Title: Behavioral Economics — LearnCoachAssist

Q: What is behavioral economics?
A: A field that combines insights from psychology and economics to explain why people often make decisions that deviate from the predictions of standard rational-choice models.

Q: Who are Daniel Kahneman and Amos Tversky?
A: Israeli-American psychologists who pioneered research on cognitive biases and prospect theory, fundamentally reshaping the field of behavioral economics.

Q: What is prospect theory?
A: A theory developed by Kahneman & Tversky (1979) stating that people evaluate outcomes relative to a reference point and are more sensitive to losses than to equivalent gains.

Q: How does the value function in prospect theory differ from standard utility theory?
A: The value function is S-shaped: concave for gains (risk aversion) and convex for losses (risk seeking), and it is steeper for losses than for gains.

Q: What is a reference point in prospect theory?
A: The baseline against which outcomes are judged as gains or losses; it is often the status quo or an expectation level, not an absolute wealth measure.

Q: What is loss aversion?
A: The empirical finding that losses loom roughly twice as large as gains of the same magnitude, i.e., losing $100 feels about twice as painful as gaining $100 feels pleasurable.

Q: What is the typical loss-aversion coefficient (λ) found in experiments?
A: Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain.

Q: How does loss aversion affect investor behavior?
A: Investors tend to hold losing stocks too long (hoping to break even) and sell winning stocks too early (locking in gains), a pattern called the disposition effect.

Q: What is the disposition effect?
A: The tendency of investors to sell assets that have increased in value while keeping assets that have decreased in value, driven largely by loss aversion.

Q: How does loss aversion influence labor supply decisions?
A: Studies of taxi drivers show they set daily income targets and quit early on high-demand days while working longer on slow days, contrary to rational supply predictions.

Q: What is the endowment effect?
A: The phenomenon where people value an object more highly simply because they own it, leading to a gap between willingness to accept (WTA) and willingness to pay (WTP).

Q: Who first demonstrated the endowment effect experimentally?
A: Richard Thaler coined the term, and classic mug-trading experiments by Kahneman, Knetsch, and Thaler (1990) provided strong experimental evidence.

Q: How large is the typical WTA/WTP gap in endowment effect experiments?
A: Sellers typically demand roughly 2 to 3 times the price that buyers are willing to pay for the same object.

Q: What explains the endowment effect under prospect theory?
A: Giving up a good is coded as a loss relative to the ownership reference point, making it feel more costly than the gain a buyer anticipates.

Q: How does the endowment effect impact real estate markets?
A: Homeowners often set asking prices anchored to their purchase price, refusing to sell at a loss even when market conditions have changed significantly.

Q: What is mental accounting?
A: A concept introduced by Richard Thaler describing how people categorize, evaluate, and track financial activities in separate mental accounts rather than treating money as fungible.

Q: Give an example of mental accounting in everyday life.
A: A person might refuse to spend $50 from a "savings" account on dinner but happily spend a $50 gift card on the same meal, even though both have equal monetary value.

Q: What is the house money effect?
A: The tendency to take greater risks with money perceived as winnings (e.g., casino profits) because it is mentally categorized as "free money" rather than personal wealth.

Q: How does mental accounting explain the sunk cost fallacy?
A: People continue investing in a failing project because they have a mental account tracking prior expenditures and feel compelled to justify those sunk costs.

Q: What is narrow framing in mental accounting?
A: Evaluating each financial decision in isolation rather than considering it as part of a broader portfolio, leading to suboptimal risk management.

Q: What is nudge theory?
A: A framework by Richard Thaler and Cass Sunstein proposing that subtle changes in choice architecture can steer people toward better decisions without restricting freedom of choice.

Q: What is a "nudge" according to Thaler and Sunstein?
A: Any aspect of the choice architecture that predictably alters behavior without forbidding options or significantly changing economic incentives.

Q: What is libertarian paternalism?
A: The philosophy behind nudge theory: designing environments that guide people toward welfare-enhancing choices while preserving their freedom to choose otherwise.

Q: Give an example of a successful nudge in retirement savings.
A: Auto-enrollment in 401(k) plans dramatically increases participation rates because the default option is set to "enrolled" rather than "not enrolled."

