Supply and Demand, Consumer Choice, and Behavioral Economics

Supply and Demand, Consumer Choice, and Behavioral Economics Economics looks at the world from a perspective of choices we make given our limited resources. Economics - the study of how society manages its scarce resources Or the study of how to detect unintended consequences. People face tradeoffs Scarcity-- Limited nature of society's resources (unlimited wants, limited resources) The cost of something is what you give up Opportunity Cost - the highest valued alternative to choosing an action Health economics studies how resources are allocated to and within the health economy. There are special challenges to healthcare 1. The central roles of risk and uncertainty both the incidence of illness and the effectiveness of care are described in terms of probabilities. These change our behavior. Even the correct therapy, provided the right way may carry some risk of failure. 2. The complexities created by insurance because of risk and uncertainty, most consumers have medical insurance. This puts a wedge between the payer and the user and has a huge impact on incentives. It also complicates even the simplest transaction now there are at least three parties involved in any transaction. 3. The perils of information asymmetries not only is there incomplete information (uncertainty), there is also often asymmetric information. This can lead to a type of market failure known as adverse selection or death spiral. 4. The problems posed by not-for-profit organizations multiple stakeholders mean multiple goals. Thus, organizations become harder to manage and managerial performance becomes harder to assess. How do nonprofits and for profits compete in the same market? 5. The rapid and confusing course of technical and institutional change Technology is widely credited as the main driver for increasing health care costs. But is this driven by demand or supply? 6. The move from volume to value 1

Supply and Demand Demand The Law of Demand There is an inverse relationship between the price of a good and the amount of it consumers choose to buy Two effects of a price change: Income effect lower price means that a consumer s real purchasing power increases, which increases the consumption of the good and likewise for a price reduction. Substitution effect when the price of one good falls, the consumer has an incentive to increase consumption of that good at the expense of the other, now relatively more expensive goods. Determinants of individual Demand 1. Income 2. Prices of related goods 3. Tastes 5. Expectations Demand Schedule and Demand Curve Price D Quantity Market Demand vs. Individual Demand -- market demand is horizontal summation of individual demand curves Shifts in the Demand Curve Change in prices of related goods Change in income (normal and inferior goods) Change in tastes Change in Expectations Price elasticity of demand and its determinants Defn: Price elasticity of demand -- a measure of how much the quantity demanded of a good responds to a change in the price of that good. 2

Determinants: Necessities vs. luxuries Availability of close substitutes Definition of the market Time horizon Variety of Demand Curves Supply There is a direct relationship between the price of a good and the quantity supplied Determinants of individual Supply 1. input prices 2. technology 3. expectation The Supply Schedule and the Supply Curve Price Supply Quantity Market Supply vs. individual Supply Shifts in the Supply Curve Change in the price of inputs Change in technology Change in the number of suppliers Price Elasticity of Supply 3

Price Supply and Demand Together Equilibrium 75 Supply 50 25 Demand 50 100 150 Quantity Note that the only stable price here is 50. If the price is set at, say 75, then the quantity demanded will be 50 and the quantity supplied will be 150 so there will be a surplus of 100 units of the good. This would put downward pressure on the price (firms trying to unload unsold goods). Likewise if the price is set at, say 25, then the quantity demanded will be 150 while the quantity supplied will be only 50 so there will be a shortage of 100 units. This will put upward pressure on the price (consumers scrambling to try and get one before they are sold out). The only place price will stay put is at 50 here quantity demanded just equals quantity supplied everyone who wants to buy at a price of 50 is able to, and everyone who wants to sell at 50 is able to. Thus, there is no tendency to change equilibrium. Is this equilibrium good? Allocative efficiency we are producing the right amount of this good from society s standpoint. Consumer Surplus a measure of how much better off consumers are because this market exists. This is represented by the area above the price but below the demand curve. Eg the consumer would have paid 75 for the 50 th unit, yet they only paid 50. So they are $25 better off. Do this for all units between 0 and the equilibrium quantity (100) and you get consumer surplus. Producer Surplus a measure of how much better off producers are because this market exists. If the firm had no fixed costs this would be equal to profit. This is represented by the area below the price but above the supply curve. Eg the firms would have sold the 50 th unit for 25, yet they got 50 for it, so they are $25 better off. Do this for all units between 0 and the equilibrium quantity (100) and you get consumer surplus. 4

