"Familiarity breeds contempt - and children." - Mark Twain

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"A more general bias is called the "curse of knowledge"—people who know a lot find it hard to imagine how little others know. The development psychologist Jean Piaget suggested that the difficulty of teaching is caused by this curse. (Why is it so hard to explain something “obvious” like consumer indifference curves or Nash equilibrium to your undergraduate students?)* Anybody who has tried to learn from a computer manual has seen the curse of knowledge in action

* - Here is an example from the business world: When its software engineers refused to believe that everyday folks were having trouble learning to use their opaque, buggy software, Microsoft installed a test room with a one-way mirror so that the engineers could see people struggling before their very eyes (Heath, Larrick, & Klayman, 1998)...

Many studies have also shown that the method used to elicit preferences can have dramatic consequences, sometimes producing "preference reversals"-- situations in which A is preferred to B under one method of elicitation, but A is judged as inferior to B under a different elicitation method... Another form of preference reversal occurs between joint and separate evaluations of pairs of goods (Hsee et al, 1999; see Hsee & LeClerc, 1998, for an application to marketing). People will often price or otherwise evaluate an item A higher than another item B when the two are evaluated independently, but evaluate B more highly than A when the two items are compared and priced at the same time.

"Context effects" refer to ways in which preferences between options depend on what other options are in the set (contrary to "independence of irrelevant alternatives" assumptions). For example, people are generally attracted to options that dominate other options (Huber, Payne & Puto, 1982). They are also drawn disproportionately to "compromise" alternatives whose attribute values lie between those of other alternatives (Simonson & Tversky, 1992).

All of the above findings suggest that preferences are not the pre-defined sets of indifference curves represented in microeconomics textbooks. They are often ill-defined, highly malleable and dependent on the context in which they are elicited. Nevertheless, when required to make an economic decisions—to choose a brand of toothpaste, a car, a job, or how to invest—people do make some kind of decision. Behavioral economists refer to the process by which people make choices with ill-defined preferences as "constructing preferences" (Payne, Bettman & Johnson, 1992; Slovic, 1995).

A theme emerging in recent research is that, although people often reveal inconsistent or arbitrary preferences, they typically obey normative principles of economic theory when it is transparent how to do so. Ariely, Loewenstein and Prelec (in press) refer to this pattern as "coherent arbitrariness" and illustrate the phenomenon with a series of studies in which the amount subjects demanded to listen to an annoying sound is sensitive to an arbitrary anchor, but they also demand much more to listen to the tone for a longer period of time. Thus, while expressed valuations for one unit of a good are sensitive to an anchor which is clearly arbitrary, subjects also obey the normative principle of adjusting those valuations to the quantity – in this case the duration -- of the annoying sound.*

* - A joke makes this point nicely. An accountant flying across the country nudges the person in the next seat. "See those mountains down there?" the accountant says. "They're a million and four years old". Intrigued, the neighbor asks how the accountant can be so sure of the precise age of the mountaints. The accountant replied, "Well, four years ago I flew across these mountains and a geologist I sat next to said they were a million years old. So now they're a million and four." [Ed: Footnote in a later edition of the chapter]

... A second anomaly is apparent negative time discounting. If people like savoring pleasant future activities they may postpone them to prolong the pleasure (and they may get painful activities over with quickly to avoid dread). For example, Loewenstein (1987) elicited money valuations of several outcomes which included a "kiss from the movie star of your choice," and "a nonlethal 110 volt electric shock" occurring at different points in time. The average subject paid the most to delay the kiss three days, and was eager to get the shock over with as quickly as possible (see also Carson and Horowitz, 1990; MacKeigan et al, 1993). In a standard DU model, these patterns can only be explained by discount factors which are greater than one (or discount rates which are negative). However, Loewenstein (1987) showed that these effects can be explained by a model with positive time discounting, in which people derive utility (both positive and negative) from anticipation of future consumption..

One component of behavioral game theory is a theory of social preferences for allocations of money to oneself and others (discussed above). Another component is a theory of how people choose in one-shot games or in the first period of a repeated game. A simple example is the `pbeauty contest game": Players choose numbers in [0,100] and the player whose number is closest in absolute value to p times the average wins a fixed prize. (The game is named after a well-known passage in which Keynes compared the stock market to a `beauty contest’ in which investors only care about what stocks others think are `beautiful’.) There are many experimental studies for p=2/3. In this game the unique Nash equilibrium is zero. Since players want to choose 2/3 of the average number, if players think others will choose 50, for example, they will choose 33. But if they think others use the same reasoning and hence choose 33, they will want to choose 22. Nash equilibrium requires this process to continue until players beliefs’ and choices match. The process only stops, mathematically, when x=(2/3)x, yielding an equilibrium of zero.

In fact, subjects in p-beauty contest experiments seem to use only one or two steps of iterated reasoning: Most subjects best-respond to the belief that others choose randomly (step 1), choosing 33, or best-respond to step-1 choices (step-2), choosing 22. (This result has been replicated with many subject pools, including Caltech undergraduates with median math SAT scores of 800 and corporate CEOs.)...

Shefrin and Thaler (1992 and this volume) present a "behavioral life cycle" theory of savings in which different sources of income are kept track of in different mental accounts. Mental accounts can reflect natural perceptual or cognitive divisions. For example, it is possible to add up your paycheck and the dollar value of your frequent flyer miles, but it is simply unnatural (and a little arbitrary) to do so, like measuring the capacity of your refrigerator by how many calories it holds. Mental accounts can also be bright-line devices to avoid temptation: Allow yourself to head to Vegas after cashing an IRS refund check, but not after raiding the childrens’ college fund or taking out a housing equity loan. Shefrin and Thaler (1992, and this volume) show that plausible assumptions about mental accounting for wealth predict important deviations from life-cycle savings theory. For example, the measured marginal propensities to consume (MPC) an extra dollar of income from different income categories are very different. The MPC from housing equity is extremely low (people don’t see their house as a pile of cash). On the other hand, the MPC from windfall gains is substantial and often close to 1 (the MPC from one-time tax cuts is around 1/3-2/3)...

