2. The Rational Man

Question 1

What is the causal relationship of rationality?

Answer 1

people respond to incentives –> change in behavior

Question 2

Give one example where rats respond to incentives.

Answer 2

Learn that they could earn drinks by pressing on the levers, and familiarised themselves with how much each lever produced.
Experimenters set “prices” by adjusting the machine to dispense less/more drink per press of the lever; set “income” by limiting the total number of lever presses in each session. Root beer is delicious but expensive, so rats compromise, slaking their thirst on nasty quinine solution but also enjoying some root beer. They don’t press the lever at random. Drink more quinine even when it gets more expensive, as long as the servings are still larger than those of the root beer. Rats respond to budget as well as price.

Question 3

What is a “giffen good”?

Answer 3

A Giffen good is a good like the quinine water, one that is such a wretched necessity for the poor that when the price rises, demand rises, because the price rise creates more poverty and the poverty creates more demand.

Question 4

Why are young people now having more oral sex?

Answer 4

Increased cost of regular sex.
Weigh the costs and benefits of oral sex against alternatives like regular sex.
Regular sex is more costly than it used to be because of the spread of HIV/AIDS. HIV is much more likely to be spread by regular sex than oral sex. So people turn to alternatives like oral sex because the costs of oral sex are lower than the costs of regular sex.
This is a sign that teenagers are behaving more responsibly by rationally-choosing an alternative to riskier sex.

Question 5

How do you explain the fall in STDs when abortion notification laws are passed?

Answer 5

Abortion notification law significantly raises the risk/cost of unprotected sex because parents have to be informed for an abortion, and that the teenagers rationally respond to that risk/cost by reducing that behavior. Reducing unprotected sex naturally results in fall in STDs.

Question 6

How is knowledge and experience with people with AIDS related to sexuality?

Answer 6

Rise of AlDS has made it more risky to have sex with men. Makes it more dangerous for men to be homosexual, and for women to be heterosexual. When cost of one’s sexual orientation is perceived to have gone up, we expect rational people to respond to that. Men who had a relative with AlDS were less likely to find the idea of sex with men appealing. Women who had a relative with AlDS also seemed to be turned off by the idea of sex with men: They were more likely to say they were homosexual or bisexual. Both men and women with an acute awareness of the risks of AlDS were shifting away from an obvious way of catching it. Experience of AIDS had inspired safer sex practices

Question 7

Do murderers respond to the death penalty?

Answer 7

Yes, even though most murders are considered an act of passion and irrationality, most econometric research reveals a substantial deterrent effect of capital punishment. Murderers respond to incentives! Even in the moment of rage, it still matters what the murderer perceives his chances of escaping are. Suggests that people respond significantly to incentives even in situations where we don’t usually imagine their behaviors to be calculated or rational. Response to incentives may be as INNATE as any other instinctive behavior.

Question 8

What is rationality specifically?

Answer 8

Refers to how people rank order their preferences and then choose the most desirable feasible choice. Though mistakes can be made, but rationality is still a better theory than arationality or irrationality because people are rational most of the time.

Question 9

What is the difference between irrationality and arationality?

Answer 9

Arationality – people making choices randomly

Irrationality – people choosing the opposite of what they desire

Question 10

What are the 2 important assumptions of rationality?

Answer 10

1) Assume that people’s preferences are COMPLETE
Any basket of goods can be compared as to its desirability to another bundle
2) Assume that people’s preferences are TRANSITIVE
If people prefer basket A to basket B, and basket B to basket C, then they prefer basket A to C.

Question 11

What is the concept of utility?

Answer 11

The happiness a consumer derives out of the consumption of a given quantity of a good

Question 12

Draw and describe the utility function.

Answer 12

Law of diminishing marginal returns (LDMR)
Captures the relationship between utility and quantity of good consumed. Typically people’s’ preferences are assumed to display diminishing marginal utility
Means that the first unit of a good makes me very happy but each extra unit makes me happier but at a decreasing rate.

