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Economics is the study to how people response to incentiveWeek 2- RationalityRationality: People can rank their preferences and then choose the most desirable feasible choice. >Rationality is different from selfishness. Rational behavior is not necessarily selfish. Selfishness is a result of...

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Economics is the study to how people response to incentive Week 2- Rationality Rationality: People can rank their preferences and then choose the most desirable feasible choice.  >Rationality is different from selfishness. Rational behavior is not necessarily selfish. Selfishness is a result of being rationality  Mistakes can be made. But it is a better theory than: 

Arationality: people make choices randomly

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Irrationality: people choose the opposite of what they desire

 Eg. If an industry has a higher profit margin than other industries, business move to that higher paying industry  When the cost of an action goes down, people are more likely to do it  Assumption of rationality:  People’s preferences are complete. ( we can rank any types of good to others)  People’s preferences are transitive. (if people prefer basket a to B, and basket b to c, then they prefer basket A to C)  People are not assumed to have perfect self-control and they make decision they later regret -> we must not be quick to label such behaviors irrational  > Rationality is a good enough theory to describe how people act because most of the times when we do things we are familiar with and experienced in, mistakes are less likely to occur.  We choose differently based on the way choices are framed -> irrationality due to the phrasing of choices affecting choices made.  One of the few reasons why we are not rational: 

Endowment effect: we tend to overvalue things above market value that we own

 Rationality can be used to make prediction: 

Seat belt: if the law obliges you to wear seat belt, the price of driving reckless (probability of an accident) goes down -> people feel like they have been protected by seat belt and can afford to drive more recklessly, so we should observe more accidents. -> we indeed observe more accidents but fewer deaths

per accidents. -> on net, the total number of deaths remains essentially unchanged. Incentive:  Monetary incentive: 

Can backfire as it can decrease the sense of obligation to do something

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May not work well if people do not see it as an incentive. For example, workers may see bonuses as building coalition of powerful forces (bribing) rather than boosting workplace morale.

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Standard economic reasoning: car sale man wants to sell us car at a higher price as they will receive more bonuses. However ,if the price offered by the sale man is too high, no one will want to buy car from him

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Offer monetary rewards when the performance at task is highly responsive to extra effort -> does not apply to people who have passions/hatred about task at hand or daughter

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Offer monetary value rewards when intrinsic motivation is weak

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High rewards tend to make people choke. When more is at stake, people freeze up and make mistake

 Non-monetary incentives: Recognition/ fame, Praise , Fulfillment of responsibility, Maintaining a relationship  Too much incentives can backfire by making people complacent or lazy. For example, in Norway, people are paid fully of the first year of sick leave. Even if they get fired, the unemployment benefits are long and generous -> people are less keen on working and they are used to the idea that they don’t have to work and hence shouldn’t work  People often respond to the same incentives in different ways. Incentives matter through the medium of how a person perceive what is at stake in the choice. -> in order to set the right incentive -> we need to know the value and culture of people we are dealing with.

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Some people are corrupt -> dun have a sense of responsibility

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People who have less respect because of contempt

Cancelling out and balancing effects of incentives  Better healthcare lowers the cost of being unhealthy, more people choose to be unhealthy/ or less choose to be healthy

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Seat belt: if the law obliges you to wear seat belt, the price of driving reckless (probability of an accident) goes down -> people feel like they have been protected by seat belt and can afford to drive more recklessly, so we should observe more accidents. -> we indeed observe more accidents but fewer deaths per accidents. -> on net, the total number of deaths remains essentially unchanged.

Utility function:

 Economist use the concept of utility to describe the happiness a consumer derives out of consumption of given quantity of good -> Utility function captures the relationship btw utility and quantity of good  The curve of utility function portrays Diminishing Marginal Utility -> each extra unit of ag good one consumes, make one happier but the increases in happiness is smaller than the increases in happiness by the previous unit ( each extra gives us less utility) Indifference curve: show consumption preference if we have to choose btw two goods.

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Every point on the curve is a bundle of two goods.

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Points on the same indifference curve have the same amount of utility (all the bundle on the same indifference curve make the consumers equally happy)

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The curve is concave to show diminishing marginal utility principle.

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As we move to a higher indifference curve, our happiness (the level of utility) increases.

Week 3 – The beauty of a market: Market system: 

The importance of price: a market generates prices that reveal information about how much buyers and sellers value a particular good.

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In private market system, the seller who provide the good or services, earns benefit of selling while in a public system, random people earn the benefit. Thus, in a private system, incentives are given out effectively while the incentives in a public system are given out randomly.

