Behavioural Economics And Finance - GBV

Behavioural Economicsand FinanceMichelle BaddeleyO Routledgeg J Taylor &.Francis CroupLONDON AND NEW YORK

Table of contentsList of illustrationsAcknowledgementsPART 1Background1IntroductionWhat is behavioural economics? 3Why behavioural finance? 3A quick history of behavioural economics 4David Hume 4Adam Smith 5Jeremy Bentham 5Vilfredo Pareto 6Irving Fisher 6John Maynard Keynes 6Friedrich von Hayek 7George Katona 8Modern behavioural economics versus standard approaches 8What are the standard assumptions of neoclassical economics?Methodological tools 1O'\Game theory 11Experimental economics 11Behavioural policy implications 13The structure of Behavioural Economics and Finance 14A note on mathematics 16Further reading 16Some introductions to behavioural economics 16Behavioural game theory/classical game theory 16Experimental economics 17Experimental software 172Foundations: psychologyIntroduction18

viiiTable of contentsPersonality theory 19Freud's psychoanalytic theory 19Jung's archetypes 20Modern personality theory 20Measuring cognitive skills 21Personality tests 21Cognitive functioning 22Behavioural psychology 23Social psychology 25Social learning theory 26Social influences and social pressureConclusion 28Further reading 29327 — 'Foundations: neuroscience and neuroeconomicsIntroduction 30What are nerves and how do they work? 30Anatomy of the brain 32Brain areas and functions 34Modularity 35Neuroscientific data and techniques 36Neuroeconomics 41What is neuroeconomics? 41Neuroeconomic data 42Neuroeconomic models and theories 43Controversies in behavioural economics and neuroeconomicsWhat's next? 46Further reading 473045}PART 2Behavioural microeconomic principles4Learning.49\Introduction 51Belief learning 51A belief learning model 52Cheung and Friedman's experiments 53Reinforcement learning 54A reinforcement learning model 55Erev and Roth's empirical evidence 57Experience-weighted attraction 58Experimental evidence about EWA models 58Comparative econometric evidence on EWA versus RL and BL modelsSocial learning and information cascades 61Social learning theories 61Experimental tests of Bayesian herding 635160

Table of contentsixOther behavioural approaches to social learning 66Social influence 67Evolutionary approaches 68Neuroeconomic analyses of learning and social influence 70Belief learning and reinforcement learning 70Reward learning and reward prediction error 70Observational learning 71Case study: social influences in real-world networks 73Social influences on household energy decisions 73Firms' reputation-building and corporate social responsibility 73A study of social influences in Indian villages- 74Conclusions and policy implications 755Sociality and identity77Introduction 77Some experimental evidence 77Ultimatum games and dictator games 79Experiments with trust games 80Social preference models 81Social utility models 81Cooperation and punishment 86Altruistic punishment 86Extrinsic versus intrinsic motivations 86Evolution and social cues 88Ostracism in social networks 88Identity 89Social identity theory 89Akerlofand Kranton'sidentity theory 90, Neuroeconomic analyses 91de Quervain et al. 's analysis of altruistic punishment in the trust gameNeuroeconomic studies of empathy and trust 95Case study: social norms and environmental decision-making 96Fairness and inequity aversion 96Social norms 97 \Familial influence and identity 99Conclusions and policy implications 1006 Heuristics and biasesIntroduction 102Defining rationality 102Procedural versus substantive rationality 103Ecological rationality 103Kahneman 's maps of bounded rationality 104Heuristics and decision-making 105Tversky and Kahneman on heuristics and biasesRepresentativeness 106Availability heuristic 11191102106

