INTRODUCTION TO BEHAVIORAL
ECONOMICS
INTRODUCTION TO BEHAVIORAL
ECONOMICS
NONECONOMIC FACTORS THAT SHAPE ECONOMIC DECISIONS
David R. Just
Cornell University
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Library of Congress Cataloging-in-Publication Data
Just, David R.
Introduction to behavioral economics: noneconomic factors that shape economic decisions / David R. Just, Cornell University.
pages cm
Includes bibliographical references and index. ISBN 978-0-470-59622-7 (pbk.)
1. Economics–Psychological aspects. 2. Human behavior–Economic aspects. I. Title. HB74.P8J87 2014
330.01'9—dc23
2013019192
Printed in the United States of America 10 9 8 7 6 5 4 3 2 1
To Vibeka, Liam, Alex and Caden for the inspiration
and education they have lovingly provided me.
BRIEF CONTENTS
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Preface |
xv |
1 |
Rationality, Irrationality, and Rationalization |
1 |
Part 1 Consumer Purchasing Decisions |
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2 |
Transaction Utility and Consumer Pricing |
17 |
3 |
Mental Accounting |
41 |
4 |
Status Quo Bias and Default Options |
70 |
5 |
The Winner’s Curse and Auction Behavior |
93 |
Part 2 Information and Uncertainty |
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6 |
Bracketing Decisions |
125 |
7 |
Representativeness and Availability |
156 |
8 |
Confirmation and Overconfidence |
187 |
9 |
Decision under Risk and Uncertainty |
214 |
10 |
Prospect Theory and Decision under Risk or Uncertainty |
250 |
Part 3 Time Discounting and the Long and Short Run |
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11 |
Disagreeing with Ourselves: Projection and Hindsight Biases |
281 |
12 |
Naïve Procrastination |
309 |
13 |
Committing and Uncommitting |
347 |
Part 4 Social Preferences |
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14 |
Selfishness and Altruism |
389 |
15 |
Fairness and Psychological Games |
417 |
16 |
Trust and Reciprocity |
450 |
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Glossary |
473 |
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Index |
495 |
vii
CONTENTS
PREFACE |
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xv |
1 RATIONALITY, IRRATIONALITY, AND RATIONALIZATION |
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Rational Choice Theory and Rational Modeling |
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Rationality and Demand Curves |
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Bounded Rationality and Model Types |
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Special Relationship between Behavioral Economics |
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and Experimental Economics |
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Biographical Note: Herbert A. Simon |
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Thought Questions |
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References |
13 |
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Advanced Concept: Deriving Demand Curves |
13 |
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PA R T 1 CO N S U M E R PU R C H A S I N G DE C I S I O N S |
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2 TRANSACTION UTILITY AND CONSUMER PRICING |
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Rational Choice with Fixed and Marginal Costs |
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Fixed versus Sunk Costs |
21 |
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The Sunk Cost Fallacy |
22 |
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Theory and Reactions to Sunk Cost |
25 |
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History and Notes |
28 |
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Rational Explanations for the Sunk Cost Fallacy |
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Transaction Utility and Flat-Rate Bias |
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Procedural Explanations for Flat-Rate Bias 31 |
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Rational Explanations for Flat-Rate Bias |
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History and Notes |
33 |
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Transaction Utility and Consumer Preferences in Reference |
34 |
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Theory and Reference-Dependent Preferences |
35 |
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Rational Explanations for Context-Dependent Preferences |
36 |
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Biographical Note: Richard H. Thaler |
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37 |
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Thought Questions |
38 |
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References |
38 |
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Advanced Concept: Fixed Costs and Rational Choice |
39 |
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CONTENTS |
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3 MENTAL ACCOUNTING |
41 |
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Rational Choice with Income from Varying Sources |
42 |
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The Theory of Mental Accounting 45 |
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Budgeting and Consumption Bundles |
49 |
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Accounts, Integrating, or Segregating |
52 |
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Payment Decoupling, Prepurchase, and Credit Card Purchases 55 |
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Investments and Opening and Closing Accounts |
57 |
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Reference Points and Indifference Curves |
60 |
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Rational Choice, Temptation and Gifts versus Cash |
61 |
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Budgets, Accounts, Temptation, and Gifts |
62 |
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Rational Choice over Time 64 |
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Rational Explanations for Source-Based Consumption and Application 66 |
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Biographical Note: George F. Loewenstein |
67 |
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Thought Questions |
68 |
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References |
69 |
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4 STATUS QUO BIAS AND DEFAULT OPTIONS |
70 |
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Rational Choice and Default Options |
71 |
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Preference Formation, Framing, and the Default Option 72 |
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Rational Explanations of the Status Quo Bias |
76 |
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History and Notes |
76 |
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Reference Points, Indifference Curves, and the Consumer Problem 77 |
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An Evolutionary Explanation for Loss Aversion |
81 |
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Rational Choice and Getting and Giving Up Goods |
83 |
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Loss Aversion and the Endowment Effect |
85 |
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Rational Explanations for the Endowment Effect |
87 |
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History and Notes |
88 |
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Biographical Note: Amos N. Tversky |
89 |
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Thought Questions |
