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Table of Contents
Introduction 1
About This Book 1
Conventions Used in This Book 2
What You’re Not to Read 2
Foolish Assumptions 3
How This Book isOrganized 3
Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 4
Part II: Understanding Choice 4
Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 4
Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 5
Part V: The Part of Tens 5
Icons Used in This Book 6
Where to Go from Here 6
Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 7
Chapter 1: Decoding Behavioral Economics 9
Making Wise Assumptions 9
Why reality matters 10
Why incentives matter — even in behavioral economics 10
Making Sense of Choice 11
Maximizing versus satisficing 11
The effect of emotions 12
The avoidance of loss 12
How options are framed 12
Paternalism versus free choice 13
The role of social context in decision making 14
Relative positioning 14
Growing the Economic Pie 15
Deciphering Bubbles and Busts 15
Inefficient markets and investment behavior 16
Emotions, intuition, animal spirits, and business cycles 16
Understanding Happiness: Money Isn’t Everything 17
Chapter 2: Getting Real about Assumptions 19
Defining an Economic Model 20
Explaining economic phenomena 21
Making simplifying assumptions 21
Discovering the irrelevance of facts 22
Understanding the role of math in model building 23
Considering cause and effect 26
Watching out for spurious correlations 26
Contemplating Conventional Economic Assumptions and Real-World Alternatives 27
Conventional assumption #1: People’s preferences are stable and consistent 27
Conventional assumption #2: People are solitary decision makers 28
Conventional assumption #3: How people form preferences doesn’t matter 28
Conventional assumption #4: People have the same preferences 29
Conventional assumption #5: People are all maximizers 30
Conventional assumption #6: People have perfect knowledge 32
Conventional assumption #7: People have unbounded computational capabilities 33
Conventional assumption #8: People have willpower 34
Conventional assumption #9: People are capable of acting upon their preferences 35
Understanding Rational Economic Behavior 36
You can do no wrong: Errors and biases in decision making 37
Selfishness and the smart society 38
Getting to Know the Behavioral Economics Actor 39
Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis 41
Where Neuroeconomics Fits in the Behavioral Economics
Perspective 43
The Brain and Economics 45
The evolution of the human brain 45
The division of labor in the human brain 48
The Emotional Brain 49
Descartes’ error: The somatic marker hypothesis 49
Phineas Gage and the social and emotional side of rational decision making 50
How Emotions Affect Decision Making 53
Fear and decision making 53
Happiness and decision making 54
The Limits of the Human Brain and Homo Economicus 54
The brain isnot a calculating machine 55
The brain isa scarce resource 55
What Brain Sciences Confirm for the Behavioral Economist 57
People prefer the present to the future 57
People’s aversion to loss affects their decision making 58
What people feel isn’t always what they experience 58
People care about keeping up with — and beating —the Joneses 60
People’s brains evolve over their lifetimes 61
People value fairness 62
People like to trust and be trusted 63
Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything 65
The Role of Economic Incentives for Economic Behavior 66
Why money isall that matters in conventional economics 67
Opportunity costs for Homo economicus 69
Decision Making and Opportunity Costs 71
Using up your mind: Bounded rationality 71
Considering costs other than money: Psychological costs 72
Reducing opportunity costs in the real world: Satisficing behavior 73
Weighing the opportunity cost of altruism 75
Supply and Demand and Behavioral Economics 75
Introducing the bandwagon effect 76
Investigating the snob effect 77
Interjecting morals and ethics 78
Introducing sociology to supply and demand 79
Economic Psychology: How Thoughts and Feelings Impact Decisions 84
Loss aversion: How framing, ownership, and control affect economic behavior 85
How the fear of uncertainty influences decisions 85
The warm glow: Why people sacrifice money for fairness or justice 87
Forfeiting money for status 88
Part II: Understanding Choice 89
Chapter 5: Exploring the Limits to Free Choice 91
Free Choice in Economic Decision Making 92
What conventional economics says 92
What behavioral economics says 93
Revealed Preferences: When Choices Reveal Your Inner Self 94
The narrative about preferences 95
False preferences versus true preferences 96
The limits of revealed preferences and free choice 98
The Illusion of Free Choice 99
Advertising and preference distortions 99
Self-control and free choice 101
Defaults as a determinant of choice 102
Herding, the bandwagon effect, and free choice: Are followers irrational? 103
Constraining Choice versus Freedom of Choice 104
Information 104
Education 105
Consumer rights 105
Chapter 6: Quick and Simple Heuristics and Real-World Decision Making 107
A Bird’s-Eye View of Smart Decision Making in Conventional Economics 108
Decision-making norms in conventional economics: The human calculating machine 109
The optimizing decision-making machine in conventional economics 110
Core conventional benchmarks for rational choice: To dream an impossible dream 111