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Competitive market (many buyers and sellers): ensure that the right amount of good is going to be sold to the right buyer by the right seller. Competitive market allocates resources efficiently because they: 

Allocate consumption of a good to potential buyers that have the highest willingness to pay

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Allocates sakes of a good to potential sellers that have lower costs

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Ensure that all transactions made are mutually beneficial

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Ensure that all transaction not made are not mutually beneficial

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Monopoly (one seller) vs competitive market ( many buyers and sellers) -> monopoly is a market system that do not cause efficiency

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Pareto efficiency: a distribution of resources is paraeto efficient when it is not possible to make somebody better off without making somebody worse off 

Ensure that there is no waste

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Efficiency ask the question: “ can we make somebody better off without making smb worse off?” if the answer is yes, then the distribution is not efficient.

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A pareto efficiency is not fair

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Prisoners’ dilemma: an example rationality does not imply efficiency

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The second theorem of welfare economics: 

Any Pareto efficient distribution can be achieved by competitive after adjusting the starting position

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We can redistribute the resources among the citizens and then let the competitive market take over

Analysis of starbucks: 

The key to starbuck’s success as a coffee chain is its ability to secure good location – places with heavy commuting traffic, no rival coffee chain -> thanks to exclusive deal with landlord

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There is an unlimited number of potential coffee bars and a limited number of attractive sites -> the landlords have upper hand -> the landlord can dictate terms and force it on the companies wanting to rent space.

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Bargaining strength comes from scarcity – if there are more buyer, the sellers have upper hand. Otherwise if there are more sellers, the sellers have no bargaining

power and the buyers have upper hand. -> as relative scarcity shifts, bargaining power shifts. 

The price the seller can charged = the difference in yield between the goods and its alternative.

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The price is also affected by how valuable is the good (if the good is important, the price can be higher) 

premium coffee price is higher than the price of normal quality coffee

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The willing to pay top dollar for convenient coffee set high rent. Coffee bars can be seen near subway station but not Chinese food because Chinese places choose to rent cheaper place as customers are in less of a hurry and more willing to walk or delivery -> for coffee brand, cheaper rent is no compensation for loss of a flood of price-blind customers

Rational bad behavior 

Failure can be caused by rational behavior, arising from the clashes of interest between people -> people feel that they can advance their own interest. By causing harm to others -> it is rational because the decision employs correct reasoning

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People who choose to cause harm to others (the winner) tend to be a few in kind and highly motivated by the immediate and bug gain while the losers tend to be less motivated to repel as the losers have more in numbers and thus each only bear a small cause. Eg, farmers asking for unproductive subsidies

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Tragedy of commons

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The logic of collective action

Week 4 – Are we rational? Two system of thinking: 1. System 1: operate automatically and quickly, with no or little effort and no sense of voluntary control -> tend to make mistake -> we tend to act irrationally 

System 1 operates automatically and cannot be turned off at will

2. System 2: allocate attention to attention to the effortful mental activities that demand it, including complex computation -> often associated with the subjective experience of agency, choice and concentration

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The operation of system 2 require attention and are disrupted when the attention is drawn away

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To identify optical and other illusion requires system 2

System 1 operate automatically and quickly, with no or little effort and no sense of voluntary control

tend to make mistake -> we tend to act irrationally System 1 operates automatically and cannot be turned off at will -> involuntary

System 2 allocate attention to attention to the effortful mental activities that demand it, including complex computation-> take more time often associated with the subjective experience of agency, choice and concentration operation of system 2 require attention and are disrupted when the attention is drawn away -> perform less well when attention is not given enough

System 1 is good at what it does: its models of familiar situation and its short-term predictions are accurate. System 1 has biased and systematic errors System 1 has little understanding of logic and statistic System 2 has the ability how system 1 works System 1 are innate skills we are born with Instense focusing on a task can make people (ability to perceive the world, recognize subject, orient attention, avoid losses and fear effectively blind, even to stimuli that danger). Other skills can be made fast and normally attract attention. We can be blind automatic through prolonged practice. to the obvious and are also blind to blindness ( associations btw ideas, reading, understanding social situations). Knowledge is stored in memory and accessed without intention and without effort Interplay btw system 1 and 2 System 1 runs automatically and system 2 is normally in comfortable low-effort mode, in which only a fraction of its capacity is engaged. System 1 continuously generate suggestion for system : impression, intuitions, intentions and feelings. If endorsed by system 2: impression and feeling turn into beliefs and impulses turn into voluntary actions . if everything goes smoothly, system 2 will adopt suggestion by system 1 (you tend to believe your impression and act on ur desires). System 2 arise when system 1 run into a problem it do not have an answer for. System 2 is also credited with the continuous monitoring of your own behavior. > the interplay of system 1 and system 2 is highly efficient: it minimize effort and optimizes performances

