4. Value Theory

Question 1

What are the two kinds of theories in economics?

Answer 1

Normative and descriptive

Question 2

Normative theories

Answer 2

A theory that describes how people think about a problem in the right or logically consistent way

Question 3

Rational choice theory

Answer 3

Normative theory at the heart of economic reasoning that describes the optimizing model

Question 4

True or false. Economic theory today mostly uses one theory to serve both normative and descriptive purposes

Answer 4

True

Question 5

Who invented the idea of risk aversion?

Answer 5

Bernoulli

Question 6

What is the principle of diminishing sensitivity?

Answer 6

An idea in risk aversion theory that peoples happiness, or utility, increases as they get wealthier but at a decreasing rate

Question 7

What does the curved upward shape of a utility function in a graph (with utility on y and wealth in x) suggest?

Answer 7

It implies risk aversion because utility of the first thousand dollars is greater than the utility of the second thousand

Question 8

What is expected utility theory?

Answer 8

It describes how to make decisions in risky situations

Question 9

What is an alternative to expected utility theory?

Answer 9

Prospect theory, which is a prediction of the actual choices real people make; a theory about the behavior of humans

Question 10

What change to a utility function of the graph did Kahneman and Tversky made?

Answer 10

They changed the X axis from level of wealth to changes in wealth

Question 11

What was Bernoulli’s graph called?

Answer 11

Diminishing marginal utility of wealth

Question 12

What was Kahneman and Tversky’s graph called?

Answer 12

The value function

Question 13

True or false. People think about life in terms of levels, not changes

Answer 13

False. Vice versa

Question 14

What is one of the earliest findings in psychology called?

Answer 14

The Weber Dash Fechner law which states that the just notable difference (JND) in any variable is proportional to the magnitude of that variable.

So if I gain 1 ounce in weight I don’t notice it, but if I’m buying fresh herbs the difference between two and 3 ounces it’s obvious.

Question 15

What is the implication that people have diminishing sensitivity to both gains and losses?

Answer 15

That people are risk of verse for gains but risk seeking for losses

(Revisit page 33)

Question 16

How do you explain loss aversion?

Answer 16

The fact that a loss hurts more than an equivalent gain gives pleasure.

It has become the single most powerful tool in behavioral economics

Question 17

Summing up chapter 3:

We experience life in terms of ______, we feel _______ to both gains and losses, and ______ sting more than equivalently sides ______ feel good

Answer 17

Changes
Diminishing sensitivity
Losses
Gains