xTable of contentsAnchoring and adjustment 114Loss aversion, endowment effects and status quo bias 116Biases and heuristics in expert judgment 118Choice overload and cognitive dissonance 119Choice overload 119Cognitive balance and cognitive dissonance 120Neuroeconomic analyses 121Case study: heuristics and biases in real-world decision-making 122Online heuristics and biases 122Heuristics, biases andfolk wisdom in environmental decision-making 124Conclusions and policy implications 126' — '7Prospects and regrets128Introduction 128Behavioural paradoxes 128St Petersburg paradox 128Allais paradox 129Ellsberg paradox 129Monty Hall/three prisoners paradox 130Expected utility theory 131Bar-Hillel and Folk's solution to the three prisoners problem 131Kahneman and Tversky's critique of expected utility theory 132Certainty effect 135Reflection effect 136Isolation effect 137Kahneman and Tversky's prospect theory 138Editingphase 138Evaluation 139The value function 139Loss aversion 141The weighting function 141Evidence from game shows 143Cumulative prospect theory 144Mental accounting and framing 144Mental accounting 144Framing and bracketing 146Regret theory 147Neuroeconomic analyses 149Case study: buying insurance 150Conclusions and policy implications 1518Personality, moods and emotionsIntroduction 153Personality and individual differences 153Personality and cognition 155Personality and preference parameters 155Individual differences and human capital investment:153156

Table of contentsxiMoods 158Moods and weather patterns 158Social mood in socionomic analyses 158Emotions and affect 159Emotions and heuristics 160The somatic marker hypothesis 160Basic instincts and visceral factors 162Social emotions 163Cognition and emotion in dual-system models 164Neuroeconomic analyses 167Sanfey et al.i fMRIstudy of social emotions -167Neuroeconomic studies of empathy 170Case study: emotional trading 170Conclusions and policy implications 1729Time and plans174Introduction' 174Exponential discount functions 174Individual differences with exponential discounting 174Behavioural discount functions 175Behavioural anomalies 175Animal models 176Behavioural discounting models 176Time inconsistency in the real world 179Behavioural life-cycle models 181Limitations of the Angeletos et al. behavioural life-cycle model 183Temporal mental accounting and bracketing 184Bracketing in labour supply 184Neuroeconomic analyses 185McClure, Laibson, Loewenstein and Cohen 'sfMRI evidence 185Glimcher, Kable and Louie s analysis of delayed choices 186Case study: intertemporal planning and the environment 187Behavioural discount functions for environmental decision-making 187Goals, planning andfeedback 188Conclusions and policy implications 18910 Bad habitsIntroduction 191Rational addiction models 191Becker, Grossman and Murphy's model 191Becker and Murphy's empirical evidence 195Other econometric studies of addiction 196Rational addiction models: summary of evidence and implicationsCue-triggered consumption 200Laibson s cue theory of consumption 201Bernheim and Rangel on hot-cold systems 201Cues in natural addiction models 202:191199

xiiTable of contentsVisceral factors 203Neuroeconomic analyses 204Naqvi et al.'s lesion patient study 204Post-mortem studies 205Case study: healthy lifestyles 205Bad health habits: not going to the gym 207Conclusions and policy implications 208PART 3Macroeconomics and financial markets.21111 Financial instability213Introduction 213Herding, learning and social influences 214Social learning 214Beauty contests 215Reputation 216Heuristics, biases and prospect theory 216Over-reactions and under-reactions 217Diversification biases and the availability heuristic 218Momentum trading 219Prospect theory, loss aversion and ambiguity aversion ,219Time and instability 221Moods, emotions and personality 222An emotional finance model 223Akerlofand Shiller s animal spirits 224Neuroeconomic evidence 225Risk, impulsivity andfear 226Financial herding and social emotions 22 7Conclusions and policy implications 23012 Behavioural macroeconomics, happiness and wellbeingIntroduction 232'Keynes's psychology of the macroeconomy 233Keynes s fundamental psychological laws 233Expectations and the state of confidence 233Macroeconomic conventions 234Entrepreneurial animal spirits 235A behavioural analysis of macroeconomic interactionsAkerlofand Shiller s animal spirits 23 7Macroeconomic actors 238Investment 238Consumption and saving. 242Labour markets and unemployment 243Government policy-making 244Happiness 245236232

Table of contentsxiiiUtility and happiness 246Wellbeing 247Measuring wellbeing 249Wellbeing and the environment 250Neuroeconomic studies of happiness 252Conclusions and policy implications 253BibliographyIndex255284

Behavioural policy implications 13 The structure of Behavioural Economics and Finance 14 A note on mathematics 16 Further reading 16 Some introductions to behavioural economics 16 Behavioural game theory/classical game theory 16 Experimental economics 17 Experimental software 17 2