of bad habits and inconsistent plans he analyses self-deceit and the
impact of customs and fashions – which are also the focus in modern behavioural economics
analyses of social influences and group bias.
The history and evolution of
behavioural economics
Jeremy Bentham (1748–1832)
• The founder of utilitarianism.
o Analyse a range of behavioural and psychological drivers of human action, especially the
impacts of pleasures and pains.

o His conceptions of utility were focused on the balance of pain and pleasure and formed the
basis for the emphasis on utility in modern economic theory.

o If welfare, utility and happiness are quantifiable, then right and wrong can be measured by
reference to the greatest happiness principle: the greatest happiness for the greatest
number.
o Happiness to be objectively quantifiable and easily aggregated, implying that people’s
(personalized)
utilities are separable.
 The history and evolution of
behavioural economics
• Principle of psychological hedonism
o Aguide for legislators, focusing on the assumption that people maximize their own self-
interest.

o Pain and pleasure are the “sovereign masters” motivating what we do.

o Something is good if the pleasure outweighs the pain; it is evil if the pain outweighs the
pleasure.

o Legislators can formulate rewards and punishments to exploit this psychological hedonism
principle and thereby promote the greatest happiness principle.

o Emphasize the quantification of happiness and developed a hedonic calculus – a detailed

taxonomy ranking key features of pleasures and pains  parallels in today’s happiness
and well-being literatures.
The history and evolution of
behavioural economics
Vilfredo Pareto (1848–1923)
MC=MB: perfect competitive market, no DWL
 Famous for his mathematical rigour, Pareto efficiency and general equilibrium theory.

 Less well-known: social psychology later in his career, specifying the nature of social relationships,
foreshadowing modern behavioural analyses of social influence.

 Trattato di sociologia generale (1916; translated to “The Mind and Society” in 1935:

 Explore a range of behavioural/psychological influences and divergences between logical and non-logical
conduct, focusing on feeling, residues (instincts) divided up into classes to explain individual differences and
derivations (logical justifications) – paralleling the dual processing models seen in modern behavioural
economics.

 Recognize the importance of diversity in skills: in describing cyclical sociological forces, he explores how
intergroup conflicts mirror a struggle between foxes and lions  link to the idea in modern behavioural
economics that there are differences amongst people – a challenge to the conventional economist’s
assumption of homogeneity – that is that all people behave in the same way, on average at least
The history and evolution of behavioural
economics
Irving Fisher (1867–1947)
o Time preference is affected by individual
• Early analyses of investment and interest rates and the differences in foresight, self-control and
balance between impatience to spend and opportunities to willpower, and factors reflecting social
invest. susceptibility to fashions and fads – all ideas
developed in modern behavioural economics.
• The impatience principle:
o Fisher’s analysis of money illusion is another
o The rate of time preference, what modern economists
illustration of a way in which Fisher
call the discount rate, captures the fact that interest is the
foreshadowed modern behavioural
reward for postponing consumption
economics because it is a form of bias
o Balancing present versus future pleasures and rewards consistent in the analyses of Kahneman,
form the bedrock of modern analyses of inter-temporal Tversky and others.
decision-making
o Fisher’s explains sluggishness in the
o Subjective, psychological motivations are driving choices. adjustment of nominal interest rates in terms
of people’s confusion about the difference
o The “inner impatience” of consumers is balanced against between real and nominal values  links
“outer opportunities” for rewards from interest. with Akerlof and Shiller’s (2009) identification
of money illusion as one of the animal spirits
o Focus on “personal factors” as determinants of time constraining rational decision-making.
The history and evolution of behavioural
economics
John Maynard Keynes (1883–1946)
• The General Theory of Employment, Interest and Money:

o Economic and financial decision-making is driven by a series of fundamental psychological laws: the propensity to
consume, attitudes to liquidity and expectations of returns from investment.

o Psychologically analyzing the interactions between the players in financial markets and the macro economy.

o Short-term speculators, preoccupied by a thirst for liquidity, are driven by social influences and conventions
to “beat the gun” and “outwit the crowd”  speculation becomes similar to parlour games.

