behavioral.pptVIP

August 2006 How are preferences revealed? Bringing Behavioral Economics into the Classroom Alan B. Krueger Princeton University Elements of Rational Decision Making Individuals make choices to maximize some objective function (usually utility function) under the constraints that they face Utility function is stable If there is uncertainty, individuals maximize expected utility by assigning probabilities to different states of the world Implications: Compare opportunity cost of various decisions Pursue an activity until marginal benefit equals marginal cost Sunk costs are sunk Consistent behavior More choice is better ? Great strength is that we can rely on choices to infer preferences – idea of revealed preference. Behaviorial Economics Fastest growing field in economics Behavioral economics is concerned with the ways in which the actual decision-making process influences the decisions that are made in practice; combines psychology and economics Assumes bounded rationality – meaning that people have limited time and capacity to weigh all the relevant benefits and costs of a decision. Decision making is less than fully rational. People are prone to make predictable and avoidable mistakes. At the same time, decision making is systematic and amenable to scientific study. Six Key Ideas from Behavioral Economics 1. Framing. Allowing the way a decision is presented to affect the choice that is selected even though the marginal benefit and marginal cost are unaffected. 2. Letting Sunk Costs Matter. Allowing sunk costs, which have already been paid and do not affect marginal costs regardless of which option is chosen, to affect a decision. 3. Faulty discounting. Being too impatient when it comes to decisions that involve benefits that are received in the future or discounting future benefits inconsistently depending on when the delay in receipt of benefits occurs. 4. Overconfidence. Believing you will know what will happen in the future to a g