Deviations from Rational Choice under Certainty Flashcards
Decision making under uncertainty
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.
Strategic Interaction
Outcome depends not only on own choice but also on other’s choice e.g. two firms competing on the market.
Preference
a relation, describing an individual’s attitudes or values over a set of alternatives.
>
is better than (strict preference relation)
> /
is at least as good as (weak preference relation)
~
is as good as (indifference)
Transitivity
Consider a set U
xRy and yRz => xRz (x, y, z) is a subset of U. Let R denote the relation “is taller than”.
Completeness
xRy or yRx, (x, y) is a subset of U. Let R denote the relation “is at least as tall as”.
Preferences of the consumer
U(x, y)
Consumer budget constraint
pxX + pyY = m
What is a rational consumer choice composed of?
Has rational preferences (transitive + complete) + utility maximization: choose most preferred item on the menu (in case of ties, one of the most preferred items)
The rational choice model also assumes:
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.
Opportunity cost of an alternative
what you have to forego if you choose this alternative
Intertemporal Labour Supply
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.
Sunk costs
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.
Menu Dependence
People’s preferences are influenced by a menu.
When does the Decoy effect occur?
when the introduction of a subpar option causes individuals to change their preferences
What is description and procedure invariance?
different representation of the same choice problem should yield the same preference
What is Insatiation?
more is always better
What is the expansion condition?
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)
What is the Endowment effect?
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
What is the choice overload hypothesis?
As the number of different options increases, an individual may experience conflict & have difficulty choosing
