ix
List of Tables
1.1
Decision-making in the standard model
11
5.1
Phenomena inconsistent with EUT
154
5.2
The Allais paradox
154
5.3
Same payoffs but different probabilities of winning
155
5.4
The Ellsberg paradox
160
5.5
Empirical results related to weighting function
185
5.6
Combination and cancellation
189
5.7
Violations of the combination principle
191
7.1
Empirical estimates of discount rates
279
8.1
Rational consumers (exponential discounters}
298
8.2 Naïve
consumers
298
9.1 Prisoner’s
dilemma
337
9.2
Dominant strategy equilibrium
343
9.3
Iterated dominant strategy equilibrium
343
9.4
Game with no dominant strategy
344
9.5
Battle of the sexes
351
9.6
Game with no Nash equilibrium in pure strategies
352
9.7
Mixed strategy equilibrium
353
9.8
Iterated dominance game
365
9.9
Stag hunt game
375
9.10
Information requirements for different learning theories
378
9.11
Receiver’s success rates
384
9.12
Payoffs in a two-player game
384
10.1 Prisoner’s
dilemma
403
10.2
Structure of payoffs in prisoner’s dilemma
403
10.3
Prisoner’s dilemma – monetary payoffs
426
10.4
Prisoner’s dilemma – social utilities
427
10.5
Pareto effi ciency and risk dominance
435
10.6
Effort costs for salesperson
455
x
Preface
The fi rst edition of this book started out by saying that there should not really need
to be a book entitled ‘Behavioral Economics’. The same still applies some four years
later. All economics is behavioral in the sense of examining how people choose to
act and allocate resources in different types of situation. However, over the last three
decades the standard model of economic rationality, based largely on the assumption
of expected utility maximization, has come under increasing criticism from both outside
and inside the economics profession. The recent global fi nancial crisis has exacerbated
this situation. There are a large number of empirical anomalies that the standard
model fails to explain.
Behavioral economics attempts to answer many of these criticisms by taking a
broader approach to studying economic phenomena. It is behavioral in the sense that
it combines the approaches of all the behavioral sciences, in particular economics,
psychology, sociology and biology. This is currently not easy to do, since these
different disciplines have traditionally adopted different and in many ways confl icting
approaches. It is the essential philosophy of this book that economics is ‘at its best’
when it takes a cross-disciplinary approach.
Yet, in spite of building criticisms and the considerable interest and debate in the
profession, there are still hardly any current texts available on behavioral economics.
There are books on behavioral aspects of other disciplines, such as marketing, fi nance,
and even managerial accounting; there are collections of papers on behavioral
economics; and there are books on particular aspects of behavioral economics, such as
behavioral game theory. Thus there appears to be both high demand and low supply
for a text in this area.
Many undergraduate students are now starting to study aspects of behavioral
economics. The book is particularly appropriate for students in the third or fourth
years of undergraduate study, or in a postgraduate program, once they have become
familiar with the standard economics curriculum, its assumptions and methods, and
to some extent its limitations. For postgraduate students in particular the text should
serve as a foundation of linked themes and materials, providing a jumping-off point for
further reading of the original papers on which the book is based.
The objectives of the text remain the same as with the fi rst edition:
1 Present the principles and methods of behavioral economics in a logical and
amenable manner, contrasting them with those of standard models.
2 Illustrate how behavioral approaches have begun to supplement standard models
and in many contexts offer superior explanations and predictions, using a wide
variety of empirical examples from both observational and experimental studies.
3 Provide a critical examination of the rapidly growing literature in behavioral
economics.
4 Explain the policy implications of behavioral approaches, particularly when these
differ from those of standard economics.
5 Provide a coherent psychological and social scientifi c
framework underpinning the
fi ndings of behavioral economics.
6 Indicate the current trajectory of the subject, in terms of future challenges and
areas meriting further research.
P R E F A C E
xi
It should not be inferred from this that there is a single behavioral model that has
universal acceptance. Within particular areas, like intertemporal choice and social
preferences, there is often a profusion of models. Indeed, one main criticism of
behavioral economics has been that there is an excessive number of different models,
many of which may apply in a given situation. However, this issue arises in different
guises with standard approaches as well, notably in the context of solution concepts
in game theory, or more generally in response to ‘ad hoc’ model specifi cations in
applied areas such as industrial organization or the theory of the fi rm. Economics has
a common analytical language but it has certainly moved away from grand unifying
frameworks of analysis that general equilibrium theory once promised to offer.
As stated above, the central theme of the book is that it is intended to be highly
cross-disciplinary in nature. Any book on behavioral aspects must of course involve
psychology, but it is important to consider other areas too, notably evolutionary
psychology and neuroscience, social psychology and sociology.
Many economists and psychologists reject the theories of evolutionary psychology
as being largely speculative. They are frequently dismissed in the social sciences as being
‘just-so’ stories, meaning that they are not true scientifi c theories in terms of proposing
testable hypotheses. This view is caused by two main factors: (1) it is impossible by
defi nition to perform experiments on the past; and (2) the past record of facts is highly
incomplete. But on closer inspection there is considerable evidence in support of key
tenets of evolutionary psychology. Furthermore, the tendency of many economists to
limit explanations to economic phenomena is even more unsatisfactory as far as ‘just-
so’ stories are concerned. For example, many readers would not be satisfi ed with the
explanations that people tend to succumb to temptation because they have short time
horizons in decision-making, and that they make bad decisions when they are angry.
These can also be regarded as ‘just-so’ stories because they both beg the questions
regarding why people have short time horizons, and why we have seemingly harmful
emotional responses like anger.
The fast-developing area of neuroscience can also be of great benefi t to economics.
The conjunction of the two disciplines has led to the birth of neuroeconomics.
Economists have traditionally relied on ‘revealed preference’, meaning choice, in
market behavior to develop their theories, but this approach has signifi cant limitations.
We will examine situations where choice and preference do not coincide, and where
intertemporal choice and framing effects cause preference reversals. These anomalies
have important welfare implications. Cognitive neuroscience is offering fresh insights
into the neurological basis of individual behavior. We now know, for example, that
different types of cost and benefi t are processed in different areas of the brain, and
that both altruistic and spiteful behavior, in the form of punishment, give pleasure,
in spite of what the doer might say about their motivation. Admittedly, much of the
extant research in neuroscience is not yet fully connecting to economic decision-
making as such, and neuroeconomics, like evolutionary psychology, has attracted some
strong criticism from within the economics profession. But we feel that students of
behavioral economics will benefi t from studying the underlying debates to sharpen
their understanding of the evidence base and methodological basis of behavioral
frameworks of analysis.
This edition of the text has signifi cantly expanded from the fi rst edition, with
some 80,000 words of new material. Virtually all the chapters have undergone detailed
revision, and two new chapters were added, one on methodology, and one on beliefs,