Chapter 8: Behavioral Economics: A Closer Look at Decision Making

What will you learn in this chapter? • What time inconsistency is and how it accounts for procrastination and other problems with selfcontrol. • Why sunk costs should not be taken into account in deciding what to do next. • What types of opportunity cost people often undervalue and why undervaluing them distorts decision making. • What fungibility is and why it matters in financial decision making.

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1© 2014 by McGraw-Hill Education 1 Chapter 8 Behavioral Economics: A Closer Look at Decision Making © 2014 by McGraw-Hill Education 2 What will you learn in this chapter? • What time inconsistency is and how it accounts for procrastination and other problems with self- control. • Why sunk costs should not be taken into account in deciding what to do next. • What types of opportunity cost people often undervalue and why undervaluing them distorts decision making. • What fungibility is and why it matters in financial decision making. © 2014 by McGraw-Hill Education 3 Scenario 1: When are sunk costs sunk? • Suppose you buy a ticket to attend a concert for $20. Upon arriving, your ticket is not in your pocket. How do you react? 1. “Oh well, I’ll just buy another ticket for $20.” 2. “No way, I’m not going to spend $40 on this concert! I’d rather go do something else instead.” 54% of people indicated they would react like 1. 46% of people indicated they would react like 2. 2© 2014 by McGraw-Hill Education 4 Scenario 2: When are sunk costs sunk? • Now suppose you arrive at the concert and you are missing $20. How do you react? 1. “Oh well, I’ll just buy a ticket for $20.” 2. “You know what? Forget the concert.” 88% of people indicated they would react like 1. 12% of people indicated they would react like 2. © 2014 by McGraw-Hill Education 5 When are sunk costs sunk? • Scenarios 1 and 2 are identical. – You arrive at a concert intending to see a concert. – You have $20 less than you expected. • If you are short on cash, it makes sense to skip the concert. • If you are not short on cash, why does it matter if you lost a $20 bill before or after you’d converted it into a concert ticket? – This is not rational behavior. – Emotionally, however, it seems to matter for some. • Behavioral economics studies why individuals appear to act irrationally by studying insights from psychology. © 2014 by McGraw-Hill Education 6 Dealing with temptation and procrastination • Individuals struggle against procrastination and temptation. • They do not complete the actions they had planned to do. – Does this reveal preferences of valuing less the activities not performed? – Or, that they weren’t acting rationally? • Individuals feel conflicted when they know they want to do one thing, but find themselves constantly doing another. – Actions revealing true desires . • These desires may go against understanding of self. – Labelling conflicts irrational is giving up and suggests an inability to model and predict individuals’ decisions. 3© 2014 by McGraw-Hill Education 7 Dealing with temptation and procrastination • The conflict between plans and actions can be better understood using time inconsistency, competing selves, and commitment. • One theory on why individuals give in to temptation is that individuals can hold two inconsistent sets of preferences: 1. What we would like to want in the future. 2. What we will want in the future, when the future comes. • When individuals change their minds about what they want simply because of the timing of the decision, they exhibit time inconsistency. © 2014 by McGraw-Hill Education 8 Active Learning: Time inconsistency You have a test tomorrow. If your friends are going to the movies now, would you go with them and study after the movie? © 2014 by McGraw-Hill Education 9 Time inconsistency • Time inconsistency helps to explain behaviors like procrastination and lack of self-control. It is as if there are two selves inhabiting our thoughts. – Future-oriented self: Clear-sighted preferences to get things done. – Present-oriented self: Backslides when faced with alternative choices now. • No matter how wise the decisions about the future are that the future-oriented self makes, when that future becomes the present, the present-oriented self will be in charge again. 4© 2014 by McGraw-Hill Education 10 Time inconsistency • Individuals who are aware of their time- inconsistent preferences often seek out ways to remove temptation. • A commitment device can be used to help fulfill a plan for future behavior that would otherwise be difficult. – Increasing the cost of engaging in certain activities. – Blocking that activity from your choice set. © 2014 by McGraw-Hill Education 11 Active Learning: Time inconsistency What commitment devices can be used to assure that you will study when the movie ends? © 2014 by McGraw-Hill Education 12 Thinking irrationally about costs • People weigh the trade-off between costs and benefits to arrive at a decision. – If the benefits of doing something are greater than the opportunity cost, rational people are assumed to do it. – If the benefits are smaller than the opportunity cost, they won’t choose to do it. • In reality, people don’t always weigh costs and benefits rationally. – Failing to ignore sunk costs. – Undervaluing opportunity costs. • This erroneous decision making is an example of cognitive bias. 5© 2014 by McGraw-Hill Education 13 Sunk-cost fallacy • Many times individuals remain engaged in an activity even though the benefit of continuing is less than the opportunity cost, especially if a cost was incurred to engage in the activity. – This is referred to as the sunk-cost fallacy. • It is hard for individuals to accept losses. • Costs that cannot be recovered are irrelevant to whether an individual should remain engaged in the activity or select a new activity. © 2014 by McGraw-Hill Education 14 Active Learning: Sunk costs Suppose you are almost failing a class but the deadline to drop and receive a tuition refund has passed. • What factors should and should not be considered when deciding whether to drop the class? © 2014 by McGraw-Hill Education 15 Undervaluing opportunity cost • When making a decision, sometimes the alternative is not readily apparent. • This causes individuals to overvalue the benefits and undervalue the opportunity cost of the not selected alternative. • People tend to undervalue opportunity costs when they are nonmonetary: – Individuals’ time cost. – Implicit cost of ownership: Overvaluing items that are owned. 6© 2014 by McGraw-Hill Education 16 Forgetting about fungibility • Many individuals commit to a specific purchase by setting money aside for that purchase. – Using envelopes to mark money for certain purchases. – Depositing money into separate bank accounts. • Separating money into mental categories helps individuals commit to buying what they thought was right during categorization. • However, money is fungible and thus can be easily substituted between purchases. – May derail individuals from staying on their budget. © 2014 by McGraw-Hill Education 17 Forgetting about fungibility • Forgetting that money is fungible can lead individuals to make poor choices. • For example, suppose that an individual has a $2,000 credit card balance and $5,000 in the bank. • Net wealth is identical whether the individual pays off the balance or not: – With balance: $5,000 - $2,000 = $3,000. – Without balance: $3,000. • However, the individual pays interest when carrying a credit card balance, but doesn’t if the balance is paid off. © 2014 by McGraw-Hill Education 18 Forgetting about fungibility • Forgetting that money is fungible can also make individuals riskier. • For example, gamblers typically play riskier once they win a sum of money. – Many think that they are “playing with the house’s money,” even though it is their own. 7© 2014 by McGraw-Hill Education 19 Summary • For many decisions, individuals act rationally. • For some decisions, it appears that individuals are not acting in what is in their best interest. • Many of these irrationalities are due to pitfalls in the way that humans think. • Understanding these human tendencies can help individuals avoid common decision- making pitfalls.