Introduction to Behavioral

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Nature of the standard model

Economists generally try to eliminate the many ambiguities surrounding the notion 

of ‘pursuing enlightened self-interest’ by using the more precise and formal model of 

rational behavior described in the (augmented) standard model. Although it may seem 

daunting at fi rst, it will facilitate the exposition of the material throughout the book if 

we now consider a stylized version of the standard model, modifi ed from Rabin (2002b) 

and proceeding from the three components of rationality psychologically defi ned as 

above, and being covered in the rest of the book as described.

The reader should not be intimidated by the mathematical language of this model; 

it is designed to make it easier to understand, not more diffi cult. The expression 

of the Standard Economic Model (referred to hereafter as the standard model) in 

mathematical terms enables us to achieve three important objectives:

• 

A concise description of the relevant factors affecting decision-making.

• 

An illustration of the various components of the model that will be examined in 

the following chapters.

• 

A general consideration of the assumptions underlying the model in terms of how 

they relate to the various components.

The model can be stated in the following terms: 

Individual i at time t = 0 maximizes expected utility subject to a probability distribution 

p(s) of the states of the world s ∈ S:

    

ϱ

max     

⌺ ␦

t

    

⌺p(s

t

) U( x

i

t

 | s

t

). 

     (1.1)

x

i

t

∈X

i

  t=0    s

t

 ∈S

t

The utility function U(x | s) is defi ned over the payoff x

i

t 

of individual i and future utility 

is discounted with a (time-consistent) discount factor 

␦.

We can now disaggregate (1.1) into four main components as follows:

                       

ϱ

(1) max 

(2)  ⌺ ␦

t

 

(3)  ⌺ p(s

t

) 

(4)  U( x

i

t

 | s

t

).

   

 

x

i

t

∈ X

i

 

 

t=0  s

t

∈ S

t

The main assumptions underlying the standard model can now be stated in terms of 

how they relate to these components:

1  Economic agents are motivated by expected utility maximization (1), (3) and (4).

2  An agent’s utility is governed by purely selfi sh concerns, in the narrow sense that it 

does not take into consideration the utility of others (4).

3  Agents are Bayesian probability operators (3).

4  Agents have consistent time preferences according to the discounted utility 

model (2).

5  All income and assets are completely fungible (4).

We will examine the meaning and implications of these assumptions in detail in 

the relevant chapters, since in some cases this will merit a considerable amount of 

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discussion. The various components of the standard model, along with the chapters 

where each aspect is discussed, are outlined below:

1   Value formation (4) and choice (1) – Chapters 3 and 10

2   Belief formation (3) – Chapter 4

3   Expected utility theory or EUT (1), (3) and (4) – Chapter 5

4   Discounting (2) – Chapters 7 and 8

At this point, in view of the abstract nature of the exposition of the standard model 

above, it is useful to provide a simple example that will illustrate some of the above 

points, in particular, the fi rst, third and fourth components of the model. You are a 

new student of behavioral economics and you are considering what to drink before 

going to class. The canteen offers only coffee and beer. There are also two ‘states of 

the world’ as far as the class is concerned: it could be interesting or it could be boring. 

You believe from what you have heard that there is a probability of 0.8 that the class 

will be interesting and a probability of 0.2 that it will be boring (these are subjective 

‘Bayesian priors’). Table 1.1 shows the payoffs that result from either drink in either 

state of the world.

Table 1.1   Decision-making in the standard model

 

Decision 

State of the world 

Probability 

Payoff

 Coffee 

Interesting 

0.8 

10

  

Boring 

0.2 

2

 Beer 

Interesting 

 

0.8 

6

  

Boring 

0.2 

4

If the class is interesting it is a good idea to drink coffee beforehand in order to get the 

most benefi t. However, if the lecture is boring, drinking beer is better than drinking 

coffee (it is assumed here), because then it allows the student to drift off to sleep 

which is better than staying awake and not getting any benefi t from listening to the 

class. Therefore, the optimal decision, which maximizes expected utility, depends on 

the probability estimates of the states of the world. The student should verify that 

the expected payoff or utility of drinking coffee is 8.4, while the expected utility of 

drinking beer is 5.6. Thus the best decision in this situation is to drink coffee. However, 

if the probabilities were reversed, so that it was estimated that the probability of an 

interesting class was only 0.2, then the optimal decision would be to drink beer. We 

can see from this example that the estimation of Bayesian prior probabilities has an 

important effect on decision-making. The rational person will update these in the 

light of new information, so that if the class turns out to be boring this will reduce the 

estimated probability of the next class being interesting, and may affect the student’s 

drink decision next time round.

Applicability of the standard model

Over the last two or three decades behavioral economists have drawn increasing 

attention to various limitations in the standard model. Consider the following questions:

1  Why is the return on stocks so much higher on average than the return on bonds?

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