o Strongly emphasize the role of emotion and sentiment in economic decision-making

o A social view of economic progress requires a long-term view, longer-term outlooks cannot rest on strictly rational
grounds because in a world of uncertainty it is rational for profit-seekers to focus on the short term  emotionally-
based animal spirits of entrepreneurs that propel the far-sighted behaviours necessary to justify sufficient capital
accumulation for sustained economic growth.

o Economic behaviour is the outcome of a complex mixture of the rational and psychological/emotional  fits with
modern neuroeconomic models in which behaviour is the outcome of a complex interaction of emotion and cognition.
There are
further parallels:
The history and evolution of
behavioural economics
Joseph Schumpeter (1883–1950)
• Foreshadowing the modern emphasis in behavioural economics on the importance of social
influences in driving corporate behaviour.
• Entrepreneurship is driven by social forces but nonetheless is essential to the success of a
capitalist economy.
• Social influences drive not only the outward-facing publicity initiatives of businesses, they also
lead businesses to copy each other.
• An innovative entrepreneur will bring a new idea to the marketplace, and this will attract hordes
of imitators – or “imitative swarms” – each seeking to emulate industry leaders.
• As each new imitator joins an industry, the opportunities for new profits from new opportunities
will reduce as the swarm of imitators grows too large  the business cycle is driven by socio-
psychological influences.
•  groundbreaking but have only recently found their way into modern behavioural analyses of

business behaviour
The history and evolution of
behavioural economics
Friedrich von Hayek (1899–1992)

The Sensory Order (1952):

The nature of mind and distinguishes two “orders”: classify objects into the phenomenal and physical:
the subjective, sensory, perceptual order versus the objective, scientific order – what von Hayek
referred to as the “geographical” order.

 link with the focus in modern behavioural economics and neuroeconomics on interacting neural
systems, analyses the processing of stimuli and the biological aspects and characteristics of the
nervous system to construct a theory of mind in which the mental order mirrors the physical order
of events seen in the world around us.
The history and evolution of behavioural
economics
George Katona (1901–1981)
• Early work on economic psychology inspired some economists to return to psychological
analysis.
• Use ideas from cognitive psychology to analyse how individuals learn from groups
o Distinguish between different forms of learning
o Behaviour is not about understanding deeper processes and direct experience of problems
but instead is about relying on simple observation of others
to acquire information.
• Developing socio-psychological themes
o group forces and group motives are important, reflecting not only imitation and conscious
identification with a group but also group-centred goals and behaviour.
o Imitation and suggestion reinforce group situations and group coherence but are not
necessary conditions for being part of a group.
o Reference groups provide standards for behaviour and group-centred belonging and
motivation are more likely to be important in small groups.
o People prefer shortcuts and follow simplifying rules of thumb and routines, foreshadowing
the “fast and frugal heuristics
o Individual differences of opinion are ignored and similarities in small parts of information are
transmitted to large numbers of people.
 The history and evolution of
behavioural economics
Hyman Minsky (1919–1996)

• One of the pioneers in extending Keynes’s insights about sociopsychological forces in the
macroeconomy specifically into the impact of these influences on the financial system.

• More popular in the aftermath of the 2007/8 sub-prime mortgage crisis and the subsequent
global financial crises and recession
• Outline a powerful intuitive account of what might have contributed to this instability, and
particularly the role played by emotions and self-fulfilling prophecies: key elements in his
“financial fragility hypothesis” - how emotional influences destabilize financial structure.

• Boom phases are characterized by excessive optimism – leading to over-lending and over-
investment – creating pressure on financial systems and the macroeconomy.
 What’s new?
• Neo-classical economics:
o Focus on unrealistic behavioural assumptions about humans’ capacity for rationality.

o Theories are founded on mathematical principles  economics treats people as if they are
mathematical machines.

• Economic theories are analytical and relatively objective:

o Behavioural economics:

o Combine more realistic behavioural assumptions with some of the analytical rigour of
economic theory.
 What’s new?
• Standard neoclassical models:
o focus on a conception of people as Homo economicus
o economic actions are described as the outcome of mechanical data
processing.