Q: What is a default option nudge?
A: Setting the pre-selected choice to the socially or individually optimal option, exploiting the tendency of people to stick with the status quo.

Q: How has nudge theory been applied to organ donation?
A: Countries with opt-out (presumed consent) systems have much higher organ donation rates than opt-in countries, illustrating the power of defaults.

Q: What is bounded rationality?
A: A concept by Herbert Simon stating that human decision-making is limited by available information, cognitive capacity, and time constraints, leading people to satisfice rather than optimize.

Q: What does it mean to "satisfice"?
A: To choose an option that is good enough to meet a minimum threshold of acceptability rather than searching for the theoretically optimal solution.

Q: How does bounded rationality differ from full rationality assumed in neoclassical economics?
A: Neoclassical models assume agents process all available information and maximize utility perfectly, while bounded rationality acknowledges cognitive limitations and the use of heuristics.

Q: What are heuristics in behavioral economics?
A: Mental shortcuts or rules of thumb that simplify decision-making, often useful but sometimes leading to systematic biases and errors.

Q: What is the availability heuristic?
A: Judging the probability of an event based on how easily examples come to mind, leading to overestimation of dramatic or recent events (e.g., plane crashes).

Q: What is the representativeness heuristic?
A: Judging probabilities based on how closely something resembles a prototype, often ignoring base rates and leading to conjunction fallacies.

Q: What is the anchoring effect?
A: The cognitive bias where people rely too heavily on the first piece of information (the anchor) encountered when making subsequent judgments or estimates.

Q: How does anchoring affect price negotiations?
A: The initial asking price serves as an anchor; even arbitrary starting points significantly pull final negotiated prices toward the anchor value.

Q: How does anchoring manifest in financial markets?
A: Investors anchor to metrics like 52-week highs, IPO prices, or round numbers, which can distort valuation judgments and trading behavior.

Q: What did Kahneman and Tversky's wheel-of-fortune experiment demonstrate about anchoring?
A: Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on.

Q: How do analysts' price targets demonstrate anchoring bias?
A: Analysts often anchor to previous price targets or consensus estimates, adjusting insufficiently even when fundamentals change dramatically.

Q: What is herd behavior in economics?
A: The tendency of individuals to mimic the actions of a larger group, often disregarding their own information or analysis in favor of following the crowd.

Q: What causes herd behavior in financial markets?
A: Factors include informational cascades (inferring information from others' actions), social pressure, and the career risk of deviating from consensus.

Q: What is an informational cascade?
A: A situation where individuals sequentially observe others' decisions and rationally choose to follow them, ignoring their own private signals, potentially leading the group astray.

Q: How does herd behavior contribute to market bubbles?
A: As more investors buy into a rising asset, others follow based on social proof rather than fundamentals, inflating prices far beyond intrinsic value.

Q: What is a speculative bubble?
A: A market condition where asset prices rise to levels significantly above fundamental value, driven by exuberant buying and the expectation that prices will continue to increase.

Q: Name a famous historical market bubble.
A: The Dutch Tulip Mania (1637), where tulip bulb prices reached extraordinarily high levels before collapsing dramatically.

Q: What was the Dot-Com Bubble?
A: A speculative bubble in late 1990s–2000 where internet company stocks soared based on hype and optimism, then crashed when expected revenues failed to materialize.

Q: What role did behavioral biases play in the 2008 housing crisis?
A: Overconfidence, herd behavior, and mental accounting led homebuyers, lenders, and investors to underestimate risk and fuel unsustainable housing price appreciation.

Q: What is overconfidence bias?
A: The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers.

Q: How does overconfidence affect trading volume?
A: Overconfident investors trade excessively, believing they can outperform the market, which typically leads to lower net returns after transaction costs.

Q: What is the certainty effect in prospect theory?
A: People disproportionately prefer outcomes that are certain over those that are merely probable, even when the expected value of the probable outcome is higher.

Q: What is the Allais Paradox?
A: A decision-making paradox showing that people violate expected utility theory by preferring certainty in some gambles while choosing risky options in structurally identical ones.

Q: What is the isolation effect (also called the cancellation effect)?
A: The tendency to disregard components shared by all options and focus on what differs, which can lead to inconsistent preferences depending on how choices are framed.