89 |
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References |
90 |
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Advanced Concept: The Shape of Indifference Curves with Constant Loss Aversion 91
5 THE WINNER’S CURSE AND AUCTION BEHAVIOR |
93 |
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Rational Bidding in Auctions 93 |
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Procedural Explanations for Overbidding 97 |
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Levels of Rationality |
98 |
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Bidding Heuristics and Transparency |
99 |
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Rational Bidding under Dutch and First-Price Auctions 101 |
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History and Notes |
105 |
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Rational Prices in English, Dutch and First-price Auctions 105 |
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Auction with Uncertainty 106 |
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Rational Bidding under Uncertainty |
107 |
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Contents |
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xi |
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The Winner’s Curse and Anchoring and Adjusting 110 |
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History and Notes |
116 |
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Rational Explanations for the Winner’s Curse |
117 |
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Biographical Note: Matthew Rabin |
117 |
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Thought Questions |
118 |
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References |
119 |
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Advanced Concept: Bayesian Nash Equilibrium and Bidding |
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under Uncertainty |
119 |
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PA R T 2 IN F O R M A T I O N A N D UN C E R T A I N T Y |
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6 |
BRACKETING DECISIONS |
125 |
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Multiple Rational Choice with Certainty and Uncertainty |
126 |
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The Portfolio Problem |
133 |
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Narrow versus Broad Bracketing |
135 |
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Bracketing the Portfolio Problem |
139 |
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More than the Sum of Its Parts |
140 |
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The Utility Function and Risk Aversion |
140 |
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Bracketing and Variety |
144 |
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Rational Bracketing for Variety |
144 |
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Changing Preferences, Adding Up, and Choice Bracketing 145 |
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Addiction and Melioration 146 |
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Narrow Bracketing and Motivation |
149 |
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Behavioral Bracketing |
149 |
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History and Notes |
150 |
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Rational Explanations for Bracketing Behavior |
151 |
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Biographical Note: Drazen Prelec |
151 |
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Thought Questions |
152 |
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References |
152 |
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Advanced Concept: The Portfolio Problem 153 |
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Advanced Concept: Bracketing the Portfolio Problem |
154 |
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7 |
REPRESENTATIVENESS AND AVAILABILITY |
156 |
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Statistical Inference and Information 157 |
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Calibration Exercises |
162 |
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Representativeness |
165 |
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Conjunction Bias 167 |
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The Law of Small Numbers |
169 |
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Conservatism versus Representativeness |
178 |
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Availability Heuristic |
180 |
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Bias, Bigotry, and Availability |
181 |
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History and Notes |
183 |
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xii |
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CONTENTS |
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Biographical Note: Daniel Kahneman |
184 |
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Thought Questions |
185 |
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References |
185 |
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8 CONFIRMATION AND OVERCONFIDENCE |
187 |
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Rational Information Search |
188 |
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Confirmation Bias |
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192 |
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Risk Aversion and Production |
203 |
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Overconfidence |
204 |
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Self-Serving Bias |
207 |
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Is Bad Information Bad? 208 |
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History and Notes |
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210 |
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Biographical Note: Colin F. Camerer |
211 |
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Thought Questions |
211 |
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References |
212 |
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9 DECISION UNDER RISK AND UNCERTAINTY |
214 |
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Rational Decision under Risk 215 |
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Modeling Intransitive Preferences: Regret and Similarity |
220 |
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Independence and Rational Decision under Risk |
226 |
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Allowing Violations of Independence 234 |
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The Shape of Indifference Curves 236 |
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Evidence on the Shape of Probability Weights |
237 |
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Probability Weights without Preferences for the Inferior |
239 |
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Practical Implications of Violations of Expected Utility |
240 |
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What to Do When You Don’t Know What Can Happen |
242 |
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History and Notes |
246 |
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Biographical Note: Maurice Felix Charles Allais |
246 |
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Thought Questions |
247 |
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References 248 |
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Advanced Concept: The Continuity Axiom |