Total welfare = Producer + Consumer Surplus Note that under the market equilibrium total welfare is maximized. Thus what the free market produces is the best amount to produce from society s standpoint it is allocative efficient. But there are some pretty big assumptions we are making to get here many of them having to do with information we will get to these assumptions. Changes in Equilibrium The market for pizza when the price of tomatoes increases The market for pizza when the price of beer increases Health reform that succeeds in covering many of the uninsured. How would this affect the markets for health care in the short run? Hospitals can hire only baccalaureate RNs. How would this affect the market for hospital care? 5

Government lowers reimbursement rates paid to physicians for Medicare patients. How would this affect the market for non-medicare patients? What about when Medicare lowers DRG rate to hospitals? How does this impact prices to non- Medicare patients? Market Failure We just described how the free market results in the outcome that is the best outcome from society s standpoint. This is often the case but there are some assumptions we make to get there. We will get into those in more detail later, but there are a few situations where the market does not produce an efficient level of output. I. Public Goods, Common Resources, and Natural Monopolies Any good or service can be characterized by two attributes: Rivalry -- if one person consumes the good, does it go away? Excludability is it possible to exclude non-paying customers? By this there are 4 types of good: 1. PRIVATE GOODS rival and excludable. The market does a good job of producing these types of goods. To steal an example from Dr. Shay: Sandwich it is rival if I eat it, it is not there for anyone else to eat. It is excludable if you don t pay for it you can t have it. 2. PUBLIC GOODS nonrival and nonexcludable. The market doesn t do so well here. Firework show, national defense, music, aerobics class (group project?) Problem is freeriders I have an incentive to wait until someone else buys it then use theirs (think group project with a single grade). But we all have this incentive so the market tends to either not produce the good at all, or it will produce too little from society s perspective. 3. COMMON RESOURCES rival and nonexcludable. The market doesn t do too well here either. Creates a Tragedy of the Commons situation Fisheries, wildlife, clean air and water, congested roads, etc. healthcare??? 6

4. NATURAL MONOPOLY nonrival and excludable. We will see this from a different angle next week. But think about cable tv, power companies, a noncongested toll road. Some argue Health Insurance is a natural monopoly and we should, therefore, have a single payer. Bottom line: Markets do best when goods are rival and excludable they struggle (or fail completely) when nonrival and (especially) nonexcludable. II. Externalities One of the assumptions we made when we talked about the supply and demand graphs was that all of the costs of producing the good were incurred by the firms producing it, and all of the benefits of consuming it were enjoyed by those actually consuming it. This is normally how it is, but not always and when this is not the case the market tends to not do too well. 1. Negative Externalities in production Think about producing electricity by burning coal much of the costs are transportation, running the factory, etc. These are internal costs that are completely borne by the firms producing electricity. However, there are other costs when coal is burned it puts pollution into the air. This imposes external costs on individuals who are not involved with the decision to produce electricity. 100 75 B C Total Cost (social costs) Internal Cost (supply) 50 A Demand 75 100 In this case note that since there are both internal and external costs, there are two cost curves. The firm only cares about the internal costs so when it is considering how much of the good they are willing to sell at any given price, they ignore the external costs and only pay attention to the internal costs. In this case the market 7

equilibrium is at point A: Price = 50, quantity =100. But note this is NOT allocatively efficient. The market is producing 100 units the value of the 100 th unit is $50 to the consumer BUT the (total) cost of producing it was 100. So we took resources valued at 100 and converted it into a good that is worth 50 not so good. The market over-values the good. The loss to society because of this is the area ABC The efficient level of output would be point B this is where the total cost crosses the demand curve. So 75 is the allocatively efficient level of output, and the price would be 75. When there are negative externalities the market tends to produce too much of the good and it is priced too low from what would be best for society. Usually the solution here is to tax the production of this good to internalize the external costs. 2. Positive Externalities in consumption. Another situation is when the benefits of the good are not solely enjoyed by the consumers of the good. A classic example is education. Getting an education not only benefits those getting the education but others (you are more interesting to talk with, you contribute to society, etc.). So if left to its own devices the market will produce too little of the good. 100 C Supply 75 B 50 A Internal benefits (demand) Social Benefits 75 100 8

