What is behavioural economics
Behavioural Economics increases the explanatory power of economics by providing it with more realistic psychological foundations
The Expected Utility Theory Axioms
- Completeness = For any lotteries, either L>L’, LL’ and L’>L’’ then L>L’’
(1+2= rational agent) - Continuity= for any lotteries L>L’>L’’ there must be a weighted average between L and L’’ such that the individual is indifferent between that average and L’
- Independence= if A>B then At+(1-t)C> Bt+(1-t)C
Expected Utility Theorem
If agent satisfies all 4 axioms, then it is possible to assign utility that represents their preferences such that L>L’ if and only if U(L)>U(L’).
Anomalies/ Deviations from EUT
- Framing Effect - Asian Disease
- Allais Paradox - violates Independence Axiom
- Ellsberg Paradox - ambiguity aversion
- Endowment Effect - loss aversion
Framing Effect
Asian Disease
A: saves 200/600 lives
B: saves all with probability 1/3 and none with probability 2/3
C: causes 400 to die
D: causes 600 to die with probability 2/3 and none with probability 1/3
=> A rational individual that prefers A, should prefer C, but in reality, those who chose A also chose D. This is because of the way it was framed - in terms of losses for the second one, willing to be more risk-seeking.
Allais Paradox
Violates the independence axiom.
A= 4000, 80% or B= 3000, 100%
C= 4000, 20% or D=3000, 25%
=> those who chose B then chose C => certainty effect, reducing the probability from 100 to 25% has a greater effect than from 80 to 20%.
Ellsberg Paradox
Ambiguity aversion - urns of red (known to be 30), black and yellow balls (60 remaining either black or yellow).
A= 100 if the ball is red, nothing otherwise
B= 100 if the ball is black, nothing otherwise
C= 100 if the ball is red or yellow, nothing otherwise
D= 100 if the ball is black or yellow, nothing otherwise
People chose A over B and D over C – ambiguity aversion - betting against/in favour the known information is preferred - we do not like ambiguous situations.
