This chapter looks at the whether behavioral economics can be used by policy-makers to help people make better choices. It illustrates the importance of institutions, this will take us into the world of practical policy design and intervention. The chapter shows that institutions can be of two basic kinds: formal institutions, such as markets, and informal institutions, such as social norms. In recent years there has been much excitement that behavioral economics can change the way in which policy is viewed when it comes to individual incentives. The opens up interesting new ways to think of economics and policy, informed by behavioral economics. The mindspace principles are designed to help policy-makers better understand how possible policies might change behavior; they are a kind of checklist of things to think about. The Institute for Government has come up with the idea of mindspace. In many instances …

We develop and test a model that provides a unified account of the neural processes underlying behavior in the classical economic choice task. The model portrays brain processes engaged in evaluating information in the experimental stimuli. This portrayal produces a consistent account of several important features of the decision process in different environments (e.g., when the probability is specified or not): these features include the choices made, the time to decide, the error rate in choice, and the patterns of brain activation. Complex information describing two economic options is represented on the retinas of the subject as a collection of photons. A collection of photons is converted (via a sequence of neuronal processes) to a measure indicating which option has the higher utility magnitude. Data are processed by the brain until evidence sufficient to favor one option is reached. The model predicts that the further two stimuli are from each other in utility space, the faster the reaction time will be, fewer errors in choice will be made, and less brain activation will be required to make the choice; the model also predicts that choices with ambiguity can be made quicker and will require less brain activation in the horizontal intraparietal sulcus than for choices with risk. Also, we demonstrate how, ceteris paribus, with a larger certainty option in the choice, there is more brain activation, and furthermore, with less experience on the part of the subject making choices, there is more activation.

We study the behavior of subjects facing choices between certain, risky, and ambiguous lotteries. Subjects' choices are consistent with the economic theories modeling ambiguity aversion. Our results support the conjecture that subjects face choice tasks as an estimation of the value of the lotteries, and that the difficulty of the choice is an important explanatory variable (in addition to risk and ambiguity aversion).The brain imaging data suggest that such estimation is of an approximate nature when the choices involve ambiguous and risky lotteries, as the regions in the brain that are activated are typically located in parietal lobes. Thus such choices require mental faculties that are shared by all mammals, and in particular are independent of language. In contrast, choices involving partial ambiguous lotteries additionally produce an activation of the frontal region, which indicates a different, more sophisticated cognitive process. (c) 2004 Elsevier Inc. All rights reserved.

In this article we use laboratory experiments to ask a fundamental question: Do individuals behave as if their risk preferences are stable across institutions? In particular, we study the decisions of cash-motivated subjects in the repeated play of three different institutions: a value elicitation procedure for the sale of a risky asset, an English clock auction for the sale of a risky asset, and a first-price auction for the purchase of a riskless asset. We first do a simple categorical comparison of each subject's risk preferences across tasks by comparing the individual's decisions with an expected value maximizer. All subjects acted as if they were risk-loving in the English clock auctions and risk-averse in the first-price auctions. In the Becker, Degroot, and Marschack procedure, behavior was split between risk-loving and risk-averse bidding. For each institution we also estimate an individual's risk coefficient. We test the hypotheses that for the same individuals the estimated risk coefficient across institutions is the same. We find that these estimates are statistically different.

In two different types of institutions, English and Dutch auctions, we collect heart rate data, a proxy for emotion, to test hypotheses based on findings in neural science about the effect of emotion on economic behavior. We first demonstrate that recording heart rates does not distort prices in these auctions. Next we ask if knowledge of the intensity of a participant's emotional state improves our ability to predict price setting behavior beyond predictions of price based on usual economic variables. Our answer is that "institutions matter." In the Dutch (English) auctions we find (no) evidence that knowledge of emotional intensity affects our ability to predict price setting behavior. We then entertain the proposition that the cardiac system is an information system that processes economic events. We are able to show that this hypothesis is consistent with our observations and furthermore that the processes differ across institutions.

ABSTRACTWe examine the effect of higher order beliefs on the ability of decentralized decision makers to coordinate and take advantage of improvements in information transparency that can increase welfare. Theories that address this question have not been empirically explored. We study coordination in a laboratory experiment with privately informed decision makers. Economic outcomes in the setting depend both on agents' rational beliefs regarding economic fundamentals and on their rational beliefs regarding the beliefs of other agents. Increasing information transparency mitigates uncertainty about economic fundamentals but may increase strategic uncertainty, precipitating multiple equilibria and less efficient group outcomes. We provide evidence that sometimes the equilibrium attained by creditors is inferior from a welfare perspective to other available equilibria. Risk dominance appears to determine equilibrium selection in our setting.