The limits of conventional rationality 112
Rethinking Bounded Rationality and the Limits of the Mind 113
Bounded rationality and satisficing: Rationality within reason 114
The two blades of the decision-making scissors: Ecological rationality 114
Prospect Theory: Describing Average Decision-Making Behavior 116
Introducing prospect theory: Real-world decision making under uncertainty 117
Thinking about prospect theory and conventional norms 118
Exploring emotions as a hot bed of irrationality 118
The fundamentals of prospect theory: Understanding the value function 119
Unveiling Some Implications of Loss Aversion 122
Loss aversion and the certainty effect 122
Risk seeking in losses 123
The endowment effect: Explaining attachment to possessions 124
Uncovering Errors and Biases in Decision Making 125
Overconfidence 125
Herd behavior 125
Confirmation bias 126
Anchoring 126
Generalizing 127
Less isBest in Decision-Making: Fast and Frugal Heuristics 127
Exploring the superiority of heuristics 128
Understanding human rationality: New benchmarks built on human capabilities 130
Chapter 7: How the Framing of Choices Affects Decision Making 131
The Framing Effect 131
Framing and the economic schools of thought 132
The effect of framing on preferences and choices 133
Appreciating the objective unimportance of frames: The errors and biases approach 133
Understanding frames as heuristics 134
Framing in Pictures: The Possibility of Cognitive Illusions 134
Framing the Mona Lisa 135
Distorting the line illusion 135
Framing faces 136
Framing automobiles: Surface beauty versus substance 137
The letter illusion 138
We’re All Framed: Framing and Decision Making 139
Framing and loss aversion: The classic Asian disease experiment 140
When money isn’t everything 142
Saving a penny to lose a bundle: Framing prices through relative positioning 143
Frames as Defaults: How Anchors Sway the Course of Decision Making 144
Changing default options and choices 144
Revisiting choice architecture 146
Framing isimportant, but so are income and prices 147
The Inescapable Frame and Rational Decision Making 148
Understanding frames as an information-generating machine 148
Repairing frames and rational decision making 148
Introducing product labels into the framing arsenal 149
Market Failure and the Framing Effect 149
Chapter 8: How Norms, Peers, History, and Culture Influence Choice 153
Making Decisions in a Bubble, the Conventional Economics Way 154
Making decisions as if other people don’t matter 155
Making decisions as if history doesn’t matter 155
Making decisions as if society doesn’t matter 157
Introducing Social Norms to Decision Making 157
Looking at some norms 158
Identifying how trust impacts economic development 161
Seeing how discriminating norms can lead to a slow economy 162
Studying the role of education in the formation of norms and the shaping of preferences 163
The carrot and the stick: Exploring the enforcement of social norms 163
Peer Pressure: Seeing How Peers Affect Decision Making 164
How History and Culture Affect Choice 165
Rooting choice in history 165
Culture club: How culture affects the formation of preferences and choices 166
Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis 167
How Gender Affects Choice 167
Not tonight, honey: Conventional choice theory 168
Household bargaining power and women’s rights 169
Understanding household choices when women have a voice 171
Exploring population growth when women’s preferences count 172
Understanding why women go on welfare even if they want to work 174
Identifying why women are more risk averse than men 175
Exploring women’s altruistic preferences 176
Examining labor market discrimination 177
The Role of Children in Economic Decision Making 179
News Flash! Preferences Change with Age 179
Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 181
Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law 183
Why Most People Pay Taxes: The Big Stick versus the Warm Glows 183
How the big stick induces tax payments 184
The niceness effect 185
Social norms and taxes 186
A sense of fairness and tax compliance 186
Different Perspectives on Reducing Pollution 187
Exploring the economics of pollution control 187
Thinking about the green corporation 188
Understanding the links between green consumption and green production 189
Studying social norms and the greening of the world 189
Understanding the mix of economic and non-economic variables in determining green production 190
Crime and Punishment 190
The calculating criminal 191
Addiction and criminal behavior 193
The role of identity and social networks in determining criminal behavior 193
Why most people don’t commit crimes even when crime pays 194
Chapter 11: Labor Supply in the Real World 197
An Introduction to Labor Supply 197
Decoding the reality of labor supply 197
Mapping out changes to labor supply 198
Uncovering what people do when they aren’t working 201
Labor Supply When People Prefer Leisure: The Conventional Economics Perspective 202
The income-leisure trade-off: Bribing people to work 203
Why economics predicts that more income reduces labor supply: Work as an inferior good 206
How to increase the labor supply when people dislike work: Using the big stick 207
How Economic Necessity, Norms, and Love of Work Determine Labor Supply 207
How target income affects labor supply 208
