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TASMANIAN SCHOOL OF BUSINESS AND ECONOMICSBEA106 Introduction to BehaviouralEconomics1. Traditional economics1.1. Rational choice1.2. Components of ra ...
TASMANIAN SCHOOL OF BUSINESS AND ECONOMICSBEA106 Introduction to BehaviouralEconomics1. Traditional economics1.1. Rational choice1.2. Components of rationality2. Individual choice 2.1. Choice under certainty 2.2. Choice under risk 2.3. Strategic choiceTo p i c 1. Traditional economics and rational choiceProfessor Swee-HoonChuah
1. Traditional economics•Economics is the science which studies human behaviouras a relationship between endsand scarce means which have alternative uses (Lionel Robbins 1935)•The concept of choiceunderpins economics -a trade-off between alternatives•Economists study behaviourin order to explain and predict -prescribe policies to governments•Economists use models, which comprises of variables and assumptions, e.g.behaviour= f (ends, means)•Variables: what we study, e.g.behaviour, ends, means•Assumption: statement of fact taken as given•Main assumption underlying economic theory: choice is rationalTOPIC 1
1.1. Rational choice•Rational choice theory: when faced with several courses of action, people usually do what they believe is likely to have the best overall outcome for themselves(Elster1989)•In economics, rational choice is instrumental: the individual has a set of preferences and will choose the action they correctly calculate to be the most instrumental in satisfying their preferences (i.e.that maximises their utility)•The homo economicus(economic man) is assumed to be instrumentally-rational•The homo economicusor instrumental rationality assumption underlies traditional economic theoryTOPIC 1
1.2. Components of rationalityGoals, desires, aims, wants (which give utility) “Reason is … the slave of the passions” (Hume, Treatise on Human Nature)Axioms, e.g.completeness, transitivityA choice between alternative courses of actionProbabilities, expectationsInformation, dataElster1989, Nuts and Bolts for the Social Sciences:TOPIC 1
•Uncertainty: where the outcomes of the actions are completely unknown•Risk:where the outcomes of the actions are unknown, but probabilities can be attached to each of them2. Individual choiceSTRATEGICCertaintyIntervention by natureIntervention by othersPARAMETRIC•Certainty:where the outcomes of the actions are completely known to the decision makerUncertaintyRiskTOPIC 1
Risk analysisAction 1Player 1Action 2$5HeadsTa i l s$10$0•You face a choice between two actions: -Action 1 gives you $5 for certain-Action 2 involves tossing a fair coin. If it shows Heads, you win $10. If it shows tails, you win nothing.•Which do you choose?Represent using decision treedecision nodechance nodebranches denote actionsterminal nodes denote outcomes with utilities TOPIC 1
2.1. Choice under certainty•Outcome of action is certain•Each individual making choice has a preference ordering •The preference ordering can be represented by an ordinal utility function (need to rankpreferences only)•Preferences over two outcomes, X and Y, are assumed to be (axioms):1.reflexive (X ≈ X), 2.complete (either X>Y, X Y and Y > Z, then X > Z), and4.continuous (If X > Y, then situations “close to” X must also > Y)•Choice maximises utilityTOPIC 1
ActionsA1A2A3OutcomesX1X2X3UtilityU1U2U32.1. Choice under certaintyA1A2A3Player 1U1U2U3X1X2X3White wineRed wineRosePlayer 1HighestMediumLowestHappyHeadacheMeh✓TOPIC 1
2.2. Choice under risk•Each action may have more than one outcome and outcome is uncertain (risky)•Individual making choice forms expectations about the respective likelihood of these outcomes, which are expressed as a probabilitydistribution •Preference ordering must be represented by a cardinalutility function (the strengthof preferences needed)•Preferences must obey axioms•Choice maximises expected utility, i.e. utility on average (expected utility theory, EUT)TOPIC 1
X2.1P2.1U2.1X2.2P2.2 U2.2X2.3P2.3U2.3X1.1P1.1 U1.1X1.2P1.2 U1.2OutcomeProbabilityUtilityA1A2Action**+= EU (A1)***++= EU (A2)2.2. Choice under riskExpected Utility: EU = ∑(Pi Ui) X3.1P3.1U3.1X3.2P3.2 U3.2A3= EU (A3)**+TOPIC 1
2.2. Choice under riskA1A2A3Player 1U1.1U2.1X1.1X2.1X3.1P1.1 P1.2 P2.1 P2.2 P2.3 P3.1 P3.2 X1.2X2.2X2.3X3.2U1.2U2.2U2.3U3.1U3.2EU (A1) = P1.1(U1.1) + P1.2(U1.2)EU (A2) = P2.1(U2.1) + P2.2(U2.2) + P2.3(U2.3)EU (A3) = P3.1(U3.1) + P3.2(U3.2)TOPIC 1
2.2. Example of choice under riskVietnamLaosCambodiaFirm 1$20 mil$25 milBoomBoomBoom0.6 0.4 0.2 0.3 0.5 0.2 0.8 BustMaintainBustBust$10 mil$15 mil$12 mil$30 mil$12 milEV (Vietnam) =0.6(20)+ 0.4(10)= 16EV (Laos) =0.2(25)+ 0.3(15) + 0.5(12)= 15.5EV (Cambodia) = 0.2(30)+ 0.8(12)= 15.6✓TOPIC 1
X1.1P1.1 V1.1X1.2P1.2 V1.2OutcomeProbabilityValueA1Action**+= EV (A1)Expected Value: EV = ∑(Pi Vi) X2.1P2.1V2.1X2.2P2.2 V2.2A2= EV (A2)**+EV (A1) = 1(5) = 5EV (A2) =0.5 (10) +0.5(0)= 5???Risk analysisWhich is preferred depends on the person’s risk attitude:•Risk neutral: A1 = A2•Risk averse: A1 > A2•Risk loving: A1 < A2TOPIC 1
2.3. Strategic choice•You are one of two firms in a market.•Both firms deciding between two actions: cut or maintain price-If both maintain, they each keep current market share, and earn $3 mil each-If one cuts and the other maintains, the former completely steals market share from the latter, and earns $5 mil-If both cut, they each keep current market share, but earn $1 mil each due to price cut•Which do you choose?TOPIC 1
2.3. Strategic choiceCut pricePlayer 1Player 2 Maintain price$1 mil, $1 milCut priceCut priceMaintain price$5 mil, $0$0, $5 mil$3 mil, $3 milMaintain price✂✂✂✓TOPIC 1
TASMANIAN SCHOOL OF BUSINESS AND ECONOMICSBEA106 Introduction to BehaviouralEconomicsProfessor Swee-HoonChuahTo p i c 1. Traditional economics and rational choice
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