Here note that there are benefits that go to those external to the market so the demand curve does not reflect the full social benefits of the good. The market equilibrium (point A) is where the supply curve crosses the demand (internal benefits) resulting in 75 units at a price of 50. Note from society s standpoint this is too little. Note that the 75 th unit of the cod costs of 50 to make but is worth 100 we would benefit with more of this good than what the market produces. The market undervalues that good. The area CBA represents how much better off we would be as a society if we produced the efficient level of output When there are positive externalities the market tends to produce too little of the good and it is priced too low from what would be best for society. Usually the solution here is to subsidize the consumption of this good to internalize the external benefits. Hence we have public schools, generous student loan programs, etc. 3. Negative Externalities in consumption. Another situation is when there are costs imposed on other consumers when the good is consumed. A classic example is smoking. If I choose to smoke a cigarette, I enjoy all the benefits of smoking but note I potentially also impose some costs on you if you are near me. So if left to its own devices the market will produce too much of the good. Supply 75 B 50 A Internal Benefits (demand) 25 C 75 100 Social benefits 9

Here note that there are costs that go to those external to the market so the demand curve does not reflect the full social benefits of the good. The market equilibrium (point B) is where the supply curve crosses the demand (internal benefits) resulting in 75 units at a price of 100. From society s standpoint this is too much. Note that the 100 th unit of the cod costs of 75 to make but is worth only 25 we would benefit with less of this good than what the market produces. The market overvalues that good. The area BCA represents how much better off we would be as a society if we produced the efficient level of output When there are negative externalities in consumption the market tends to produce too much of the good and it is priced too high from what would be best for society. Usually the solution here is to tax the consumption of this good to internalize the external costs. Also, social norms are really important here smoking, drunk driving, gun use? If this all seems irrelevant, hold on we will see this has a direct application to healthcare. III. IV. Market power We will talk more about this next week but one of the assumptions we make when we draw the supply and demand curve above is that there are many firms producing the good. If there is only one firm (or just a few) then things don t work as smoothly the market will tend to produce too little of the good and charge too much Information Asymmetry Again, we will spend a lot of time on this later since it is a huge deal in health care markets, but when one side of the market has more information than the other (the buyers of insurance often have a much better idea of their risk than the sellers, or the seller of a used car might know much more about the quality of the car than a potential buyer) the market can struggle even can fail completely resulting in a death spiral What if we don t like the market price? Even though the market equilibrium is, in general, an efficient allocation of resources, we may not like it or think it isn t fair. What can be done? Suppose we consider the market for housing. Keep it simple and assume there is one quality level so a single product: 10

C B Supply 1000 750 D E A F Demand The 75 100 125 market equilibrium is a price of 1,000/month with a quantity of 100 units. We want to make housing more affordable since 1,000 is a lot. If we had a lower price then more people could afford to live on their own and the world would be a better place. So let s set a price ceiling at $750/month as the maximum price that can be charged. What will happen? At a price of $750, more people want to buy an apartment quantity demanded goes from 100 to 125 (so 25 new people can now afford a place). But note that quantity supplied shrinks. Only 75 apartments are available to rent. So this creates a shortage of 50 apartments 25 new entrants can t find one, but note also that there were 25 people who used to have an apartment who can no longer find one. The consumers who are able to get an apartment are potentially made better off but note there is a net loss in welfare. Total welfare goes from CFE prior to the price control to CBAE after the price controls are imposed. A net loss of BFA is incurred. Secondary effects quality, discrimination, etc. The elasticity of the supply curve will be important here. Economist in general will argue that price controls are always per se bad any time we impose them we will always decrease social welfare but think about Medicare and their prospective payment system which is a form of price control good or bad? 11

What happens when we tax a market? (skip if short on time) Suppose we consider the market for gasoline. In order to raise money to pay for street repair the state decides to impose a $.50 per gallon on the sales of gasoline. Gasoline sellers are required to send $.50 per gallon of gasoline they sell to the state at the end of each month. How does this affect the market for gasoline? Supply w/ tax Supply 2.50 D 2.25 E B 2.00 F A 1.75 G C H Demand 100 150 Before the tax the market is in equilibrium at point A price is $2.00 and 150 gallons are sold. When the tax is imposed, note this can be thought of as a cost to the firm. So for any given quantity, it costs an extra $.50 to produce the good supply shifts up by $.50. But note price cannot go to 2.50 since if it did demand would drop to close to zero. Instead the new equilibrium is at point B. The new quantity is 100 so they make 100*.50=$50 in tax revenue (not $150*.50=$75 which some would expect). The price that consumers pay goes to $2.25, and the price that firms get to keep (after paying the tax is 2.25-.5=1.75. So consumers are paying an extra.25 and firms get.25 less because of the tax. In this case the burden of the tax is split evenly between firms and consumers. In general the burden of the tax is a function of demand and supply elasticity (draw some of these). What are the net effects of this tax on society s well being? Prior to the tax: 12

