Chapter 16 & 17: Behavioural economics

Question 1

What is utility?

Answer 1

A measure of the level of satisfaction that a consumer enjoys from the consumption of goods and services.

Question 2

How do economists measure utility?

Answer 2

Util: A personal unit of satisfaction used to measure the enjoyment from consumption of a good or service.

Question 3

What is total utility?

Answer 3

The total aggregate satisfaction from consuming a good or service

Question 4

What is marginal utility?

Answer 4

The additional satisfaction derived from consuming one more unit of a good or service
Marginal utility is not the same as marginal utility per dollar spent

Question 5

When does diminishing marginal utility occur?

Answer 5

When marginal utility declines as consumption increases

Question 6

What is the consumer optimum?

Answer 6

The combination of goods and services that maximises the consumer’s utility, or satisfaction, for a given income or budget.

Question 7

How do we reach consumer optimum with more than two goods?

Answer 7

We equate the Marginal Utility per price of each good to another

Question 8

What is the effect when prices decrease or increase on the marginal utility per dollar spent?

Answer 8

Price decrease → Increases marginal utility per dollar spent and causes consumers to buy more of the good
Price increase → Decreases marginal utility per dollar spent and causes consumers to buy less of the good
Law of Demand

Question 9

When does the substitution effect occur?

Answer 9

When consumers substitute a product that has become relatively less expensive as the result of a price change

Question 10

When does a real-income effect occur?

Answer 10

When there is a change in purchasing power as a result of a change in the price of a good

Question 11

What is purchasing power?

Answer 11

The value of your income expressed in terms of how much you can afford.

Question 12

What does the diamond-water paradox explain?

Answer 12

Why water, which is essential to life, is inexpensive, while diamonds, which do not sustain life, are expensive
Water is abundant and would yield less marginal utility than something rare, diamonds (MUw < MUd).
However, if water were as rare as diamonds, there is no doubt that the price of water would exceed the price of diamonds.

Question 13

What is behavioural economics?

Answer 13

The field of economics that draws on insights from experimental psychology to explore how people make economic decisions

Question 14

What is the theory of bounded rationality (aka limited reasoning)?

Answer 14

Proposes that although decision-makers want a good outcome, either they are not capable of performing the problem solving that traditional economic theory assumes or they are not inclined to do so.

Question 15

What are the three ways this theory of bounded rationality can be explained?

Answer 15

The information the individual uses to make the decision is limited or incomplete.
The human brain has a limited capacity to process information.
There is often a limited amount of time in which to make a decisions

Question 16

What are behaviours that are not accounted for in the assumptions of rational behaviour/maximisation?

Answer 16

Misperceptions of probabilities
Inconsistencies in decision making
Judgement about fairness

Question 17

What are Misperceptions of probabilities and some examples

Answer 17

People perceive low probability events with over-anticipation and high probability events with under-anticipation

• Games of Chance: People have incomplete information about the probabilities and prize structure and operate under the false belief they have control over the outcome
• Difficulties in Assessing Probabilities: A failure in recognising the true underlying probabilities, combined with an irrational fear of regret, leads to many poor decisions
• Seeing Patterns Where None Exist
  
  • Gambler’s Fallacy: The belief that recent outcomes are unlikely to be repeated and that outcomes that have not occurred recently are due to happen soon
  • Hot Hand Fallacy: The belief that random sequences exhibit a positive correlation (relationship).

Question 18

What are Inconsistencies in decision making and examples?

Answer 18

• Framing effect: When people change their answer depending on how the question is asked (or change their decision depending on how alternatives are presented).
  
  • eg. opt-in v opt-out
• Priming effect: When the order of the questions influences the answers.
• Status Quo Bias: When decision-makers want to maintain their current choices, even when an objective evaluation of their circumstances suggests that a change would be beneficial
  
  • eg. explains why new companies do not gain much traction
• Inter-temporal decision-making: involves planning to do something over a period of time which requires valuing the present and the future consistently
  
  • eg. retirement plan from income

Question 19

What are judgements of fairness?

Answer 19

• Fairness cannot be explained
• Example: Ultimatum Game
  
  • An economic experiment in which two players decide how to divide a sum of money
  • Illustrates that people reject a proposal to help themselves in the name of fairness

Question 20

What are the behaviours that are not accounted for in the assumption that people are consistent in their risk-taking preferences?

Answer 20

Preference reversals

Prospect theory

Question 21

What are preference reversals?

Answer 21

• Occurs when risk tolerance is not consistent
• This went against the standard economic model which assumed individuals would fit in three distinct groups
  
  • Risk-averse people: who prefer a sure thing over a gamble with a higher expected value
  • Risk-neutral people: who choose the highest expected value regardless of the risk
  • Risk-takers: who prefer gambles with lower expected values, and potentially higher winnings, over a sure thing
    
    • Expected value is calculated by multiplying each outcome by its respective probability
  • Risk tolerance depends on financial circumstances and how much gain or loss can be experienced

Question 22

What is prospect theory?

Answer 22

• Suggests that individuals weigh the utilities and risks of gains and losses differently
  
  • Evaluate the risks that lead to gains separately from the risks that lead to losses