An Introduction To Behavioral Economics


There are different explanations for this error, including how we remember past events. Finally, as my vacation days go by, I will simply get used to it and my happiness will level out. According to the concept of hedonic adaptation, changes in experiences tend only to induce happiness temporarily as we get used to new circumstances (Frederick & Loewenstein, 1999). In addition to inertia, future discounting is another key problem that explains low retirement savings rates. One piece of research suggests that behavioral change could be achieved by helping people connect with their future selves. In the study, people who saw an age-progressed avatar of themselves were more likely to accept future financial rewards over immediate ones (Hershfield et al., 2011).

Combination E is preferred to combination A, but is unattainable given the budget constraint. Knowing that individuals experience diminishing marginal utility, how do businesses react? Recall that consumer surplus is the area below the demand curve but above the price. Think of some examples of how businesses react given the law of diminishing marginal utility. But, the total utility of water is much higher than the total utility of diamonds.

Fairness is related to a human desire for reciprocity, our tendency to return another’s action with another equivalent action. Reciprocity, however, can have positive and negative aspects. In the real world, charities sometimes use reciprocity to their advantage. For example, one field experiment investigating donation behavior showed that people who received a large gift with a donation solicitation letter had a 75 percent higher donation frequency compared to a ‘no gift’ baseline condition .

This can come in the form of physical goods such as gold, oil, or land. When demand is constant, but supply declines, we have a supply-driven scarcity. In other words, there is a dwindling supply that cannot be extended.

Indifference curve Assume rational consumers Many consumers buy goods on impulse. The collapse of the housing market in 2008 indicate that not all consumers make rational choices. However, the majority of consumers are rational and consumption decisions are made carefully. Thus, it would be safe to assume that consumption decisions are mi amor meaning made on the basis of stable consumer preferences. Marginal utility, not total utility, is proportional to price! Assuming additive utility function (i.e., the utility of each good is independent of the other good), total utility of diamonds is the area below the MU of diamonds and that of water is the area below the MU of water.

According to time-discounting theories, present events are weighted more heavily than future ones (Frederick, Loewenstein & O’Donoghue, 2002); for example, many people prefer to receive £100 now over £110 in a month’s time. Discounting is non-linear, and its rate is not constant over time. People’s preference for receiving £100 a week from now versus £110 a month and one week from now will not be the same as their preference for receiving £100 a year from now versus £110 a year and one month from now. Although the gap is one month in both cases, the value of events that are farther in the future falls more slowly than those closer to the present .

Others will reject the offer, saying that it is worth at least five dollars to them to deny they businessman the $4,995. Remember that when we talk about utility, it includes not only monetary items but also the nonmonetary. Services often follow a similar pricing scheme with lower average prices for more frequent attendance.