A popular account of unemployment posits that wages are deliberately paid above the marketclearing level, which creates an excess supply of workers and hence, unemployment. But why are wages too high? One interpretation, "efficiency wage theory," is that paying workers more than they deserve is necessary to ensure that they have something to lose if they are fired, which motivates them to work hard and economizes on monitoring. Akerlof and Yellen (1990 and this volume) have a different interpretation: Human instincts to reciprocate transform the employerworker relation into a "gift-exchange". Employers pay more than they have to as a gift; and workers repay the gift by working harder than necessary. They show how gift-exchange can be an equilibrium (given reciprocal preferences), and show some of its macroeconomic implications...

Perhaps the simplest prediction of labor economics is that the supply of labor should be upward sloping in response to a transitory increase in wage. Gneezy and Rustichini (this volume) document one situation in which this is not the case. They hired students to perform a boring task and either paid them a low piece-rate, a moderately high piece-rate, or no piece-rate at all. The surprising finding was that individuals in the low piece-rate condition produces the lowest "output" levels. Paying subjects, they argued, caused subjects to think of themselves as working in exchange for money and, when the amount of money was small, they decided that it simply wasn't worth it. In another study reported in their chapter, they showed a similar effect in a natural experiment that focused on a domain other than labor supply. To discourage parents from picking their children up late, a day-care center instituted a fine for each minute that parents arrived late at the center. The fine had the perverse effect of increasing parental lateness. The authors postulated that the fine eliminated the moral disapprobation associated with arriving late (robbing it of its gift-giving quality) and replaced it with a simple monetary cost which some parents decided was worth incurring. Their results show that the effect of price changes can be quite different than in economic theory when behavior has moral components which wages and prices alter...

The so-called "Groucho Marx" theorem states that people should not want to trade with people who would want to trade with them, but the volume of stock market transactions is staggering. [Ed: "I sent the club a wire stating, PLEASE ACCEPT MY RESIGNATION. I DON'T WANT TO BELONG TO ANY CLUB THAT WILL ACCEPT ME AS A MEMBER." - Groucho Marx]...

The rise of behavioral finance is particularly striking because, until recently, financial theory bet all its chips on the belief that investors are too rational to ignore observed historical patterns-- the "efficient markets hypothesis." Early heretics like Shiller (1981), who argued empirically that stock price swings are too volatile to reflect only news, and DeBondt and Thaler (1985), who discovered an important overreaction effect based on the psychology of representativeness, had their statistical work "audited" with special scrutiny (or worse, were simply ignored). In 1978 Jensen called the efficient markets hypothesis "the most wellestablished regularity in social science." Shortly after Jensen’s grand pronouncement, however, the list of anomalies began to grow. (To be fair, anomaly-hunting is aided by the fact that market efficiency is such a precise, easily-testable claim). A younger generation are now eagerly sponging up as much psychology as they can to help explain anomalies in a unified way...

Jolls et al note that behavioral concepts provide a way to constructively address concerns that laws or regulations are paternalistic. If people routinely make an error they are unaware of, or regret, then rules that inform them of errors or protect them from making them will help. This line of argument suggests a form of paternalism which is “conservative”— a regulation should be irresistible if it can help some irrational agents, and does little harm to rational ones (see Camerer et. al., in press). An example is “cooling-off” periods for high-pressure sales: People who are easily seduced into buying something they regret have a few days to renege on their agreement, and cool-headed rational agents are not harmed at all. Behavioral science can help inform what sorts of mistakes might be corrected this way. [Ed: This paragraphs is from a later version of the chapter; consequentialist libertarians won't like Behavioral Economics]...

Another potential problem with evolutionary reasoning is that most studies posit a special brain mechanism to solve a particular adaptive problem, but ignore the effect of how that mechanism constrains solution of other adaptive problems. (This is nothing more than the general equilibrium critique of partial equilibrium modelling, applied to the brain.) For example, a fashionable interpretation of why responders reject ultimatum offers is that agents cannot instinctively distinguish between one-shot and repeated games. But agents who could not do this would presumably be handicapped in many other sorts of decisions which require distinguishing unique and repeated situations, or accurately forecasting horizons (such as life-cycle planning), unless they have a special problem making distinctions among types of games...

Critics have pointed out that behavioral economics is not a unified theory, but is instead a collection of tools or ideas. This is true. It is also true of neoclassical economics. A worker might rely on a "single" tool-- say, a power drill-- but also use a wide range of drill bits to do various jobs. Is this one tool or many? As Arrow (1986) pointed out, economic models do not derive much predictive power from the single tool of utility-maximization. Precision comes from the drill bits—such as time-additive separable utility in asset pricing including a child's utility into a parent’s utility function to explain bequests, rationality of expectations for some applications and adaptive expectations for others, homothetic preferences for commodity bundles, price-taking in some markets and game-theoretic reasoning in others, and so forth. Sometimes these specifications are even contradictory— for example, pure self-interest is abandoned in models of bequests, but restored in models of life-cycle savings; and risk-aversion is typically assumed in equity markets and risk-preference in betting markets. Such contradictions are like the "contradiction" between a Phillips-head and a regular screwdriver: They are different tools for different jobs. The goal of behavioral economics is to develop better tools that, in some cases, can do both jobs at once."

--- Behavioral Economics: Past, Present, Future, Colin F. Camerer