Introduction to Behavioral

 
Decision 
State of the world 
Probability 
Payoff
Coffee 
Interesting 
0.8 
10
Boring 
0.2 
2
Beer 
Interesting 
0.8 
6
Boring 
0.2 
4
If the class is interesting it is a good idea to drink coffee beforehand in order to get the 
most benefi t. However, if the lecture is boring, drinking beer is better than drinking 
coffee (it is assumed here), because then it allows the student to drift off to sleep 
which is better than staying awake and not getting any benefi t from listening to the 
class. Therefore, the optimal decision, which maximizes expected utility, depends on 
the probability estimates of the states of the world. The student should verify that 
the expected payoff or utility of drinking coffee is 8.4, while the expected utility of 
drinking beer is 5.6. Thus the best decision in this situation is to drink coffee. However, 
if the probabilities were reversed, so that it was estimated that the probability of an 
interesting class was only 0.2, then the optimal decision would be to drink beer. We 
can see from this example that the estimation of Bayesian prior probabilities has an 
important effect on decision-making. The rational person will update these in the 
light of new information, so that if the class turns out to be boring this will reduce the 
estimated probability of the next class being interesting, and may affect the student’s 
drink decision next time round.
Applicability of the standard model
Over the last two or three decades behavioral economists have drawn increasing 
attention to various limitations in the standard model. Consider the following questions:
1
Why is the return on stocks so much higher on average than the return on bonds?

---

12
I N T R O D U C T I O N
PT
•