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Behavioural Economics (Types of Heuristics (Availability (Issues (Saliency…
Behavioural Economics
Types of Heuristics
Status Quo Bias
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"When faced with a choice among options, people have a tendency to stick with the default. The effect is driven by the (even small) cognitive costs involved in thinking about the choice and switching."
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Pervasive because many choices we make have a history and therefore a default that we are reluctant to change
Endowment Effect
"The tendency for people to ascribe more value to items they own compared to equivalent items they do not own"
Violates Coase Theorem - allocation of resources should be independent of initial property rights in the absence of transaction costs
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Representativeness Bias
Stereotypes about lawyers and Engineers
(Participants ignored base frequency 70:30 and over-relied on representativeness
Representativeness is:
The degree to which the event:
(i) is similar to essential characteristics of parent population
(ii) reflects salient features of the process by which it is generated
but since the sample size does not represent any property of the population, its expected to have little or no effect on judgment of likelihood
The bias
But the sample size is too small to represent the population accurately, representativeness should not in fact make something more likely. Thus, using representativeness tends to lead to overestimation of the probability and "neglect of relevant base rates"
Consequences
Mean regression Bias
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Individuals tend to assume that the instance they observe is representative of the outcome they are attempting to predict, and therefore that the value of the outcome is as extreme as the observed instance
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Availability
Recalling Frequency of Alphabet in 1st and 3rd position
(easier to recall words starting with R than in 3rd position)
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"Availability is a judgemental heuristic in which a person evaluates the frequency of classes or the probability of events by the ease with which relevant instances come to mind"
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Awareness of bias can lead to its disappearance
(if experimenter explains the ease of retrieval of spurious story, the bias disappears)
Anchoring
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Explanation for the general finding that: people tend to overestimate probability of conjunctive events and underestimate that of disjunctive events
Use elementary event probability and adjust, but adjustment is usually insufficient
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Consequences
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Impacts decisions of pricing, bargaining willingness to pay in transactions
Framing
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"Decision frame" refers to decision-makers conception of acts, outcomes and contingencies associated with a particular choice
Frame adopted is controlled partly by formulation of the problem and partly by the norms, habits and personal characteristics of the decision-maker
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Relevance to Contracts
Wages of an employee
Case 1) Owner changes wage of SAME employee to match market
Case 2) Employee leaves and owner changes wage of NEW employee
Case 3) Employee changes jobscope and wage decreases
Case 1 is deemed most unfair, Case 2 most acceptable
Naive Accounting
Case 1) Company decreases real wages by lowering nominal wages
Case 2) Company decreases real wages by not increasing nominal wages as much as inflation
Case 1 considered unfair while case 2 fair
Possible explanations
Different anchors
If there is history of similar transactions between firm and transactor, then the most recent price/wage/rent is the anchor
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Losses and Gains
Case 1) A company making losses reduces wages by 10%
Case 2) A company making losses stops giving annual bonuses of 10%
Case 2 is judged acceptable while 1 is not
An action seen as a loss is more likely to be judged as unfair than if it cancels a potential gain
An action more likely to be judged unfair if it achieves a gain to the firm than if it averts a loss
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