Q: What is framing effect?
A: The phenomenon where people's decisions are influenced by how information is presented (e.g., "90% survival rate" vs. "10% mortality rate") rather than by the objective facts alone.

Q: How did Kahneman and Tversky demonstrate framing effects?
A: In the Asian Disease Problem, participants preferred a sure option when outcomes were framed as lives saved (gains) but chose the risky option when framed as lives lost (losses).

Q: What is status quo bias?
A: The preference for the current state of affairs, where changes from the baseline are perceived as losses and thus resisted even when change would be beneficial.

Q: How does status quo bias relate to loss aversion?
A: Any change from the status quo involves potential losses in some dimensions, and because losses loom larger than gains, people disproportionately favor staying put.

Q: What is the decoy effect (asymmetric dominance)?
A: Adding a third, clearly inferior option (the decoy) to a choice set to make one of the other options appear more attractive by comparison.

Q: What is present bias?
A: The tendency to give disproportionate weight to immediate payoffs over future ones, leading to procrastination and under-saving for retirement.

Q: What is hyperbolic discounting?
A: A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting.

Q: How does hyperbolic discounting explain procrastination?
A: The immediate cost of effort is heavily weighted while the future reward is deeply discounted, making it always seem optimal to delay action.

Q: What is the concept of "choice overload"?
A: Having too many options can paralyze decision-making, reduce satisfaction, and lead to suboptimal choices, as shown in Iyengar and Lepper's jam study.

Q: What did the famous jam study by Iyengar and Lepper find?
A: Shoppers who saw a display of 24 jams were less likely to purchase than those who saw only 6 jams, demonstrating that excess choice can reduce action.

Q: What is the peak-end rule?
A: People judge an experience based on how they felt at its most intense point (peak) and at its end, rather than on the sum or average of every moment.

Q: How did Kahneman demonstrate the peak-end rule?
A: In colonoscopy experiments, patients rated a longer but gradually easing procedure as less painful than a shorter one with an abrupt end, despite more total discomfort.

Q: What is the sunk cost fallacy?
A: The tendency to continue an endeavor because of previously invested resources (time, money, effort) rather than evaluating future costs and benefits objectively.

Q: How does the sunk cost fallacy manifest in business decisions?
A: Companies may continue funding failing projects because executives feel compelled to justify the resources already spent, rather than cutting losses.

Q: What is regret aversion?
A: The tendency to avoid actions that might lead to future regret, often causing investors to make overly conservative choices or follow the herd.

Q: How does regret aversion differ from loss aversion?
A: Loss aversion concerns the pain of actual losses, while regret aversion involves the anticipated emotional pain of having made a wrong decision.

Q: What is the Dunning-Kruger effect and how does it relate to market behavior?
A: People with low competence overestimate their abilities while experts may underestimate theirs, contributing to novice investors taking on excessive risk.

Q: What is the gambler's fallacy?
A: The mistaken belief that past random events affect future probabilities, e.g., thinking a coin that landed heads five times is "due" for tails.

Q: How does the gambler's fallacy affect trading?
A: Traders may expect a stock on a losing streak to reverse simply because it has fallen for several consecutive days, ignoring actual market conditions.

Q: What is confirmation bias?
A: The tendency to search for, interpret, and remember information that confirms pre-existing beliefs while ignoring contradictory evidence.

Q: How does confirmation bias affect investors?
A: Investors seek out news and analysis that supports their positions, creating an echo chamber that prevents them from recognizing when to exit a losing trade.

Q: What is the hindsight bias?
A: The tendency to believe, after an event has occurred, that one "always knew" it would happen, distorting memory and lessons learned from past decisions.

Q: What is the affect heuristic?
A: Making judgments based on current emotions rather than objective analysis; for example, fearing investments in industries one has negative feelings about regardless of fundamentals.

Q: What is myopic loss aversion?
A: The combination of loss aversion and frequent portfolio evaluation, leading investors who check returns often to take less risk because short-term losses feel painful.

Q: How did Benartzi and Thaler use myopic loss aversion to explain the equity premium puzzle?
A: They showed that if investors evaluate portfolios annually and are loss-averse, they would demand a high premium for stocks, matching observed equity premiums despite rational models predicting lower premiums.