Why increasing income doesn’t reduce labor supply 209
Labor supply when market employment isa superior good 210
Social welfare programs and labor supply 210
Norms, anchors, default retirement age, and labor supply 213
Chapter 12: The Black Box of the Firm: Human Relationships and Productivity 215
Survival of the Fittest, the Firm, and Contemporary Economic Theory 216
Doing the best we can: From slave to free labor to the big boss 216
Determining industrial relations through market forces 217
Maximizing profits and minimizing costs in the calculating firm 218
Understanding why the behavioral firm wins out 221
When People Don’t Behave According to Conventional Economics: X-Inefficiency 221
Types of x-inefficiency 221
When product markets aren’t competitive enough 222
Increasing inefficiency, managerial slack, and the art of lobbying 223
Preferences, managerial slack, and x-inefficiency 223
How low wages produce x-inefficiency and high wages contribute to x-efficiency 224
Efficiency wages: Connecting wages, effort, and productivity 226
Exploring fairness and gift exchange inside the firm 227
Understanding the relationship between conventional, x-efficiency, and efficiency wage theories 227
Chapter 13: The Good Economy: How Ethical Behavior Can Grow the Economy 229
Ethical Behavior: An Introduction 229
The Conventional Perspective on Ethical Behavior and the Economy 231
The Good Company 233
The Compatibility between Ethics and Profits 236
Examining x-efficiency and the socially responsible firm 236
How ethical consumers sustain and grow ethical production 239
Chapter 14: Why Institutions Matter 243
What Behavioral Economics Has to Say about Institutions 244
The decision-making context 245
The theory of the firm 245
The New Institutional Economics 246
Institutions and Wealth Creation 250
Governance 251
Culture 255
Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 257
Chapter 15: Deciphering Behavioral Finance 259
What Behavioral Finance is259
The Efficient Asset Market Models and Their Limits 260
The efficient market hypothesis 261
The random walk hypothesis 262
Irrational Exuberance: Smells Like Animal Spirit 264
Bubbles and Busts: A Preface to Inefficient Markets 266
The Dutch tulip bulb bubble 266
Contemporary bubbles: Evidence of inefficient markets 268
The causes of financial bubbles 271
Chapter 16: Looking into Recessions and Depressions 275
Introducing Psychology in Business Cycle Narratives 276
Grasping the meaning of macroeconomics, recessions, and depressions 276
Understanding animal spirits 279
Deconstructing business cycles: The tango between psychology and “real” factors 284
Economic Psychology and Government Policy 285
How Fairness, Reciprocity, and Punishment Influence Wages, Effort, and the Business Cycle 286
How efficiency wages cause sticky wages and involuntary unemployment 287
Why businesspeople don’t like to cut wages over the business cycle 287
Insights on money illusion: Tricking workers into cutting their wages 288
Why high wages don’t necessarily cause higher unemployment 289
How unemployment undermines confidence and destroys productivity 289
Chapter 17: The Art and Science of Happiness: Can You Be Happy without More Money? 291
Happiness and Conventional Economics 291
How happiness ismeasured 292
The art of being happy 292
Why conventional economics assumes that money makes you happy 294
Diminishing returns for income and wealth 295
What increasing per-capita income ignores 295
Happiness and Behavioral Economics 296
What makes us happy: The individual versus the expert 297
Why money alone can’t make you happy (at least if you’re well off) 298
The new empirics of the happiness debate 301
What money can’t buy (at least not easily) 303
How Government Policy Affects Happiness 306
Part V: The Part of Tens 309
Chapter 18: Ten (Or So) Key Public Policy Implications of Behavioral Economics 311
Consumer Rights and Protection and the Framing of Information 312
Product Labeling and Consumer Choice 312
Financial Markets and Information Deceit 313
Saving for the Future 313
Organ Donations 314
Weakness of Will and Self-Control 315
Labor Market Regulation and Economic Efficiency 316
Big Brother and Behavioral Economics: Does Government Know Best? 316
Crime, Punishment, and Identity 317
Population Growth and the Empowerment of Women 318
Tax Compliance: The Carrot isas Important as the Stick 319
Trust and Economic Efficiency in an Imperfect World 319
Chapter 19: Ten (Or So) Experiments in Behavioral Economics 321
The Ultimatum Game: Fairness and Punishment 321
The Dictator Game: Being Fair Because It’s the Right Thing to Do 323
Fair Wage Experiments: Adventures into Labor Market Dynamics 324
Public Goods Games: Sacrificing for the Public Good 325
The Dark Side of Humanity: It Isn’t All about Lovingkindness 327
The Endowment Effect: How Ownership Affects Behavior 327
Market Games: Markets Work Even When They’re “Irrational” 329
Bubble Experiments: How Smart People Produce Economic Bubbles 330
Experiments on Bounded Rationality 331
Chapter 20: Ten Decision-Making Lessons from Behavioral Economics 333
Be Wary of Overconfidence 333
You Can’t Believe Everything You Read 334
Avoid Situations That Require More Self-Control Than You Can Muster 335
Don’t Blindly Follow the Herd 336
You Can’t Trust Everyone 336
Invest Simply 337
Pay Attention to Sample Size 337
Read the Fine Print 338
Being Nice Pays 338
Educate Yourself 339
Index 341
