Behavioral Finance

CHAPTER 8

The Rational Man

Economic theory aims to model human behavior in a variety of contexts. How does someone choose which car to purchase? How does one select a mate? Between a stock with a high potential return and a lot of uncertainty and one with a low potential return but with little or no uncertainty, which would one pick?

Underpinning all of these questions is a basic inquiry on how people make decisions. Historically, economics has chosen to deal with these questions with a concept known as utility theory. However, behavioral finance has revealed some of the pitfalls of utility theory and some ways in which normal human behavior deviates from the predictions of this theory. In this chapter, we explore such issues.

CONSUMER CHOICE WITH CERTAINTY

Grace lives in a world with two goods—guns and butter—which are provided by the government at no cost to the consumer beyond taxes, which have already been collected. Grace has three options: she can choose 14 guns and 15 tubs of butter, 2 guns and 45 tubs of butter, or no guns and 50 tubs of butter.

How does Grace decide which bundle to choose? Economists assume Grace chooses the bundle that makes her the happiest, which does not seem like too big of a stretch for an assumption. But how do we measure whether one bundle makes Grace happier than another?

Economists use a concept called utility to represent the happiness a consumer derives from a bundle of goods. Each bundle is given a number, or utility “score,” that represents ...