Consumer surplus = DAF Producer surplus = FAH Note this is maximizing social welfare: DAH After the tax: Consumer surplus = DBE Producer surplus = GCH Tax revenue = EBCG Total welfare = DBCH So note the area BAC is lost because of the tax 13

Consumer Choice and Challenges to the Classical Model Consumer Choice We just looked at Demand and argued that the demand curve is downward sloping the higher the price the less of the good I would like to buy. I want to explore this in a bit more detail to get at some of the main assumptions we make to get there and their implications. Then we will talk about what if those assumptions are not true this later part gets into behavioral economics which is the interception of economics with psychology. Consumer Choice People differ widely in terms of their preferences what I like might be very different from what you like. We use the term preferences Preferences the rankings consumers give to the alternative opportunities available to them Preferences are not the same as choices or demand. We make choices based on our preferences and the prices of goods and that gives rise to our demand demand incorporates prices. I would prefer to drive a much nicer car but I choose to drive a 20 year old car. Assumptions about preferences 1. People can rank alternatives: that is preferences are complete. We are able to rank any given basket of goods I don t know is not allowed. Note this is different from I don t care or I am Indifferent 2. Preferences are transitive: If a>b, and b>c, then transitivity implies that a>c. If I like Pizza more than hamburgers, and hamburgers more than barbeque, then I have to like pizza more than barbeque. 3. More is preferred to less. Consumers have insatiable desire for goods and services (or there is free disposal) These may all seem pretty reasonable and in most cases they are, but as we will see later, not always especially when we are making choices over time. But for now, let s assume these are good assumptions. Given we are in a world of scarcity unlimited wants with limited resources as individuals we have to make choices. Another assumption we make is that people make choices to maximize a stable utility function. A utility function can be thought of as some equation of the following form: 14

U = f(x1,x2,x3,.xn) where x1, x2, etc are the quantity of goods and services of the various goods the consumer chooses. The stable assumption is important that means your preferences are fixed and consistent. Independence of Irrelevant Alternatives Suppose you want to have a bowl of cereal for breakfast. You open the cupboard and find: Lucky Charms, Cocoa Pebbles, Cap n Crunch, and Wheaties. Of course you choose Cocoa Pebbles. Now, in a parallel universe, you look in the cupboard and find Lucky Charms, Cocoa Pebbles, and Cap n Crunch. IIA says you have to still choose Cocoa Pebbles. That is having Wheaties out of the mix should not affect your choice. For simplicity, let s assume there are only two goods in the world: Beer and pizza Quantity of Beer D C B A Quantity of Pizza 15

Note that a point like A (a lot of pizza, some beer) is going to bring a certain level of utility. Likewise a point like D (a lot of beer, some pizza) is going to also bring some level of utility. Completeness means we can rank points A and D. [Build an indifference curve] An Indifference Curve connects the points on a graph that correspond to market baskets of equal utility to the consumer. Indifference curves must be negatively sloped (more is better) Combinations on indifference curves farther from the origin are preferred to those closer to the origin. (more is better) Indifference curves cannot cross (transitivity) Diminishing marginal rate of substitution. The MRS is the amount of good y that a consumer would give up to obtain one more unity of good x. We generally assume this is diminishing and this is what gives indifference curves their convex shape. Take away some of my beer. At this point all we know is something about my preferences. In order to make a choice we need to know what is possible. This is where the budget comes in. Budget line Income = Pb*BEER +PP*Pizza. We assume we spend all of our income (later we can make savings a good or more accurately future consumption). So my budget line is a function of the prices of the two goods and my income. The y-intercept tells me how much beer I could buy if I spent all my income on beer. The x- intercept tells me how much pizza I could buy if I spent it all on pizza. The slope of the line tells me the relative prices of the two or the ability to trade one for the other Maximizing Utility: 16

