Economics Taster Lecture

Behavioural Economics.

Fundamental Concepts and Applications.

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Prof Mario Pezzino

Mario.Pezzino@manchester.ac.uk

School of Social Sciences, Economics

The University of Manchester

Introductions

• I am Professor of Economics and I am also currently serving as the School of Social Sciences Director of Teaching and Learning.
• My research interests:
• Health Economics
• Dynamic (evolutionary) games and applications
• Product differentiation and market regulation
• More info: https://www.research.manchester.ac.uk/portal/Mario.Pezzino.html

A couple of questions to start

• Shall we consider paying teachers and doctors in a way that reflects their performance?

• Are more auditing and tougher penalties the best way to reduce tax evasion in a country?

Outline

• A brief note on the way economists think of economic behaviour.
• Recent developments in Behavioural Economics.
• Some applications:
• Pay-for-Performance contracts and pro-social behaviour
• The economics of tax evasion

Economic agents and their behaviour

• When we take economic decisions we are all economic agents.
• How do we decide whether to buy health insurance or whether to buy a house (and take on a mortgage)? How do managers decide on the advertising, R&D, price and outsourcing strategies? How do doctors decide how many patients to see and how to treat them?

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(A few) Different approaches to the problem

• Neoclassical
• Austrian
• Behavioural

Neo-classical approach

• The neo-classical approach assumes that economic agents have fixed preferences and objectives.
• Consumers take economic decisions to maximise utility and firms operate in a market to maximise profits.
• Agents are assumed to be rational and selfish (homo economicus)
• What if agents have to operate in an environment of uncertainty?
• Firms maximise (expected) profits
• Consumers maximise (expected) utility

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Implications of the neo-classical approach

• Economic behaviour can be analysed with mathematical models.
• Theories can be tested using empirical data and experiments/
• Mathematical model can therefore guide policy intervention and regulation
• Government intervention

Austrian School

• Entrepreneurs enhance economic development and growth
• Fundamental uncertainty
• In real markets uncertainty is such that it is not possible for economic agents to maximise their objective functions (e.g. profits/utilities).
• The School is critical of excessively relying on maths/econometrics modelling.
• Government intervention?

Behavioural approach

• Agents have bounded rationality
• They are myopic, they make mistakes
• They may also be altruistic, motivated, spiteful, etc.

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Implications of the behavioural approach

• Economists should collaborate with other social scientists.
• Economic/mathematical models should allow economic agents to make mistakes.
• A behavioural approach should be used to understand unsolved puzzles in economics and the effects of various government policies.

The decision-making of myopic economic agents - Prospect theory

• Reference/status dependence. Individuals’ assessment of economic events is based on losses and gains connected to a reference point.
• Losses are more important than gains.
• Risk aversion.
• Deformed probabilities. Individuals tend to underestimate high probabilities and overestimate low probabilities.

References

• Daniel Kahneman and Amos Tversky. Prospect theory: an analysis of decision under risk. Econometrica, 47:263-291, 1979. 
• Daniel Kahneman and Amos Tversky. Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4):297-323,1992.

And Evolutionary theory

• A stream of economic analysis studies the behaviour of economic agents in the same way evolutionary biologists study animal behaviour.
• In a population individual are “programmed”/genetically inclined to take a particular action (e.g. paying taxes honestly, being risk averse, being socially responsible, etc.).
• Whether an action survives evolution in a population will depend on the way such an action affects the pay-offs of individuals.

References

• J. W. Weibull. Evolutionary game theory. MIT press, 1997.

An application - P4P contracts

• A very important problem studied in economics: how should a firm (principal) reward a manager (agent) when the effort of the manager is not observable (and therefore not contractile)?
• A fashionable solution: Pay for Perfomance contracts.
• Some dimension of the performance of agents is observable and they are paid a bonus that increases with their performance.

Issues with P4P

• What is a measure of performance? How does it relate to agents’ effort?
• It may be easier to think of measures of performance for managers, but think about doctors and teachers.
• Doctors and teachers are “special”, they are often considered as an example of motivated agents.
• Motivated agents are less driven by financial incentives. They may be intrinsically motivated.

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Motivated agents and financial incentives

• If vocational agents care less than others about pay, then offering a contract with a high salary will induce on average less motivated people to apply for a job.
• Motivated agents may care about reputation and social norms. Introducing a P4P system may produce perverse effects: crowding out.

Economics of tax evasion

• Why do people pay taxes honestly?
• According to standard economic theory, engaging in tax evasion is simply a gamble and, if the probability of being caught and the penalty are low, agents should consider evading taxes.
• Puzzle: given the auditing probabilities and penalties reported in real economies, standard theories predict that we should observe much higher levels of tax evasion.

Why do people pay taxes?

• Intrinsic motivation: tax morale
• Social norms: individuals may care about their reputation and social norms. Being caught cheating or being identified as a honest payer may affect the utility of these agents. Implications:
• Social norms evolve with time.
• Naming and shaming evaders and rewarding honest payers.
• Prospect theory: people tend to overestimate low auditing probabilities!

Selected works – Tax evasion

• Becker, G. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 76, 169–217. https:// doi.org/10.1086/259394
• Erzo F.P. Luttmer and Monica Singhal. Tax morale. Journal of Economic Perspectives, 28(4):149-68, 2014.
• Sanjit Dhami and Ali Al-Nowaihi. Why do people pay taxes? prospect theory versus expected utility theory. Journal of Economic Behavior & Organization, 64(1):171-192, 2007.
• Sanjit Dhami and Ali Al-Nowaihi. Optimal taxation in the presence of tax evasion: Expected utility versus prospect theory. Journal of Economic Behavior & Organization, 75(2):313-337, 2010.

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Selected works – Motivation

• Bénabou, R., & Tirole, J. (2006). “Incentives and prosocial behavior”. American Economic Review, 96(5), 1652–1678. https://doi.org/10.1257/aer.96.5.1652
• Besley, Timothy, and Maitreesh Ghatak. 2005. "Competition and Incentives with Motivated Agents." American Economic Review, 95 (3): 616-636.

• Thank you!