Chapter 1 Review Questions 1.1 Why is the standard economic model a good thing, and why is it a bad thing, in trying to understand economic behavior? A good economic model is simple and yet gives useful insight on economic behavior. The standard economic model makes two main assumptions: people are rational and people are selfish. At heart, these are simplifying assumptions. They give economists something objective to work with there is often only one way to be rational and selfish, but lots of ways to be irrational and kind. And the model undoubtedly gives useful insight it tells us about the law of supply, the law of demand, the remarkable efficiency of markets, and so on. The standard economic model did not, therefore, happen by accident. It is a remarkable powerful tool for looking at behavior. It is the natural benchmark against which to compare observed behavior. It is the natural starting point in developing models that allow for irrational and unselfish behavior. Some would also point towards the more positive message that the standard economic model tells us how we should behave. I am less convinced by this argument given the assumption of selfishness built in to the model economists have rightly got a bad press in the past for teaching people how to be egoists! The problem with the standard economic model is that people are neither rational nor selfish. Naturally, therefore, we need to develop alternative models that can account for this. This logic may seem common sense. It is, however, highly controversial. Some economists are convinced that people are rational and selfish, or can be modeled as such. And they object to the ad hoc nature of behavioral economics. This argument, however, has lost force over the last few decades. To explain why let me first recall that the main selling point of the standard economic model is its objectivity there is only one way to be rational and selfish, but lots of ways to be irrational and kind. Current usage of the standard economic model, however, does away with objectivity the model it seems can be contorted so that just about any behavior is rational and selfish. And the way that behavioral models are being developed is more and more objective we can draw on evolutionary theory and neuroscience to tie down what assumptions are reasonable. Time is up, therefore, on the standard economic model. It remains a fantastic tool for understanding economic behavior. But, to progress further we need to make the natural step away from it and drop the assumptions of rationality and selfishness.
1.2 Why do we need to run economic experiments? A good model makes novel testable predictions. Testing those predictions in the real world is often impossible. Experiments are a fantastic way to test predictions in a controlled environment. To illustrate, suppose you have a model of asset market bubbles. You can, and should, look at data from stock market trading to test the model s predictions. But, such data will be incredibly noisy. That makes it difficult to accept or reject your predictions maybe the prediction is correct but failed to show up in the data because of some unobservable shock. It is also difficult to compare one model against another maybe both models make the same prediction in the type of market there is in the world. In the lab you can do away with unobservable shocks and design the experiment in a way that two comparable models give different predictions. Experiments are natural in physics, chemistry, biology and economics.
1.3 Why does a heuristic usually come hand in hand with a cognitive bias? Should we emphasize how clever people are for having good heuristics, or how dumb they are for being biased? A heuristic is a simple rule of thumb for making a decision. A good heuristic makes a good enough choice most of the time. Both the good enough and most of the time leave room for bias. For example, consider the heuristic when out shopping buy the same as last time. This is a simple rule of thumb. Buying the same as last time should be good enough most of the time, but it is unlikely to be the optimal thing to do. Systematic deviations from the optimum give us cognitive bias. For example, we might end up with the cognitive bias reluctant to try new products. Whether or not we should emphasize the cleverness or dumbness of people is related to the issue of ecological rationality. Heuristics are adapted well to do the job they were designed to do. They fit the environment. Experimentalists are adept at making people use the wrong heuristic for the wrong environment. This can make people look unfairly dumb. To illustrate, consider the visual illusion below. We can think the person is dumb because he sees perspective on a 2D piece of paper. Or we can marvel at his ability to see perspective which is so useful in the world that he lives. Do not, therefore, jump to the conclusion people are dumb just because clever experimenters can get them to do dumb things. Ecological rationality, however, works both ways. Consider, for example, our desire for sugar. The heuristic eat any sugary food you can get was a good heuristic in our evolutionary past. Unfortunately, rising levels of obesity suggest it is not such a good heuristic now. Similarly, lack of saving for retirement does not seem ecologically rational in a world where people can expect to live for a long while.
1.4 Why does is make sense to mix up experimental treatments and sessions, i.e. to have multiple treatments in each session and multiple sessions for each treatment? In most experimental studies we are interested in comparing behavior across treatments. We do not want some artificial effect inducing a difference. For example, suppose an experiment has an A treatment and a B treatment. If we only perform the A treatment in sessions on a Saturday afternoon and only perform the B treatment in sessions on a Monday morning we might get a difference that has nothing to do with the change in treatment. Different people might show up to take part in an experiment on Monday mornings, and people might feel and behave differently on a Monday morning. Mixing up treatments with sessions avoids this kind of bias. A good experiment is also single and double blind. Single blind means that subjects do not know the purpose of the experiment for example those in the A treatment are ignorant of the B treatment. Double blind means the experimenter also does not know what is going on he does not know if a particular subject is in the A or B treatment. Mixing up treatments with sessions is a simple way to avoid this kind of bias. In terms of double blindness it is worth noting that we are not just talking about experimenters deliberately biasing results. We know that experimenters can subconsciously bias things. For example, if the prediction is that people will be more generous in treatment A the experimenter may subconsciously be more bubbly and happy when greeting subjects who show up for treatment A. 1.5 Is it good that experiments usually involve students as subjects? Students are used purely for convenience. So, the simple answer would appear to be that it is not good experiments usually involve student subjects. Students are unlikely to be representative of the population and so we need to be careful in generalizing the conclusions from an experimental study. That said, the problem may not be as big as it seems. First, of all students are a quite diverse group and so we should get lots of heterogeneity of behavior. Second, the externality validity of experiments appears good. Meaning that results from the lab seem to match behavior in the field, in those instances where we have checked. A further advantage of using students is that they are not intimidated by the lab environment. When working with a more general population there is far more chance for bias because of confusion over the instructions, behavior being influenced by the setting, etc.
1.6 What are the objectives of behavioral economics? I would encourage you to focus on the big objectives of understanding and predicting economic behavior. How do we behave? And why do we behave that way? Why are you reading this? Why are you studying behavioral economics? Why are you not saving for retirement? What profession do you want? How much money would you spend on a new car? Why are stock prices so high? Why are wages so low? These are the kinds of questions we need insight on. Economics is a fantastic subject to study because it is all around us, everywhere we look. So, open your eyes and start analyzing behavior. Do not get trapped into thinking the objectives of behavioral economics are things like showing the standard economic model is wrong. If the standard economic model is right then a behavioral economist would be happy to say so. 1.7 What are the objectives of studying the standard economic model? Generally speaking, the objectives of studying the standard economic model are pretty much exactly the same as the objectives of behavioral economics. The only slight difference I would note is that the standard economic model also has appeal as a mathematical puzzle. It is sometimes interesting to question what the rational outcome would be to a particular problem. As a behavioral economist the main objective of studying the standard economic model is as a benchmark from which to start. This should be clear from the way all the chapters in part II of the book are set out. If the standard economic model worked all the time there would be no need for behavioral economics. Unfortunately, it does not and so we need to build upon it.