Quantity of Beer U1 U2 U3 D 10 8 B A 5 C 1 4 6 Point A would be great the highest utility, but that is not affordable (outside of the budget constraint). We could afford a point like B, but note that if we had 10 beers and 1 pizza we would be willing to trade beer for pizza at the going price and be happier. Note point C is just right. We have achieved the highest rate of utility attainable. so at 5 beers and 4 pizzas, our willingness to trade beer for pizza is just equal to our ability to trade them. That is the slopes are the same (MRS = relative price). The last penny spent on pizza gave us the same Marginal Utility as the last penny spent on beer. Show different tastes: If you LOVE beer then (in this example) you will have very flat indifference curves. If you HATE beer, then you will have very steep indifference curves. (Corner solution) Quantity of Pizza Income-Consumption Curves Normal Goods Inferior Goods 17

What happens when he price of the good changes? Quantity of Beer U3 U2 U1 C B A 3 8 5 Price of Pizza 3 5 8 Quantity of Pizza 18

Start at point A -- suppose the price of pizza increase. That will result in an inward pivot in the budget constraint. Point A is no longer affordable. We need to find a new equilibrium. This is noted as point B a lower level of utility. Our consumption of pizza went from 5 to 3. Now suppose that, starting at Point A, the price of pizza falls. Now the budget line pivots outward, and we can afford more than point A. The new equilibrium would be at Point C, consumption goes to 8. We could do this over and over and would map out the price-consumption curve which is below the utility curve graph. Note I just made a demand curve!! It is downward sloping. The slope of the demand curve is a function of my willingness to substitute pizza for beer (or the MRS). If I have different shaped indifference curves, my demand curve will have a different slop. Elasticity of demand is a function of my willingness to trade one good for the other. 19

Challenges to the rational model of behavior Classical economics, which we have just discussed, assumes that individuals are rational that is, they do the best they can to achieve their objectives, given the opportunities they have. People make mistakes, but they learn from them. Individuals will use all the information available to them to make a decision. This has come under fire recently from behavioral economics. I want to cover some of this since it often applies to health care. Of course the model above is wrong it is overly simplistic. But note that is the point it is a simplified view of the world that allows us to better understand human behavior. It is not enough for us to just say it is wrong or find examples where people make mistakes, etc. In order to truly criticize classical model we must show there is 1) Systematic deviation from the rational paradigm 2) this deviation must be important for some economic phenomena Violations of Basic Rationality We assume that the demand curves are based on people making choices in order to maximize utility based on a stable utility function. That is was assume the independence of irrelevant alternatives. Note the economist.com example was a violation of this Note that most of these problems occur when the consumer does not have full information and is trying to fill in the gaps. 1. Framing Effects Often our choices can be greatly affected by framing effects: seemingly inconsequential changes in the way an option is presented can lead to big changes in the choices that people make. Suppose we are preparing for an unusual disease which is expected to kill 600 people. There are two alternative programs we have to choose from to combat the disease: If program A is adopted, 200 people will be saved If program B is adopted, there is a one-third probability that 600 people will be saved, and a twothirds probability that no people will be saved. What would you pick? Alternatively: If program C is adopted, 400 people will die 20

If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability a two-thirds probability that 600 people will die. Now what do you pick? In experiments people overwhelmingly choose A from the first group and D from the second group. What does this tell you? How is framing at work here? The first choice set sets the reference point to be that everyone will die and so the language is about people being saved so any amount of lives saved seems like a gain. The opposite is true for the second choice set. People tend to be loss averse -- people really hate losing something for sure. Such that when faced with a loss they tend to be risk loving in choices between losses the idea of losing 400 lives for sure is so horrible that people are prepared to take a gamble to avoid it. In contrast when it comes to gains, people tend to be risk averse. More framing effect examples: Our personal finance and budgeting. Would you accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5? Would you pay $5 to participate in a lottery that offers a 10% chance to win $100 and a 90% chance to win nothing? Employee wellness programs can either offer $550 discount on premiums, or send a check for $550 in the mail. To a rational economist these are the same, but they may have very different effects on employee s compliance. Consider the two statements: The Giants won vs. The Cowboys lost. Do they mean the same thing? When gas stations first started installing credit card purchasing cash discount vs. credit surcharge. A physician could be given two different descriptions of the short-term outcomes of a surgery: 1) The one-month survival rate is 90% 2) There is a 10% mortality in the first month. Surgery is more popular in the first frame (84% chose it) than the second (50% chose it) even though it is exactly the same information. NEJM Paper: People perceive a far larger difference between $0 and $100 then between $1000 and $1100. Used this to increase colonoscopy rates by separating the reward from routine payment (If I get a check for 100 that is different than if I get an extra 100 tacked onto my paycheck) Anchors are a type of frame 21

