College 5 Flashcards
What is a descriptive theory about?
How do people make decisions?
What is a normative theory about?
How should people make decisions?
Economists’ perspective: How much is a certain outcome worth?
- Desirability of outcome.
- Likelihood of obtaining outcome.
- If low on one, it loses worth.
Three principles of outcome value
- Principle of diminishing sensitivity.
- Relativity principle.
- Principle of loss aversion.
What is the principle of diminishing sensitivity?
- As value increases, the perceived increase of value decreases.
- Also known as ‘diminishing marginal returns’.
What is the relativity principle?
Evaluation is relative to a neutral reference point.
What is the principle of loss aversion?
- Losses loom larger than gains.
- We attach more value to the things we already own.
- … Because we do not want to lose what we already have, especially after longer ownership and physical possession.
o The endowment effect.
What is the expected value theory?
Economists’ perspective: how should people make decisions under uncertainty?
What does the expected value theory argue?
They argue that people are
- Rational
- Self-centered
o In every decision that we make, we only think about our own interest. - Stable in their preferences
o No matter the context, we always go for the same option because that is what we value to a certain extend.
St. Petersburg Paradox
Imagine the following gamble
- A fair coin is tossed….
o If heads appears you win 2 euros and the game continues.
o If heads appears again, you win 4 euros and the game continues.
o If heads appears again, you win 8 euros and the game continues.
o Etc.
o The first time tails appears, the game ends. - How much should people be willing to pay as a buy in?
o Expected value: (1/2 x 2) + (1/4 x 4) + (1/8 x 8) + … = 1 + 1 + 1 + … = an infinite amount of money
o Yet almost no human being is willing to do that
Bernoulli’s solution
“The determination of the value of an item must not be based on the price, but rather on the utility it yields. […] There is no doubt that a gain of one thousand ducats is more significant to the pauper than to a rich man though both gain the same amount.”
- Money has different “utility” (psychological value) based on various things, e.g., how much of it you already have.
When you’re in the desert, the first bottle of water is amazing. The second bottle, not so much.
Diminishing marginal returns
The more (money) one has, the less worth it has.
What was found in a study on cab drivers on diminishing marginal returns?
It is found that cab drivers, on a rainy day, often stop working in the afternoon because they have earned enough on that day. While logic would say they could better continue working, so that they can have a day off on a sunny day or have a buffer.
What does diminishing marginal returns have implications for?
Achievement & motivation
What is diminishing marginal returns also known as?
Principle of diminishing sensitivity
The infamous indifference map
Two features with the same utility
- E.g., income and leisure
- Should be interchangeable
- Both have diminishing marginal utility
Bernoulli’s error in the indifference map
Reference point is missing.
How much income and leisure do you already have?
Endowment effect
We attach more value to the thing we already own.
What did the article by Nash & Rosenthal (2014) show?
They manipulated the reference point and showed the endowment effect.
What did the experiment by Nash & Rosenthal (2014) look like?
Two students can give their top three choices for a residence hall. One student gets her top choice (A), the other doesn’t (B).
The student that got her first choice is asked how much money she would be willing to accept to move to residence hall B The other student is asked how much money she would be willing to pay to get a spot in residence hall A.
They asked the same question after they had lived in their residence hall for two months.
What are the results from the experiment by Nash & Rosenthal (2014)?
The student that was awarded her first choice rated the value 5.5 at first, and later at 6.2. The student that was denied her first choice rated the value of residence hall A as 2.5 at first and later as 2.2.
There is a big difference between how much you would be willing to pay or to accept. The student that has something to lose, values their residence hall much more than students that have something to gain.
The student that did not get their first choice, has started to grow towards their residence hall.
What are the results from Nash & Rosenthal (2014) contrary to?
The results are contrary to expected value and expected utility because based on expected utility preference for the residence hall should have the exact same value or utility for both students.
How is the relativity principle linked to the experiment with the residence halls?
- Evaluation is relative to a neutral reference point.
- Forfeiture vs. acquisition choice
o Forfeiture: losing something
o Acquisition: something to gain - In the case of the student and their residence halls, the neutral reference point is the residence hall that they have vs. what they want.
Imagine you can gamble by tossing a coin. With heads you win X euros, with tails you lose 10 euros. How high must X be for you to accept this bet? And if you repeat the bet 100 times?
A loss feels twice as much as a win might feel. A lot of people are asking for a lot of money for this bet.
But if you repeat this bet 100 times with X higher than 10, you are guaranteed to make money, considering it’s a 50% chance every time.