Q: What is the equity premium puzzle?
A: The observation that stock returns have historically exceeded bond returns by a margin too large to be explained by standard risk-aversion models.

Q: What is time inconsistency in behavioral economics?
A: When a person's preferences change over time such that what is preferred at one point is no longer preferred later, even without new information.

Q: What are commitment devices?
A: Strategies people use to lock themselves into future behavior, overcoming present bias; examples include automatic savings deductions and public goal announcements.

Q: What is the IKEA effect?
A: The tendency for people to place disproportionately high value on products they partially created, regardless of the quality of the outcome.

Q: How does the endowment effect apply to stock trading?
A: Investors may demand a higher price to sell a stock they own than they would be willing to pay to buy the same stock, creating market inefficiencies.

Q: What is social proof in behavioral economics?
A: The tendency to adopt the behavior of others in a group, assuming that the group's collective action reflects correct behavior, especially under uncertainty.

Q: How is social proof used as a nudge?
A: Showing messages like "9 out of 10 of your neighbors reduced their energy use" effectively encourages conservation through conformity to perceived norms.

Q: What is the money illusion?
A: The tendency to think of money in nominal terms (face value) rather than real terms (adjusted for inflation), affecting spending and wage negotiations.

Q: What is fairness bias and how does it affect markets?
A: People are willing to punish unfair behavior even at personal cost, as shown in ultimatum games, which can affect pricing, wages, and market transactions.

Q: What did the ultimatum game reveal about rational self-interest?
A: Responders frequently reject low offers (e.g., less than 20% of the total) even though accepting would be financially rational, demonstrating fairness preferences.

Q: What is the hot-hand fallacy?
A: The mistaken belief that a person who has experienced success has a greater chance of further success in random or independent events.

Q: What is ambiguity aversion (Ellsberg Paradox)?
A: People prefer known risks over unknown risks, choosing gambles with known probabilities even when the expected values are identical.

Q: How does ambiguity aversion affect investment decisions?
A: Investors favor familiar domestic stocks over foreign equities (home bias), preferring known risks even when international diversification would improve returns.

Q: What is the home bias in investing?
A: The tendency for investors to overweight domestic securities in their portfolios despite potential gains from international diversification, partly driven by ambiguity aversion and familiarity bias.

Q: What is default effect in choice architecture?
A: The powerful tendency for individuals to accept pre-set options, making the design of defaults one of the most impactful tools in behavioral policy.

Q: How does Thaler's "Save More Tomorrow" program use behavioral insights?
A: It combines present bias (commitment starts in the future), loss aversion (increases tied to pay raises), and inertia (auto-escalation) to dramatically boost retirement savings.

Q: What is the "winner's curse" in behavioral economics?
A: In auctions, the winning bidder often overpays because the winner tends to be the person who most overestimated the item's value.

Q: What is mental accounting's "payment depreciation" concept?
A: The psychological pain of paying for something diminishes over time, which is why pre-paid vacations feel "free" and why people prefer flat-rate pricing.

Q: What is narrow bracketing?
A: Making decisions one at a time instead of considering them as part of a broader set, leading to choices that may be locally sensible but globally suboptimal.

Q: How does prospect theory explain insurance purchasing behavior?
A: People buy insurance even at unfavorable premiums because the utility of eliminating a potential loss (which weighs heavily) exceeds the disutility of the certain premium payment.

Q: What is the reflection effect in prospect theory?
A: Risk preferences reverse between the gain and loss domains: people are risk-averse for gains but risk-seeking for losses.

Q: What are Kahneman's System 1 and System 2?
A: System 1 is fast, automatic, and intuitive; System 2 is slow, deliberate, and analytical. Many biases arise because System 1 dominates routine decisions.

Q: How does System 1 thinking contribute to anchoring?
A: System 1 automatically generates an initial estimate based on the anchor, and System 2 insufficiently adjusts from it, leaving the final judgment biased toward the anchor.

Q: What is "choice architecture"?
A: The practice of designing the environment in which people make decisions, including option layout, defaults, and information presentation, to influence outcomes.

Q: What is the distinction between "Econs" and "Humans" in Thaler's framework?
A: Econs are the perfectly rational agents of economic theory; Humans are real people who use heuristics, have biases, and are influenced by context and emotions.