We explore the management of information and the response of market prices to such information. Sellers may be uncertain of dividends. We examine whether sellers anticipate buyers' pricing behavior and whether buyers' prices reflect correct inferences of the disclosure strategy of sellers. Buyers' inferences and sellers' anticipation require implicit Bayesian updating in solving for the equilibrium decision strategies of sellers and pricing behavior of buyers. Because of traditional problems in inducing Bayesian behavior we employ a manual technology. Our results show that if we split selling strategies into “information management” (sanitization), full disclosure, and randomization, then the information disclosed is consistent with sellers anticipating buyers' pricing functional. Furthermore, prices themselves are sensitive to the information environment (full certainty, intermediate certainty, and low certainty) in which information asymmetry is manipulated.

In this study we examine how the introduction of a reference lottery with nonrandom outcomes alters the way in which choices among pairs of lotteries are made, even if it does not alter the choices. We use different domains (some of the lotteries produce gains, other losses) and different contexts (one member of the pair, the reference lottery, may be either risky or certain). In our experiment, the change from gain to loss domain affects choices: subjects are risk averse in the gain domain, but not in the loss domain. On the contrary, the context effect of the certain lottery does not affect choices. However, the introduction of the certainty reference lottery affects two behavioral variables, response time and brain activation, in a dramatic way. This result suggests that the certainty lottery promotes a different process through which preferences are revealed, even if the differences among lotteries may not be large enough to induce different choices.

Economic forces shape the behavior of individuals and institutions. Forces affecting individual behavior are attitudes about payoffs (gains and losses) and beliefs about outcomes (risk and ambiguity). Under risk, the likelihoods of alternative outcomes are fully known. Under ambiguity, these likelihoods are unknown. In our experiment, payoffs and outcomes were manipulated independently during a classical choice task as brain activity was measured with positron emission tomography (PET). Here, we show that attitudes about payoffs and beliefs about the likelihood of outcomes exhibit interaction effects both behaviorally and neurally. Participants are risk averse in gains and risk-seeking in losses; they are ambiguity-seeking in neither gains nor losses. Two neural substrates for choice surfaced in the interaction between attitudes and beliefs: a dorsomedial neocortical system and a ventromedial system. This finding reveals that the brain does not honor a prevalent assumption of economics—the independence of the evaluations of payoffs and outcomes. The demonstration of a relationship between brain activity and observed economic choice attests to the feasibility of a neuroeconomic decision science.

We develop a model of information processing and strategy choice for participants in a double auction. Sellers in this model form beliefs that an offer will be accepted by some buyer. Similarly, buyers form beliefs that a bid will be accepted. These beliefs are formed on the basis of observed market data, including frequencies of asks, bids, accepted asks, and accepted bids. Then traders choose an action that maximizes their own expected surplus. The trading activity resulting from these beliefs and strategies is sufficient to achieve transaction prices at competitive equilibrium and complete market efficiency after several periods of trading.Journal of Economic LiteratureClassification Numbers: D41, D44, D8

We designed an experiment to study trust and reciprocity in an investment setting. This design controls for alternative explanations of behavior including repeat game reputation effects, contractual precommitments, and punishment threats. Observed decisions suggest that reciprocity exists as a basic element of human behavior and that this is accounted for in the trust extended to an anonymous counterpart. A second treatment, social history, identifies conditions which strengthen the relationship between trust and reciprocity.

As early as 1973, Dickhaut found that subjects in accounting settings did not process information according to normative (e.g., Bayes') theorems. Similar results have been obtained by Wright [1978], Swieringa et al. [1976], and more recently Joyce and Biddle [1981]. While these studies on human information processing have focused on individual performance, work in related accounting areas, such as capital market research in accounting and the principal-agent area of accounting, has employed models of the individual which rest on assumptions inconsistent with the results cited above. Commenting on the apparent divergence between the capital market research and human information processing research, Einhorn [1976, p. 98] noted: Of course, the fascinating, but unanswered question remains as to how sub-optimal individual behavior can lead to 'rational' behavior at the aggregate level (if indeed this exists).