ECN374

Behavioural Economics
Dr. Ghazala Azmat
Monday 12th January 2015
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Information
Contact Info:
Office: CB313
Office hours: Wednesday 9.00-11.00
Email: g.azmat@qmul.ac.uk
Other Info:
Last two weeks will be taught by replacement teacher (w/c
23rd March and 30th March)

Todays Lecture
Introduction to Behavioral Economics
Course Overview and Structure
Links to Game Theory (topic 1)

Introduction to Behavioral (or

Experimental) Economics

1. What is Behavioral
Economics?

Behavioral Economics I
Behavioral economics is a subfield of economics that seeks to
increase the explanatory power of traditional models by
incorporating more realistic psychological foundations
social, cognitive, and emotional factors on the economic
decisions of individuals and institutions.
Behavioral models integrate insights from psychology and
microeconomic theory
NB: Behavioral economics does NOT imply a rejection of the
traditional approach to economics, such as utility
maximization, equilibrium and efficiency.
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Behavioral Economics II
Experimental economics is essentially a method of empirical
investigation. If successful the method will become a standard
instrument in economists toolbox
Behavioral game theory analyzes interactive strategic
decisions and behavior using the methods of game theory,
experimental economics, and experimental psychology.
E.g., testing deviations from typical simplifications of
economic theory such as the independence axiom, neglect
of altruism, fairness etc
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2. What are Economic

Experiments?

Experiments I
Experiments are a form of play
Play is fun but it is also adaptive and serves and important purpose:
it helps us learn
We playfully engage the world and thus come to understand it better
We design and run an experiment and record the results in order to
learn about the world
This form of learning is the essence of science
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Experiments II
Experiments mainly associated with the Natural Sciences
(dating back to 1600s)
Physics: Galileo engaged in constructing pendulums of
various weights and lengths
Chemistry: Lab experiments that tested predictions of new
molecular theory
Biology: Pasteurs germ theory experiments
Experiments in Economics started to emerge in the 1960s

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Why use Experiments in Economics?

Economic models in game theory, industrial organizations,
social choice offered competing ways to understand micro
data
Using theory and logic, one can generate predictions about the
world
The predictions tell you what to look for and tell you which
observations are surprising
In some cases multiple equilibria appear
To distinguish among the many alternatives, Economists
started to use experiments
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The Lab in Economics

The typical way Experimental Economists conduct
experiments is by using laboratory techniques
The Economics lab should not to be confused with the
Chemistry lab (no burners!)
Economic experiments are usually done in the classroom
involving
Question of interest
Payment
Repeated trials
Traditionally, experiments were done using pen and paper and
now they are mostly done using computer programs
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Todays Lab

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Experiments in Economics
A controlled situation in which individuals take actions
according to some pre-specified rules
These actions determine their payoffs.
Most experiments are strategic: Own payoffs depend on your
actions and other individuals actions.
Most frequent reward: Monetary payoffs.
Allows to observe Maximizing behaviour.
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Economic ExperimentsEverywhere!
Theory:
Macroeconomics
Microeconomics
Empirical:
Macroeconomics: Finance, Inflation
Microeconomics: Labour, Migration
Experiments:
Macroeconomics (especially in Development)
Microeconomics:
Preferences
Beliefs
Decision Rules
Mapping of Institutions (mechanisms) to outcomes
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3. Why not use existing data?

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Happenstance Data
Happenstance data observations that already exist
sometimes include just what you need to test a crucial
prediction
But it is rare
Naturally occurring processes often do not allow you to:
Observe a key variable
Separate the effects of different variables
Infer causality
In an experiment, you actively engage the world and create a
learning opportunity that would otherwise not exist
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Let the QUESTION determine the

DATA and not the other way around

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Lab Data versus Field Data

Traditional econometrics works with happenstance data, which
occur naturally
Laboratory data is created in an artificial environment
Traditional econometrics works with uncontrolled processes,
as opposed to controlled processes
Think of lab data as experimental (i.e., properly controlled)
and field data are happenstance
Field experiments are becoming increasingly important in
recent years
The idea here is to impose some controls on naturally
occurring processes
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Comparative Advantage of Lab and Field

