Behavioral Economics:decision making& opportunities ?It is all aboutFree lunches !“Free Lunches”In Economics there is no free lunchStandard economic theory assumes that allagents (consumers and organizations alike) arerational agents working effectively to maximizetheir own welfare. Since all actors in themarketplace are assumed to be at a state ofmaximized returns, it follows that there are no“free lunches.”After all, the world is optimal at its current state“Free Lunches!”In Behavioral Economics there are are all kind ofinefficiencies, and thus many free lunchesThe emerging field of behavioral economicsroutinely demonstrates that individuals andorganizations do not maximize their ownwelfare and instead follow suboptimal decisionstrategies and succumb to different decisiontraps.While this view of human rationality can be abit depressing, it also implies that themarketplace is full of free lunches.Differences have implications for:TheoryIndividuals’ decisionsBusinesses’ strategies and offeringsPolicy (taxes, medical insurance, welfare,infrastructure & educational investments,role of EPA, the efficiency of free marketsetc.)Bounded Rationality:(Herbert Simon, 1957)A human mind has limited information processing andstorage capabilities, humans must use simple rules ofthumb and heuristics to help make decisions and solveproblems.Systematic Cognitive Biases:(Kahneman and Tversky, 1974)Many heuristics, or simple rules, that people use tomake judgments and decisions lead to systematic andpredictable errors.Psychological views on rationalityVisual illusions as a metaphor for DMProspect theoryHow a “simple” change in assumption canhave far reaching implicationsAmos Tversky KahnemanProspect theoryKahneman Daniel & Tversky Amos (1979)“Prospect Theory: An analysis of DecisionUnder Risk” Econometrica 47 263-291Amos TverskyKahnemanExpected utilitySubjectiveValueValueProspect utilitySubjectiveValueValueSo ????Prospect utilityDiminishing returnsLosses are steeperPattern changes at the originVDiminishing sensitivityVDiminishing sensitivity IBuying a calculator for $15The sales person tells you that you can buy thesame calculator for $8 by walking 15 min tothe other store. Would you do it?Buying a suit for $1,165The sales person tells you that you can buy thesame suit for $1,158 by walking 15 min to theother store. Would you do it?Diminishing sensitivity IIPsychophysics of moneySpending more on cars? houses?Spending more on tomatoes?Implications….Reference pointVInvestments IaAs the president of an airline company, you have invested $10million of the company's money into a research project. Thepurpose was to build a plane that would not be detected byconventional radar,. When the project is 90 percent completed,another firm begins marketing a plane that cannot be detected byradar. Also, it is apparent that their plane is much faster and farmore economical that the plane your company is building. Thequestion is: should you invest the last 10 percent of the researchfunds to finish your radar-blank plane?NO - It makes no sense to continue spending money on the project.YES - As long as $10M is already invested, I might as well finish it.Investments IbAs the president of an airline company, you have invested $1,000 ofthe company's money into a research project. The purpose was tobuild a plane that would not be detected by conventional radar,.When the project is 0.01 percent completed, another firm beginsmarketing a plane that cannot be detected by radar. Also, it isapparent that their plane is much faster and far more economicalthat the plane your company is building. The question is: shouldyou invest the last 99.99 percent of the research funds to finishyour radar-blank plane?NO - It makes no sense to continue spending money on the project.YES - As long as $1,000 is already invested, I might as well finish it.Sunk costThe investment size should not relevantto the decision to continue or not.This is called the sunk cost effectLosses are more painfulSo we try to eliminate or delay themThus, invest more because we arealready “deep into it”Buying tickets for a BB gameYou have a ticket for a basketball game. Thedrive is 60 miles, it snows and the roads are bad.Is the likelihood that you will go to the gamedifferent if:A) you paid $10 for the ticket yesterdayB) you paid $100 for the ticket yesterday C) you paid $100 for the ticket last year D) you got the ticket for free E) you got the ticket for a discountDiminishes over time (Arkes)Reference pointsThe current state is considered the status-quoRelated to defaultsActions are considered as deviations fromthe status-quoDeviations are losses and gains from thatstarting pointLosses are steeperVLoss aversion IWould you take the following gamble:50% to get $10050% to lose $5050% to get $1,00050% to lose $500Loss aversion IIWhich would you chooseA sure gain of $24025 % to win $1,000 and 75% to win 0Which would you chooseA sure loss of $24025 % to lose $1,000 and 75% to lose 0Buyers & sellersLets trade [X]:OwnersWrite the minimum price that you willcharge to sell your [X]Non-owners (buyer)Write down the maximum price thatyou are willing to pay for [X]TradesGiven that the roles of sellers and buyerswere selected randomly, how manyexchanges would you predict?The Endowment effectThe endowment effectPaying for things you ownBasketball tickets you have vs. notYour old carMugs & chocolateKids ;)Loss aversionThe common ratios of the effects of gainsand losses across many studies is 2:1Loss aversion is the cause for “timiddecisions”Particularly when considering decisionsone at a timeLoss aversion: implicationsInsurance?Attachment?Other implications?Gains and lossesReference points is the current pointChanges are considered relative to thereference pointLosses loom larger than gainsLoss aversion …Also statues-quo biasValueLessons from prospect theory IDiminishing sensitivityLoss aversionReference pointEndowmentSunk costValueLessons from prospect theory IIThe standard theory: The carriers of utility are states of wealth,and people are risk-averse in wealthProspect theoryThe carriers of utility are changes, gainsand losses People are loss averseAccumulating empirical evidence for PTStock market?Other applications?Equity premium puzzle IThe equity premium puzzleStocks have been outperforming bonds Large difference between rate of return onequities and treasury bills.Yet many people invest in bondsA dollar