Question 13

In what cases will the utility function not apply?

Answer 13

Addicts – gamblers, drugs etc.
Hobbies
People enjoy increasing or same rates of increase of happiness the more they consume the good.

Question 14

Draw and describe the indifference curve.

Answer 14

The indifference curve shows our consumption preferences if we have to choose between 2 goods. They show consumption combinations where the consumer is indifferent. Along the same indifference curve, any consumption bundle makes us equally happy. Indifference curves are personal and depends on individual’s preference and value of each good against the other good. It is infinite.

Question 15

What happens if we move from a lower indifference curve to a higher indifference curve?

Answer 15

Our utility (happiness) increases.

Question 16

What are the 4 main qualifications of rationality?

Answer 16

1) Rationality does not always mean that people’s preferences are necessarily selfish
2) It does not mean that people do explicit calculations every time they need to make decision.
3) People are not assumed to have perfect self-control, we sometimes make irrational decisions we regret. Limits in willpower.
4) People make mistakes and have biases. There are clear limits to our abilities to calculate, think ahead, and see our way through certain cognitive traps.

Question 17

Elaborate why rationality does not always mean behaving selfishly.

Answer 17

Rational behaviors can be altruistic or even self-destructive. People are motivated by all kinds of normal human emotions. These motivations may not be financial, and not always selfish, but our responses to them are rational. We still plan, calculate, and strategise according to our emotions.

Question 18

Elaborate why rationality does not always mean people do explicit calculations every time they make a decision.

Answer 18

Many rational decisions are made unconsciously but still can fit the rational model. Evolutionary pressure has tended to produce organisms that often behave in rational ways, whether consciously or unconsciously.

Question 19

Give an argument why rationality is a good enough theory to understand the world.

Answer 19

People are less likely to make mistakes when doing something familiar and experienced in. Since we all do familiar things more often than unfamiliar things, mistakes are less likely to occur. This favours rational choice theory as a tool for understanding the world. It is not a perfect theory but it is good enough.

Question 20

What happens when observed behavior doesn’t comply with predictions of rationality?

Answer 20

Whenever behaviour does not comply with predictions, economists don’t give up but dig deeper, trying to reconcile the two. (ie. try to explain seemingly irrational decisions with rationality)

Question 21

Seat belts tend to reduce the number of driver deaths by making it easier to survive an accident. But it also increases the number of driver deaths by encouraging reckless behaviour. Which is the net effect of the two opposing predictions?

Answer 21

They cancel each other out. Specifically, we observe more accidents, but fewer deaths per accident. The net total of deaths remain the same.

Question 22

Describe one example to show that incentives can work differently on different people.

Answer 22

Incentives can depend on cultural factors.
Eg. NYC diplomats and parking violations
UN diplomats could park wherever they wanted and ignore any legal penalties.
Norway, Sweden, Canada, UK, Japan → no unpaid parking tickets
Kuwait, Egypt, Chad, Sudan, Angola, Pakistan etc. → worst violators
They all faced the same immediate incentives but results were very different. Worst violators came from diplomats from countries without a culture of meritocracy. The poorer the country, the more likely their diplomats have received special treatment all their lives, and they expect those privileges to continue. Corruption breeds subsequent irresponsibility. Swedes are more likely to regard governments as morally legitimate. So they are more likely to obey laws and take greater care to cultivate their reputations as law-abiding citizens.

Question 23

What does the example on NYC diplomats and parking violations demonstrate?

Answer 23

Demonstrates that the workings of incentives depends on how a person perceives what is at stake in the choice. Understanding the social context is very important!

Question 24

Give an example of how non-monetary incentives can work better than monetary incentives.

Answer 24

Blood donation – When people are given a small stipend for donating blood rather than simply being praised for their altruism, they tend to donate less blood. The stipend turned a noble act of charity into a painful way to make a few dollars, and it wasn’t worth it.