The anchoring effect occurs when people consider a particular value for an unknown quantity before estimating that quantity the estimates stay close to the number that people considered. Consider two sets of questions: Was Gandhi more than 114 years old when he died? How old was Gandhi when he died? vs Was Gandhi more than 35 years old when he died? How old was Gandhi when he died? People who are asked the first set of questions will give a higher answer to the second question, on average, than those who are asked the second set of questions. Similarly, in another experiment, individuals were shown a wireless keyboard then asked if they would be willing to pay an amount equal to the last two digits of their social security number (so basically a random number). Then they were asked what was the maximum price they would pay for the keyboard. What do you think happened? Top 20 3x Think about the listing price of a house, or a car and your willingness to pay. How do you respond to the price of gasoline when prices are falling vs. when they are rising? Arbitrary rationing: Limit x per person In negotiations (say over the price of a home) the first move is often an advantage Caps on damages due to personal injury or mal practice. The availability heuristic we often create our own frames. How often do people over 60 get married? To answer this question, people typically think about any examples from their past. The easier time we have coming up with examples, the larger our estimate will be. When we don t know the answer to a question we often substitute a question that we do know the answer to. Sometimes this works well, sometimes it can lead to bias. Spouses were asked: How large was your personal contribution to keeping the house clean, in percentages? Or what is your contribution to causing quarrels? The self-assessed contributions added up to more than 100% Why do people fear flying more than they do driving? Our emotions play a key role here. Some events stick in our heads easier due to the emotions attached to them. Thus they are more available even if not more likely. 22

2. Status Quo Bias Status Quo Bias is the propensity for people to choose a particular alternative just because it is the status quo or default option. People demanding a higher price to sell an object that they own than they are prepared to pay for the same object (think housing) Higher Enrollment rates in companies that have opt out 401k investment plans than those that have opt in plans Organ donors opt in vs opt out This is a concern in the insurance marketplaces Reasons for status quo bias: i. Transaction costs this would be a rational explanation for status quo bias. I say bias since in this case it isn t really bias. ii. The endowment effect According to standard economic theory the just-acceptable selling price for a good and the just-acceptable buying price should be equal. Suppose you think it would be worth $200 to go to the BCS championship game. Then theory would suggest that if you do not own a ticket, any offer price less than 200 would cause you to buy, and if you do own a ticket an offer price greater than 200 would cause you to sell. In many cases this is true. But not always. Experiment of Duke University basketball games: Willingness to pay of $170, and a willingness to accept of $2400. Suggests that those who owned the tickets valued them 14 times more than those who did not. NEJM Paper using defaults in CPOE could save $9billion in prescription drug treatment (and does not restrict choice just makes it harder to choose the expensive option) Because of an affect known as loss aversion which says the pain of giving something up is larger than the joy of getting something. There often becomes a gap between our maximum buying price and our minimum selling price. Once we own the ticket, selling it involves the pain of giving it up. If we don t own it, we consider the pleasure of getting it. Best example of loss aversion putting for par vs. putting for birdie on the PGA tour. NEJM Paper Mass General used up-front incentive payments to improve hand hygiene, increase e- prescribing, and reduce ed use. Fear of losing the payment has a stronger effect than the hope of earning it. iii. Procrastination and Decision Avoidance Often people desire to avoid difficult or complicated decisions. Sticking with the status quo then tends to happen more often. Think about end-of-life care here. iv. Perceived Recommendation. 23

