Deviations from Rational Choice under Certainty

Question 1

Decision making under uncertainty

Answer 1

cannot assign probabilities to different possible outcomes e.g. it is difficult to estimate probabilities of different possible states of the world that could result from global warming.

Question 2

Strategic Interaction

Answer 2

Outcome depends not only on own choice but also on other’s choice e.g. two firms competing on the market.

Question 3

Preference

Answer 3

a relation, describing an individual’s attitudes or values over a set of alternatives.

Question 4

>

Answer 4

is better than (strict preference relation)

Question 5

> /

Answer 5

is at least as good as (weak preference relation)

Question 6

~

Answer 6

is as good as (indifference)

Question 7

Transitivity

Answer 7

Consider a set U
xRy and yRz => xRz (x, y, z) is a subset of U. Let R denote the relation “is taller than”.

Question 8

Completeness

Answer 8

xRy or yRx, (x, y) is a subset of U. Let R denote the relation “is at least as tall as”.

Question 9

Preferences of the consumer

Answer 9

U(x, y)

Question 10

Consumer budget constraint

Answer 10

pxX + pyY = m

Question 11

What is a rational consumer choice composed of?

Answer 11

Has rational preferences (transitive + complete) + utility maximization: choose most preferred item on the menu (in case of ties, one of the most preferred items)

Question 12

The rational choice model also assumes:

Answer 12

Description and procedure invariance - different representation of the same choice problem should yield the same preferences.
Preferences are stable - do not change over time.
Insatiation - more is always better.
A consumer can evaluate any number of options and has rational preferences regardless of the number of options available.
Consumer is forward-looking & maximizes utility.

Question 13

Opportunity cost of an alternative

Answer 13

what you have to forego if you choose this alternative

Question 14

Intertemporal Labour Supply

Answer 14

Decisions today with consequences in multiple time periods. “rational” workers should work more when wages are high and consume more leisure when wages are low.

Question 15

Sunk costs

Answer 15

individuals fail to ignore sunk costs i.e., individuals continue to invest in a decision because of the resources (money) already committed, even when it is no longer rational to do so.
e.g., business projects: a firm may continue funding a failing project because they have already invested heavily in it, even though discounting would minimize future losses.

Question 16

Menu Dependence

Answer 16

People’s preferences are influenced by a menu.

Question 17

When does the Decoy effect occur?

Answer 17

when the introduction of a subpar option causes individuals to change their preferences

Question 18

What is description and procedure invariance?

Answer 18

different representation of the same choice problem should yield the same preference

Question 19

What is Insatiation?

Answer 19

more is always better

Question 20

What is the expansion condition?

Answer 20

If x is chosen from the menu {x, y}, assuming that you are not indifferent between x and y, you must not choose y from the menu {x, y, z}
- why? because theory assumes that preferences are stable and do not change over time (or simply because the menu expands)

Question 21

What is the Endowment effect?

Answer 21

Increased value of a good when the good becomes part of an individual’s endowment.
i.e. an individual’s valuation of the good is different depending on whether the individual already owns the good or not.
- Difference in price willing to pay to buy vs price willing to accept to sell the good (Willingness To Pay vs Willingness To Accept)
- Endowment effect means that preferences depend on point of preference
- can lead to fewer trades
- WTA > WTP

Question 22

What is the choice overload hypothesis?

Answer 22

As the number of different options increases, an individual may experience conflict & have difficulty choosing