249 |
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10 PROSPECT THEORY AND DECISION UNDER RISK OR UNCERTAINTY |
250 |
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Risk Aversion, Risk Loving, and Loss Aversion 253 |
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Prospect Theory 257 |
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Prospect Theory and Indifference Curves 259 |
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Does Prospect Theory Solve the Whole Problem? 267 |
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Prospect Theory and Risk Aversion in Small Gambles 269 |
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History and Notes |
275 |
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Biographical Note: Peter P. Wakker 276 |
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Thought Questions |
276 |
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References 277 |
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Contents |
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xiii |
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PA R T 3 TI M E DI S C O U N T I N G A N D T H E LO N G A N D SH O R T RU N |
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11 DISAGREEING WITH OURSELVES: PROJECTION AND HINDSIGHT BIASES |
281 |
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The Standard Models of Intertemporal Choice 282 |
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Making Decisions for Our Future Self |
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287 |
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Projection Bias and Addiction |
290 |
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The Role of Emotions and Visceral Factors in Choice |
297 |
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Modeling the Hot–Cold Empathy Gap |
299 |
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Hindsight Bias and the Curse of Knowledge |
303 |
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History and Notes |
306 |
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Biographical Note: Dan Ariely |
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307 |
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Thought Questions |
307 |
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References |
308 |
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12 |
NAÏVE PROCRASTINATION |
309 |
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The Fully Additive Model |
310 |
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Discounting in Continuous Time |
312 |
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Why Would Discounting Be Stable? 313 |
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Naïve Hyperbolic Discounting |
318 |
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Naïve Quasi-Hyperbolic Discounting |
324 |
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The Common Difference Effect |
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330 |
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The Absolute Magnitude Effect |
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331 |
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Discounting with a Prospect-Theory Value Function |
336 |
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History and Notes |
343 |
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Biographical Note: Robert H. Strotz |
344 |
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Thought Questions |
345 |
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References |
345 |
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13 |
COMMITTING AND UNCOMMITTING |
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347 |
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Rationality and the Possibility of Committing |
348 |
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Commitment under Time Inconsistency |
351 |
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Choosing When to Do It 361 |
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Of Sophisticates and Naïfs |
368 |
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Uncommitting 374 |
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History and Notes |
378 |
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Biographical Note: David Laibson 378 |
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Thought Questions |
379 |
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References |
380 |
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Advanced Concept: The Continuous Choice Problem |
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with Backward Induction |
381 |
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xiv |
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CONTENTS |
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PA R T 4 SO C I A L PR E F E R E N C E S |
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14 SELFISHNESS AND ALTRUISM |
389 |
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Rationality and Altruism |
392 |
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Rationally Selfless? 397 |
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Selfishly Selfless |
403 |
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Public Goods Provision and Altruistic Behavior 409 |
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History and Notes |
413 |
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Biographical Note: Robert H. Frank 414 |
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Thought Questions 415 |
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References 416 |
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15 FAIRNESS AND PSYCHOLOGICAL GAMES |
417 |
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Inequity Aversion |
420 |
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Holding Firms Accountable in a Competitive Marketplace 425 |
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Markets Might Not Clear When Demand Shifts 426 |
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Prices and Wages Might Not Fully Reflect Quality Differences |
426 |
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Prices Are More Responsive to Cost Increases than Decreases |
426 |
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Fairness 427 |
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Kindness Functions |
432 |
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Psychological Games 443 |
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History and Notes |
446 |
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Biographical Note: Ernst Fehr 447 |
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Thought Questions |
448 |
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References 449 |
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16 TRUST AND RECIPROCITY |
450 |
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Of Trust and Trustworthiness |
455 |
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Trust in the Marketplace |
460 |
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Trust and Distrust |
465 |
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Reciprocity |
466 |
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History and Notes |
469 |
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Biographical Note: Paul Slovic |
470 |
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Thought Questions |
470 |
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References |
471 |
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GLOSSARY |
473 |
INDEX |
495 |