Behavioural Economics

Question 1

What is Behavioural Economics?

Answer 1

• Study of choices made by economic agents to assess the strengths/weaknesses of the rational choice model (RCM)
• Rationality assumes that agents are consistent, self-interested and maximising with relevant information
• Behavioural Economics has demonstrated that basic economic theory breaks down slightly

Question 2

What is framing? Give the famous thought experiment used to explain framing

Answer 2

• How two quasi-identical choices are framed strongly affects the choices
• e.g. discount and premium shampoo- whilst both are similar, the premium one will be preferred even at a slightly higher price to many consumers
• The disease dilemma illustrates that people prefer certainty for positive actions and uncertainty for negative actions (certain deaths vs probabilities)

Question 3

What is the Anchoring/Default effect? Provide examples as how this works

Answer 3

• Anchoring effect: Most recent information gives a greater anchor
• Examples: Harvard mathematics problem [1X2X3X4…] saw means of 512 Vs 2,250 and MBA Wheel of Fortune Vs African UN nations
• Defaults: The original choice can be manipulated to ensure the choice is made
• Examples: Opt-in Vs Opt-Out organ donations [Austria-99% Vs Germany-12%]

Question 4

How can Increased Choice illustrate behavioural economic issues?

Answer 4

• Rational choice model says a consumer cannot be worse off with more choice- true in PRINCIPAL
• However, some consumers prefer fewer options [menus,Netflix,MediCare]
• This is because the cognitive test in processing the decision is long

Question 5

What are Sunk costs? How can this show behavioural economic issues?

Answer 5

• Sunk Costs are monetary investments that have already been made and will not be recovered
• RCM suggests that sunk costs do not influence decisions
• However, homeowners will want to sell their house for nothing less than what they bought it for

Question 6

How can probabilities and heuristics impact traditional economic theory?

Answer 6

• Given the information previously provided, 2 events are always less likely to occur than the first event
• P(A)>P(A&B)

Question 7

How can intertemporal discounting impact traditional economic theory?

Answer 7

• Standard economic theory suggests exponential discounting (discounting the future at a constant fraction)
• This uses time consistency, suggesting that people’s valuation doesn’t change with time
• This means that Hyperbolic discounting should be used, where present values of $1 is:
  $1 / (1+kt)
• Agents with hyperbolic time preferences discount LT future more heavily than the discount of ST

Question 8

How can the ultimatum game impact traditional economic theory?

Answer 8

• RCM suggests that you should offer £1 and keep £9
• However, it is seen that often a 50/50 split is instead offered, introducing fairness and inequality-aversion
• This can be shown as:
  Ui(x) = xi - αimax(xj-xi,0) - βimax(xj-xi,0), where α>β
• OR, individual payoff - loss from disadvantageous split - loss from advantageous split