Cost:
Field data already collected and compiled are the least costly, but
it is typically very expensive to collect new data
Lab data are generally in between, depending on the subject pool.
Validity:
Good lab techniques ensure that lab data are internally valid:
Replicable by any other competent investigator
Good lab techniques cannot ensure external validity
Regularities observed dont necessarily generalise well to the
larger, ongoing economy outside the lab
Field data have automatic external validity in their native habitat
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4. Purpose of Experiments

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1. Speaking to theorists
What is the theoretic solution and does behavior conform with
theory? (better use of theory: serves as benchmark)
in the short run
in the intermediate term (convergence)
in the long run (convergence)
What are the causes of this failure?
bounded rationality, other regarding preferences,
coordination failure, non expected utility, emotion, framing
etc.
Calculation costs; difficulty of task
[Also : bad design? redesign of experiment ]
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2. Searching for facts

Establishing regularities - parsimonious models that describe
deviation from theory?
non-expected utility models
models of fairness
models of adaptation and learning
models with error
Formulating new theories to explain newly observed
regularities
Devising new experiments to help distinguish among such
theories
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3. Whispering in the ears of Princes

Evaluation of policy proposal
How to decide on pollution rights, etc.
Matching problems (schools-students)
Comparison of institutions, use the lab as a test-bed for
institutional design
different auctions
different mechanisms (e.g. for matching markets)
different bargaining models, etc.

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5. Criticisms of Experiments

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Criticism of Experiments in Economics

1. Wrong incentives (e.g. the stakes are too low)
2. Experts behave differently than students (the usual subject pool)
3. External Validity: how can laboratory experiments help us
decide in the real world?
4. Having many repetitions is unrealistic
5. Some mechanisms dont exist in the real world
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Course Overview and Structure

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Course Content
1. Links to Game Theory
2. Experimental Design
3. Simple Bargaining
4. Trust and Social Preferences
5. Public Goods
6. Co-ordination
7. Field Experiments
8. Feedback Information and Experiments
9. Gender and Experiments
10. Neuroeconomics
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Evaluation of Course
Midterm Tests (30%)
Midterm I (Monday 9th February)
Midterm II (Monday 9th March)
Final Exam (70%)

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Lectures and Classes

Lectures will cover the theory of the topics
Basic models
Predictions
Experimental findings
Extensions
Classes will vary
Game solving
Run simple (pen and paper) experiments related to topics
Statistical analysis of data
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TOPIC 1:
Game Theory and Behavioral Economics

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Game Theory
A large number of decisions in every day life require strategic
decision making
what happens to one person is affected by another person
Economists have developed a broad array of tools to
understand how people make decisions in such situations
These set of tools are called Game Theory

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Games in everyday life I

Tennis players deciding whether to serve to the forehand or
backhand of their opponent
The only bakery in town offering a discounted price on
pastries just before it closes
Employees deciding how hard to work when the boss is away
Arab rug seller deciding how quickly to lower the price when
haggling with a tourist
A bidder making an offer for a piece of art in an auction
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Games in everyday life II

All examples illustrate game theory
In all situations, a person (or firm) must anticipate what others
will do
AND
What others will infer from the persons own actions

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Pioneers of Game Theory

Economists have developed a large body of theory
enables us to understand and analyze the nature of the
interaction between players
A lot of what we know can be traced back to John von
Neumann and Oskar Morgenstern in 1944
As well as John Nash, Reinhard Selten and John Harsanyi
The latter three together won the Nobel Prize in Economics in
1994
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Game Theory Today

Game theory is used extensively in economics, other social
sciences and all branches of business-related disciplines (e.g.,
management and marketing)
In economics, game theory is used (for example) to:
analyze behaviour of firms that worry about what their
competitors do
understand how workers behave in firms (e.g., reaction of
CEOs or salespeople to incentive contracts)
understand spread of social convention or practice

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Games and Behavioral Econ I

Behavioral or Experimental Game Theory is increasingly popular
Refers to experiments whose goal is to learn about general
principles of strategic behaviour
[Other types of experiments may be to learn about the
performance of specific institution ]
Experiments are now an important tool for the analysis of strategic
behaviour
The emergence of experimental game theory can be traced to two
factors:
The need for empirical information about principles of
strategic behaviour
The advantages of experiments in providing it
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Games and Behavioral Econ II

Traditionally, game-theoretic custom of trying to predict
behaviour entirely by theory
applying notions of equilibrium and refinements to the
structure of the game.
This custom admits a role for empirical knowledge about
players preferences
feasible decisions
information just as in nonstrategic microeconomics
But it precludes any role for empirical input about the
principles that determine how players respond to a given
game.
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Games and Behavioral Econ III

Excluding such input is not important in nonstrategic settings
where rationality, in the sense of, expected-utility maximization
provides a reasonably reliable guide to behaviour once
preferences, decisions, and information have been identified.
Exclusion is important in strategic settings
where rationality alone seldom yields definite predictions,
reliable or not, and there is no consensus on how to strengthen
In turn, most games of interest in economic applications raise
questions about strategic behaviour
Likely to be resolved only by combining theory and empirical
knowledge.