Conflict One of the task of system 2 is to overcome the impulse of system 1 -> system 2 is in charge of self-control -> we must learn to mistrust our impression. However, error of intuitive thoughts are often difficult to prevent. It is impractical and not good to be continuously vigilant. It is tiring to constantly questioning ourselves and system 2 is too slow and inefficient to serve as a substitute for system 1 in making routine decision It is easier to recognize other mistake than our own mistake Prospect theory: behavioral model that shows how people decide between alternatives that involve risk and uncertainty. It demonstrates that people think in term of expected utility relative to a reference point rather than possible outcome. 1. Reference point: Whatever you want -> set this as status quo -> usually drawn towards the status quo due to risk aversion  What you want to achieve, status quo  You will only abandon the status quo if the benefits of the new offers are large  the endowment effect: people have hard time parting with something that have acquired “for use”  wage cuts for incumbent workers are deemed unfair whereas if a new worker is hired and you pay them a lower wage, this is considered fair -> the workers have different reference points, the older worker have higher reference point  Firms when their profitability is threatened, can cut wages with ethical impunity 2. Loss aversion: due to evolutionary history, we are more impacted by loss/ bad thing than gain  This is why the success of long term human relationships depends more on avoiding the negative than purchasing the positive  Social repercussions: when changes occurs and harm people interest, people will oppose reform

3. Diminishing sensitivity for change: Utility

Prospect theory

Describe state of wealth but not change of wealth Loss and gain are linearly related

The curve portrays diminishing marginal utility- each extra unit of ag good one consumes, make one happier but the increases in happiness is smaller than the increases in happiness by the previous unit

Measure the effect of changes The losses curve is steeper than the gain curve. Loss hurts more than gain gives pleasure given the same amount -> loss eversion: most people require the gain to be substantially higher than the loss in order to accept the gamble Loss aversion ratio is 1.5 to 2.5 The curve portrays diminishing sensitivity to changes

Evaluation are based on a preference point Possibility and certainty effect: 1. Possibility effect: low possibility caused highly unlikely outcome to be weighted disproportionately more than they deserve -> outweigh small probabilities 

Make small risk seem larger than they seem

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Insurance:

2. Certainty effect: high possibility causes almost certain outcome to be given less weight than their probability justifies -> underweight large probabilities Certainty effect (high possibility):

Gains 95% win

Losses 95% to lose

Insurance, gambling, virus, ticket,

Risk averse

Risk seeking

surgery Possibility effect(low possibility):

5% chance to win

5% to lose

play in tournament

Risk-seeking

Risk averse

Allais’s paradox: we don’t make our decisions based on what we want and need. We will choose certainty over risk even if the risk is low Loss aversion we try to minimize loss when making decision Decision weight: high probability is perceived as lower and low probability is perceived as higher Marketing strategy where they make it look like you are losing out on something if you don’t purchase the goods and you lose out on the freebies. People are more likely to take chances when they think they are ahead of the game Our action is path dependent -> we reacted to occurrences happened in a process People rea willing to lie by omission rather than commission

Week 5 – the altruistic man Bystander effect: - when there is only one bystander present at an emergency, he is more likely to help when there are more bystanders. This is because the pressure to intervene do not focus on only him anymore but shared among all the onlookers. As a result, each is less likely to help – diffusion of responsibility - people are more likely to help if they assume that everyone present do not know the victims - people are less likely to help if they cannot see if somebody helps the victim, thus assuming that other would help the victim - people tend to help if they know your name -> build the trust

Prisoners’ dilemma Lab experiment vs field experiment 

Context – we act as we do because given the choices and incentives at play in a particular circumstance, it seem most productive to act that way. Lab experiments have the power to turn a person into a stupid automaton who may exhibit willingness to assist the investigator in every way possible

Scrutiny - In lab experiment, people feel like they are under scrutiny of others and

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feel the pressure of being observed, thus will tend to act like how the organizers expect them to Context – we act as we do because given the choices and incentives at play in a

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particular circumstance, it seem most productive to act that way 

people tend to get into character – selection biased.

Altruism 1. Evolutionary foundation of altruism a.

Kinship: You are helping people with the same gene as you so technically

b. Reciprocity: you are helping somebody out so that they will help you out later in life. Both sides benefit from transaction. 

The repayment of favours given and the giving of favours in anticipation of payback

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Reciprocal altruism works because of asymmetries in needs and capacities to meet them. This works especially well between different species: the asymmetries are greater.

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Reputation

d. Advertisement of dominance: -> because I am so good, I can be altruistic  Advertisements of superiority are authenticated by their cost. Only a genuinely superior individual can afford to advertise the fact by means a costly giftly 

Altruism has selfish roots.

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However, now by helping other people, you are putting yourself in danger. Thus, it is not rational. This can be explained by the theory that altruism has become a habit to us. Once upon a time, when u helped somebody in the small community, you are technically helping yourself. As a habit, this continues as the community grows bigger, helping others become a habit and you keep doing it.

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Natural selection cannot explain our sense of morality, decency, empathy and pity. Natural selection can only explain hunger, fear and sexual lust – all of which contributes to our survival or preservation of gene.

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Our survival is selfish because we have to compete with other species. Our gene ensure their own selfish relative to other genes by programming individual organisms to be selfish. We are most of time selfish but sometime our own selfish

genes...