• Extensions:
o recognizing the nature and implications of asymmetric information and other
forms of market failure,
o introducing Bayesian models to replace models of rationality based on
perfect information
 able to explain non-maximizing behaviour by allowing it to be constrained by
uncertainty and/or affected by strategic interactions between people and firms.

• Behavioural economics:
o another way to illuminate some of the deeper foundations of sub-optimal
 What’s new?
 Some would see behavioural economics as basically consistent with standard
neoclassical approaches, with some extra psychological variables embedded,
for example into utility functions, to increase realism, though at some cost in
terms of tractability
 Behavioural economics does draw on insights from many of the other “tribes”
of economic theorists:
o not all “non-behavioural” economists are neoclassical economists

o there are some particularly strong parallels between behavioural economics and
evolutionary economics, social economics, institutional economics and heterodox
economics.
 What’s new?
 Earl’s axiomatic foundations of psychological economics:

o emphasize the importance of perception and context; the social nature of behaviour; the
impacts of non-economic variables; and bounded rationality.
o include Herbert Simon’s concept of ‘satisficing’; attention biases occurring when attention
is not allocated optimally leading to inconsistencies; and heuristics and biases shaping
perceptions and judgments.

unify economics and psychology in psychological economics

economic psychology and psychological economics are different:
the former involves economists taking subjects traditionally in the psychologists’ preserve
such as addiction and altruism, and analyzing them using economic models and concepts

Psychological economics comes from the other direction and involves challenging standard
economic models by embedding insights from psychology to enhance understanding of
economic decision-making.
2.4. Debate and controversy
 Debate and controversy
1. Is it enough to assume people can be approximated by Homo
economicus, or do we need psychologically grounded assumptions?

 The methodology of positive economics advocated by Milton Friedman:

suggests things are not so obvious.
o Model and theory should be judged on its predictions and not its assumptions.
 Cognitive model or choice model?
o To a psychologist, the cognitive model is surely better.
o To an economist, the choice model is surely better.
 Behavioral economics needs to prove itself by coming up with good economic predictions,
and better predictions than that of the standard economic model.
 Debate and controversy
2. Should more emphasis be put on things that the standard economic
model does well or badly?
 Some behavioral economists prefer to emphasize the good, and some the bad

o distinction between assumptions and predictions

o people can also disagree on how to evaluate predictions

just compare a little bit, should use neo- one mainly

 Debate and controversy
3. What should we conclude if the standard economic model predicts well
only what
experienced people do?
 the standard economic model gives a poor prediction of what happens
the first time someone faces a particular situation, but a much better
prediction the fourth, fifth, sixth time they face the same situation.
 the discovered preference hypothesis: the standard economic model is a
good predictor if people have had ample opportunity to learn from
experience.
 situations in which no amount of experience helps the standard economic
model predict well.
 Debate and controversy
4. Should behavioral economics look to rewrite economics from a
psychological perspective, or adapt the standard economic model to
(extent)
take account of psychological insight?

o Behavioral economics is very much about working with the standard economic model,
whether it is a good predictor or not.
Daniel Kahneman (2003: 1449): ‘The rational agent model was our starting point and
the main source of our null hypotheses.’

o Colin Camerer and George Loewenstein (2004: 3): ‘At the core of behavioral economics
is the conviction that increasing the realism of the psychological underpinnings of
economic analysis will improve economics on its own terms.
 Summary
Behavioural economics is a wide discipline that draws on a range of other subjects from
the social and natural sciences – including psychology, sociology, neuroscience and
evolutionary biology.

• Whilst it has only recently developed a critical mass within economic theory and public policy-
making, behavioural economics draws on long traditions in economics – from Adam Smith and
Jeremy Bentham through to John Maynard Keynes, George Katona and Hyman Minsky.

• Behavioural economists rethink what economists usually assume about behaviour – not by
assuming that behaviour is irrational, but by providing a more realistic analysis of how real
people decide and choose, replacing the models associated with modern mainstream
economics, which assume that people decide as if they are mathematical maximizers.

• Behavioural economics draws on a wide range of insights from economics more generally –
including ideas about strategic decision-making from game theory, insights from theories of
learning and some themes from information economics and labour economics.