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Recap: A couple of examples

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Example I

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Social Dilemma:
Contributing to a charitable cause
You want to build a park in your locality that would be open to
everyone
You decide to approach the families in the area and ask them
to donate a certain amount

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Social Dilemma:
Contributing to a charitable cause
Not everyone has to contribute for the park to get built
As long as some of the families contribute you will have
enough money for the park
What are the chances that you will be able to raise enough
money?

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Social Dilemma:
Contributing to a charitable cause
Let us assume that, by and large, people are self-interested and
care (mostly) about their own welfare
Think about an individual trying to decide whether to
contribute or not
If she does not contribute and the park does not get built then
she is neither better nor worse off
But suppose she does NOT contribute but enough money is
raised to build the park
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Social Dilemma:
Contributing to a charitable cause
This person cannot be prevented from going to the park once it
is built
She has not contributed anything but still gets to enjoy a walk
in the park
This person is then strictly better off

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Social Dilemma:
Contributing to a charitable cause
Whether the park gets built or not for an individual who cares
primarily about her own self-interest the thing to do is not to
contribute any money
We call this free-riding
But if everyone reasoned along the same lines then no one will
contribute!
We can use experiments to see how people would actually
respond.
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The Prisoners Dilemma

Imagine the following scenario:
A crime is committed.
The police have no evidence but want to get a conviction.
So they arrest a couple of likely characters, A and B, and put
them in different cells.

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The Prisoners Dilemma

The police say to each suspect:
If you rat on your mate and blame him for the crime and he
doesnt rat on you, then we can convict him and he will get 7
years in prison, and we will let you go free.
So what if I dont rat and nor does he? asks A (or B). Then
you cant convict, can you?

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The Prisoners Dilemma

No we cant, admits the detective. But then well pin an
obstruction of justice charge on both of you. One year in the
slammer each.
And if we both rat on each other?
Then it gets a bit messy and you both get 5 years, says the
detective.

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The Prisoners Dilemma

So what will happen? Let us figure out the options from As
point of view.
Being economists, we will assume that A is rational
meaning that he will do the best he can in his own self-interest
A considers each possible action by B, and figures out his best
reaction in each case

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The Prisoners Dilemma

So if B rats on A, then As best move would be to rat on B (get
five years instead of seven)
And if B doesnt rat, then As best move is..
again, to rat! (go free instead of one year in prison)

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The Prisoners Dilemma

So As rational decision must be to rat on B.
And, similarly, Bs best move is to rat on A
So we predict this is what will happen and they both will go to
prison for five years
But if only both could have kept their mouths shut, they would
both be better off!!!

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The Prisoners Dilemma:

Payoff Matrix
B
A

Dont Rat

Rat

Dont Rat

A: 1 year
B: 1 year

A: 7 years
B: free

Rat

A: free
B: 7 years

A: 5 years
B: 5 years

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The Prisoners Dilemma

The problem is that even if one prisoner does the right
thing and keeps quiet, the other has an incentive to cheat
on him
(Rat,Rat) is the Nash Equilibrium
(Dont Rat, Dont Rat) is globally optimal but it is not
stable
Similarly in the case of the park:
it would be better if everyone contributes, but selfinterested individuals have an incentive not to do so
But if no one contributes then the park does not get
built
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Game Theory Experimental Evidence

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Experimental Evidence
It turns out that people often choose the cooperative
strategy in Prisoners Dilemma type situations
People contribute to public charities
The puzzle of course is why since that behavior is not in
accordance with individual self-interest

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Implications of Cooperation
The issue of cooperation goes beyond economics and has
ramifications for other disciplines including theories of
evolution
Biological theories suggest that those who act altruistically
or cooperatively in such situations will lose out to those
who act in their own self-interest
Over time the self-interested types will come to dominate
the population

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