Introduction to Behavioral

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In the third regime, the second salesman always took the second piece of apple away before 

handing over the goods, while the fi rst never gave freebies. So, once again, the outcomes were 

identical. In this case, however, the monkeys preferred the fi rst salesman even more strongly 

than in the second regime.

What the responses to the second and third regimes seem to have in common is a preference 

for avoiding apparent loss, even though that loss does not, in strictly economic terms, exist. 

That such behaviour occurs in two primates suggests a common evolutionary origin. It must, 

therefore, have an adaptive explanation.

What that explanation is has yet to be worked out. One possibility is that in nature, with a food 

supply that is often barely adequate, losses that lead to the pangs of hunger are felt more 

keenly than gains that lead to the comfort of satiety. Agriculture has changed that calculus, but 

people still have the attitudes of the hunter-gatherer wired into them. Economists take note.

Source:  The Economist, June 23, 2005

Issues

This ingenious experimental study illustrates three particularly important aspects of behavioral 

economics:

1  Methods

 

The experimental approach, traditionally followed by psychologists, is used here, in order 

to achieve a degree of control that would be impossible to gain through mere observation. 

Three different trading regimes are used in order to compare responses and test the basic 

hypothesis of loss-aversion. Note the use of deception, although it is unlikely in this case 

to cause a general increase in cynicism among the population of capuchin monkeys 

available as subjects.

2  Evolutionary psychology

 

The purpose of the experiment is not just to test whether capuchin monkeys have loss-

aversion, but more importantly to test whether the widely-observed loss-aversion in 

humans is likely to have an evolutionary explanation. The fact that loss-aversion has been 

observed in many different countries and societies constitutes evidence of an evolutionary 

origin, but the observation of the same characteristic in a fairly closely related species is 

even stronger evidence. This is a typical type of experiment carried out by evolutionary 

psychologists to test their hypotheses. It is also notable that the issue regarding why loss-

aversion should be an evolved psychological mechanism or adaptation is also raised. This 

issue will be discussed in more detail in Chapter 5 on prospect theory.

3

    Rationality

 

We have seen that the concept of rationality is a highly ambiguous term, which can be used 

in many different senses. However, in the current context, a ‘rational’ individual behaving 

according to the standard model should have no preference between the two ‘salesmen’ 

in the second and third trading regimes, since the outcomes from each are ultimately 

identical. The ‘irrationality’ observed in the monkeys is explained by the concept of loss-

aversion, an important aspect of prospect theory. Thus behavioral economics is better able 

to explain the behavior observed in the experiment.

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Case 1.2 Money illusion

The issue of money illusion is one that has been much discussed by economists since 

the days of Irving Fisher (1930). It has been defi ned in various ways, which has been 

the cause of some confusion, but a brief and useful interpretation has been given by 

Shafi r, Diamond and Tversky (1997) in a classic article: 

A bias in the assessment of the real value of transactions, induced by their 

nominal representation.

It should be noted that such an interpretation does not limit money illusion to the 

effects of infl ation, as will be seen. 

Economists have tended to take an attitude to the assumption of money illusion that 

Howitt describes in the New Palgrave Dictionary of Economics (1987) as ‘equivocal’. At 

one extreme there is the damning quotation by Tobin (1972): ‘An economic theorist can, 

of course, commit no greater crime than to assume money illusion.’ The reason for this 

view is that money illusion is basically incompatible with the assumption of rationality 

in the standard model. Thus a rational individual should be indifferent between the 

following two options:

Option A 

 Receiving a 2% yearly pay increase after a year when there has 

been infl ation of 4%.

Option B 

 Receiving a pay cut of 2% after a year when there has been zero 

infl ation.

In each case the individual suffers a decrease in pay in real terms of 2%. However, some 

empirical studies indicate that people do not show preferences that are consistent with 

rationality in the traditional sense, and that money illusion is widespread.

Perhaps the best-known study of this type is the one quoted earlier by Shafi r, Diamond 

and Tversky (1997; hereafter SDT). This used a questionnaire method, asking people 

about a number of issues related to earnings, transactions, contracts, investments, mental 

accounting, and fairness and morale. We will concern ourselves here with questions related 

to earnings and contracts, since these will illustrate the main fi ndings.

An earnings-related situation was presented as follows:

Consider two individuals, Ann and Barbara, who graduated from the same  

college a year apart. Upon graduation, both took similar jobs with publishing 

fi rms. Ann started with a yearly salary of $30,000. During her fi rst year on the 

job there was no infl ation, and in her second year Ann received a 2% ($600) 

raise in salary. Barbara also started with a yearly salary of $30,000. During 

her fi rst year on the job there was 4% infl ation, and in her second year Barbara 

received a 5% ($1500) increase in salary.

The respondents were then asked three questions relating to economic terms, happiness 

and job attractiveness:

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  As they entered the second year in the job, who was doing better in economic terms?

 

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