Question 25

In what circumstances should monetary incentives be used to motivate someone? (3)

Answer 25

1) Performance at a task is responsive to extra effort (requires attentiveness)
2) Intrinsic motivation is weak initially
3) Receiving money produces social approval. When people feel good about the money earned, it strengthens intrinsic motivations.

Question 26

What is are limitations of using high rewards to motivate someone?

Answer 26

1) May unduly stress out the individual. Individual may freeze and make even more errors. Stressed people tend to conform more to social opinion (groupthink).
2) May bring feelings of low self esteem.
3) Application of punishments and rewards can make us feel like slaves, and lose control, leading to poor performance.

Question 27

In what circumstances will offering rewards backfire? (2)

Answer 27

1) Individuals overreact to the feedback. Trying harder makes everything worse.
2) Individuals are doing the task wrongly to begin with.
Can intensify basic, ingrained mistakes

Question 28

Why does monetary incentive not work for children to wash the dishes? (2)

Answer 28

1) Doing the dishes becomes a job for money. Market relationship between parent and child. Undermines integrity of family.
2) Associated status of working for parents is negative. Having her own job outsides signals adulthood and independence, but money from parents feels like an allowance for an immature dependent, and will not boost the daughter’s internal motivation to do the dishes.

Question 29

How should we encourage children to do the dishes?

Answer 29

Praising the child for aptitude and talent in the task is more effective. It appeals to the desire to do a good job.

Question 30

Why do promoters not raise the price of concert tickets even though they will still sellout? (2 possible reasons)

Answer 30

1) Difficulty of procuring tickets are a form of free advertising. Promoters don’t want to sacrifice long-term value of this publicity for the short-term advantage of raising prices.
2) Promoters don’t want rich audiences, they want fanatic audiences! The kind of audiences who will buy CDs, t-shirts, and other merchandise. The kind of audiences who will rearrange their schedules just to be online at the right time to buy the tickets.
Low prices mean quick sellouts, and quick sellouts guarantee an audience that went through a lot of trouble to strategically obtain the tickets.

Question 31

Why do sales increase for products with celebrity endorsements?

Answer 31

Hiring a celebrity to endorse your product is like posting a bond. The firm makes a substantial investment up front and reaps returns over a long period of time. A firm that expects to disappear in a year won’t make such an investment. This allows consumers to infer that the firm has enough confidence in the quality of its product to expect to be around for a while. Hence, they have greater trust in the quality of the product. (same idea for banks and marble floors and greek columns)

Question 32

Explain the phenomenon of the 99 cents pricing.

Answer 32

1) mild form of irrationality where people only notice first digit of price.
2) Cash register had the ability to keep a record of sales, which is important in case employees steal from you. But cash registers record only sales that are rung up. If a customer buys an item for $1 and hands the clerk a dollar bill, the clerk can neglect to record the sale, and simply slip the bill in his pocket. If customer buys item for 99 cents, the clerk has to make change, open the cash drawer which forces the sales to be recorded.

Question 33

Why are plots of land scattered and farmers don’t make an effort to trade plots to consolidate their holdings?

Answer 33

Rational because it is a form of insurance
Farmer with one large plot is liable to be completely ruined in the event of a localised flood. By scattering holdings, farmer gives up some potential income in exchange for a guarantee that he will not be wiped out by a local disaster.

Question 34

Why do men spend less on medical care than women?

Answer 34

Men are more likely than women to die violent or sudden deathsThe value of protecting yourself against cancer is diminished if you have a high probability of being hit by a truck. Therefore rational for men to purchase less preventive care than women.

Question 35

Why do people give each other store-bought gifts instead of cash?

Answer 35

We give gifts because want to announce that we did not take much time to shop. If I really care for you, I probably will have an easy time finding the right gift. If I care less about you, finding the right gift becomes a major chore. Since everyone knows that shopping time is limited, the fact that I could find something appropriate reveals that I care.