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simply wasn't worth it. In another study reported in their chapter, they showed a similar effect in
a natural experiment that focused on a domain other than labor supply. To discourage parents
from picking their children up late, a day-care center instituted a fine for each minute that parents
arrived late at the center. The fine had the perverse effect of increasing parental lateness. The
authors postulated that the fine eliminated the moral disapprobation associated with arriving late
(robbing it of its gift-giving quality) and replaced it with a simple monetary cost which some
parents decided was worth incurring. Their results show that the effect of price changes can be
quite different than in economic theory when behavior has moral components which wages and
prices alter.
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Finance
In finance, standard equilibrium models of asset pricing assume that investors only care
about asset risks if they affect marginal utility of consumption, and they incorporate publicly
available information to forecast stock returns as accurately as possible (the "efficient markets
hypothesis"). While these hypotheses do make some accurate predictions e.g., the
autocorrelation of price changes is close to zero there are numerous anomalies. The anomalies
have inspired the development of "behavioral finance" theories exploring the hypothesis that
some investors in assets have limited rationality. Important articles are collected in Thaler
(1993) and reviewed in Shleifer (2000) and Barberis and Thaler (2001).
An important anomaly in finance is the "equity premium puzzle": Average returns to
stocks are much higher than returns to bonds (presumably to compensate stockholders for higher
perceived risks).22 To account for this pattern, Benartzi and Thaler (1995 and this volume)
assume a combination of decision isolation investors evaluate returns using a 1-year horizon
and aversion to losses. These two ingredients create much more perceived risk to holding stocks
than would be predicted by expected utility. Barberis, Huang and Santos (2001) use a similar
intuition in a standard asset pricing equation. Several recent papers (e.g., Barberis, Shleifer &
Vishny, 1998) show how empirical patterns of short-term underreaction to earnings surprises,
and long-term overreaction, can arise from a quasi-Bayesian model.
Another anomaly is the magnitude of volume in the market. The so-called "Groucho
Marx" theorem states that people should not want to trade with people who would want to trade
with them, but the volume of stock market transactions is staggering. For example, Odean (1999
and this volume) notes that the annual turnover rate of shares on the New York Stock Exchange
is greater than 75 percent, and the daily trading volume of foreign-exchange transactions in all
currencies (including forwards, swaps, and spot transactions) is equal to about one-quarter of the
total annual world trade and investment flow. Odean (1999, and this volume) then presents data
on individual trading behavior which suggests that the extremely high volume may be driven, in
part, by overconfidence on the part of investors.
22
The idea of loss aversion has appeared in other guises without being directly linked to its presence in individual
choice. For example, Fama (1991:1596) wrote that "consumers live in morbid fear of recessions." His conjecture
can only be reasonably construed as a disproportionate aversion to a drop in standard of living, or overweighting the
low probability of economic catastrophe. Both are features of prospect theory.
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The rise of behavioral finance is particularly striking because, until recently, financial
theory bet all its chips on the belief that investors are too rational to ignore observed historical
patterns-- the "efficient markets hypothesis." Early heretics like Shiller (1981), who argued
empirically that stock price swings are too volatile to reflect only news, and DeBondt and Thaler
(1985), who discovered an important overreaction effect based on the psychology of
representativeness, had their statistical work "audited" with special scrutiny (or worse, were
simply ignored). In 1978 Jensen called the efficient markets hypothesis "the most well-
established regularity in social science." Shortly after Jensen s grand pronouncement, however,
the list of anomalies began to grow. (To be fair, anomaly-hunting is aided by the fact that market
efficiency is such a precise, easily-testable claim). A younger generation are now eagerly
sponging up as much psychology as they can to help explain anomalies in a unified way.
NEW FOUNDATIONS
In a final, brief section of the book, we include two papers that take behavioral economics
in new directions. The first is case-based decision theory (Gilboa & Schmeidler, 1995 and this
volume). Because of the powerful influence of decision theory (a la Ramsey, de Finetti, &
Savage) economists are used to thinking of risky choices as inevitably reflecting a probability-
weighted average of the utility of their possible consequences. The case-based approach starts
from different primitives. It treats a choice situation as a "case" which has degrees of similarity
to previous cases. Actions in the current case are evaluated by a sum or average of the outcomes
of the same action in previous cases, weighted by the similarity of those previous cases to the
current one. Cased-based theory substitutes the psychology of probability of future outcomes for
a psychology of similarity with past cases.
The primitive process of case comparison is widely used in cognitive science and is
probably a better representation of how choices are made in many domains than is probability-
weighted utility evaluation. In hiring new faculty members or choosing graduate students, you
probably don t talk in terms of utilities and probabilities. Instead, it is irresistible to compare a
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