Often people will perceive the default as the perceived recommendation of an expert. For 401k investment plans people may perceive the default as the recommended investment level v. Fallacy of choice Usually we assume more choices are better and will always make the consumer better off. But note that there can be such a thing as too much choice which will tend to stick with the status quo. 3. Social Preferences Consider the following Game: Player A has $10 to divide between themselves and player B. They make a single take it or leave it offer (eg, I get 5, you get 5). Player B can either accept or reject. If he/she rejects then nobody gets anything. What would classical utility theory suggest would happen? What do you think would really happen? Typically Player A offers between 20 and 50% of the pie player B usually rejects offers of less than 20% What is going on? There are 3 basic classes of explanation; i. Fairness: people have a preference for fair outcomes over unfair ones ii. Altruism: people get utility from other people s happiness iii. Reciprocity: People like to punish people who have not treated them well even if it means also punishing his or herself. Dictator Game similar to above but Player B has no voice. Not if Reciprocity then now player A would keep all 10. Yet Player A still tends to share. If the game is played anonymously, however, it tends to be closer to the rational prediction. Think about how rude you are willing to be as a driver vs. in, say, the classroom. Note if i or ii are important for some people more than others it will help explain why we struggle with things like income distribution and social safety net issues. NEJM Paper: People have a strong psychological need to maintain a positive self-image. So pairing incentive programs with self-image/professional identity makes sense. So make public some component of physicians performance. 4. Time Inconsistency 24

This is a huge one with respect to healthy choices. Note that not only do we make choices across a set of goods and services (should I eat pizza or go to a move?) we also make choices over time (should I buy a new computer game or put the money in the bank so that I can buy a computer game tomorrow?). We assume time consistent preferences. We discount future utility to put it in current period terms. So the utility of consuming c1 this period c2 next period, and c3 in the third period is: U(c1,c2,c3) = u(ca) + βu(c2)+β 2 c(c3) Where β is my discount rate Imagine you were offered $100 today or $105 in the next period and you prefer $100 today. Then it must also be true that if I offer you $100 in period 3 or $105 in period 4 then you would prefer $100 in period 3. People don t always do this think about your last wicked hangover. Suppose I offered you a choice between a greasy cheeseburger or a kale salad today. What would you choose? How about if I asked you the same choice but you won t eat it until next week? Many will choose the cheeseburger today, but the kale salad next week. Note this is huge when we think about trying to get people to change to a more healthy lifestyle we all want to work out, eat right, etc. but we tend to have time inconsistent preferences. Note this is different from Gary Becker s theory of rational addiction. This says that some people have a high enough discount rate that it is rational for them to become addicted to drugs or go on a self-destructive life-style. The policy implications between the two theories are different. We have a tough time with self-control. It is in the bible: Romans 7:15 I do not understand what I do. For what I want to do I do not do, but what I hate I do. If St. Paul was a rational consumer, he would not have this issue. Behavioral Economists talk about our hot and cold selves: Why you should never go to the grocery store when you are hungry. We need ways to trick our hot selves into behaving. We need to do a better job of getting people in touch with their future selves 5. Ambiguity What happens when we don t know what the outcome of a certain event will be say who will win a race or a game? Or if we will need surgery this year or not? The standard model says that decision makers assign some probability to a particular runner or team winning and then maximizes expected utility based on that probability. It turns out it doesn t always work this way. Suppose I have an urn filled with 90 balls: 30 of them are red, and 60 are either black or yellow. Consider the following pairs of choices: a) You win $100 if you draw a red or a yellow ball b) You win $100 if you draw a black or a yellow ball 25

And c) You win $100 if you draw a red ball d) You win $100 if you draw a black ball Most people will choose c) over d) and b) over a). But note there is an inconsistency here. If you choose c) over d) that means you think there are more red than black (that is fewer than 30 black balls). But if that is true then you should prefer a) to b) since if red>black, then there should be fewer than 30 black balls and therefore more than 30 yellow balls. Note what is happening is that people are avoiding the ambiguity in d). Note that these are all special case issues and do not imply that no one can ever make a good choice. Also, to the extent that behavioral economists criticize the rational consumer model, does not imply they think consumers are irrational that is they don t just randomly make choices. It just implies that even when the have perfect information, consumers will not always make the choice that is predicted by classical economics. Thus there are reasons when markets will not work perfectly even when all the classical assumptions are met. NEJM Paper: Emphasizes that It is important to apply behavioral economically principles when a) Economically important issues. (ensuring guidelines are followed, correcting system problems such as timely discharge, perceived as difficult or inconvenient) b) The processes or outcomes are largely within the physician s control c) Don t get silly/gimmicky/trivial d) MUST PAY ATTENTION TO INTRINSIC AND EXTRINSIC MOTIVATION Sometimes extrinsic motivation can crowd-out intrinsic motivation (paying people to donate organs can actually reduce the total amount of donors) 26