Module 5 Discussion Board Reading Traditional economists also assume human being

Question

Module 5 Discussion Board Reading

Traditional economists also assume human beings have complete self-control. But, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by setting up ways for people to keep themselves free of these temptations. This includes what are called “nudges” toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they “opt out.” Almost no-one opts out in this program and employees begin saving at the early years, which are most critical for retirement.

Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to befungible, or having equal value to the individual, regardless of the situation.

You might, for instance, think of the $25 you found in the street differently from the $25 you earned from three hours working in a fast food restaurant. The street money might well be treated as “mad money” with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the “easy come-easy go” mentality replaces the rational economizer because of the situation, or context, in which the money was attained.

In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of $1,000 that has a 15% yearly interest cost, and simultaneously have a $2,000 savings account that pays only 2% per year. That means she pays $150 a year to the credit card company, while collecting only $40 annually in bank interest, so she loses $130 a year. That doesn’t seem wise.

The “rational” decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. But curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. The dollars are not being treated as fungible so it looks irrational to traditional economists.

Which view is right, the behavioral economists’ or the traditional view? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain behavior that has historically been dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place.

Discussion Board Topic:

Read the above and answer the following question:

Do you find your opinion leaning towards traditional or behavioral economic beliefs?

Explanation / Answer

A enormous false impression is that behavioral economics is set controlling folks's behavior, but it's not. Behavioral economics is set understanding customary resolution errors that folks make and why they make them. In designated, a huge side of behavioral economics is involved with the gap between intention and motion. For illustration, your purchaser could intend to avoid wasting rather a lot for retirement, however matters occur and your purchaser never gets round to taking motion.

Another large misconception is that behavioral economics is about irrationality. This false impression stems from the fact that average financial theory assumes everybody are rational, at the same time behavioral economics does no longer make this assumption. Acknowledging that individuals should not always fully rational does no longer imply that they're irrational or loopy. It just signifies that folks make systematic mistakes and that they do not consistently make picks that regularly maximize their own happiness or success.

Ordinary financial concept relies on three principal assumptions: 1) all people are rational, 2) individual choices are consistent with expected utility thought, and 3) people effectively replace their opinions and beliefs based upon new expertise that is got. However, these assumptions don't continuously hold in the actual world. In a seminal paper, Kahneman and Tversky lay the basis for behavioral economics by using proffering that psychological phenomena influence resolution-making and need to be incorporated in fiscal and monetary units.1 specifically, psychological phenomena like biases, heuristics, and framing effects should be integrated into these models. Two of the foundational principles of behavioral economics are: 1) men and women make systematic errors because of psychological blind spots that most people have, and a pair of) the context where a choice is made has an giant effect on the choice.

Behavioral economics is ready figuring out long-established selection mistakes that people make and why they make them.

Biases (choice-Making Blind Spots)

A excellent illustration of a bias that affects financial choices is over confidence. Overconfidence just isn't a rational behavior. Overconfidence is a concern wherein humans believe that they are higher in terms of skill or potential than they actually are. It's not saying that they are bad at whatever; it's only that they overestimate their capabilities. For instance, in case you take any room of adults and ask individuals to elevate their hand if they're an above traditional driver, just about all people will elevate their hand. In a similar way, each semester once I anonymously survey my behavioral finance category of pupils and ask them who believes that they're of above usual intelligence relative to the staff of students in the category, over 90% of them say they're when correctly best 50% of them may also be above average.

Overconfidence has been proven to have an effect on choices which are more massive than assessments of riding or intelligence. Barber and Odean advocate that overconfidence influences trading and funding habits in a way that motives economic losses.2 They find that overconfident guys believe that they comprehend extra about financial markets than they without a doubt do. Consequently, they churn their investment portfolios more than women, and thus earn shrink overall returns after buying and selling commissions and charges are taken into account.

Context and Framing

with regard to the significance of framing, feel the S&P 500 is presently at the 2,200 stage and remember two unique market eventualities:

(1) The market surges up with the aid of 25% over the following yr to get to 2,750 before falling by means of 40%.
(2) The market is stagnant for the subsequent yr after which falls 25%.

Which situation is worse in your purchaser? Which situation would your patron opt for?

In fact, both situations grow to be with the same special effect in your customer. However, the first scenario would mainly be regarded more painful by means of your customers considering that it used to be framed in phrases of your purchaser experiencing positive aspects that don't get locked in and then your consumer experiencing a significant loss. Within the 2d state of affairs, there's a a lot smaller market correction, so your consumer experiences less of a loss. In both scenarios, the S&P 500 ends up at 1,650. Nonetheless, the special method wherein the eventualities are framed can impact how your client would think in regards to the obstacle.

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