Mid Semester Flashcards
What are the key assumptions of microeconomics?
1) people are rational
2) people are self interested
3) utility is calculated as the weighted benefits
4) linearity in probabilities
5) people use and interpret information perfectly
6) exponential discounting
7) Only final outcomes matter
What is neoclassical utility
Eu = p u(x) + p u (y) + …. + p u(n)
as long as positive all decision makers (including risk averse) would take the rise
What does linear in probabilities mean?
the weight attached to an outcome is proportional to the probability of it occurring. This means that an outcome with twice the probability is weighted twice a much, regardless of how likely it was n the fist place
What is reference dependent preferences?
Economic agents evaluate their level of utility against a reference point and are loss averse to their reference point.
What is loss aversion?
The disutility stemming from falling behind your reference point is larger than the utility generated by an equal sized gain (asymmetric)
What is diminishing sensitivity?
Agents are less sensitive to changes the further away they are from their reference point
What is over weighting of small probabilities
People tend to put more weight on remote but meaningful outcomes that neoclassical would suggest. For example, people would prefer to lose a small amount of money for sure than face the small possibility of losing a large amount of money (loss aversion)
What is the certainty effect?
People are sensitive to changes from a sure thing to a probability smaller than 1 but are not overly sensitive to changes between intermediate probabilities.
What is the probability weighting function
Kahneman and Tversky challenge the neoclassical linear probabilities by making a new function with incorporates both over weighting of small probabilities and the certainty effect (kind of s shaped)
Increasing function that is steepest near 0 and 1.
What is prospect theory?
an outcome c is evaluated relative to a reference point, r, according to a value function (v (c - r)), The function incorporates loss aversion (a symmetric, kink at 0) and diminishing sensitivity (logish function ehich flattens off)
Why isn’t risk aversion a valid explanation for why economic agents (even rich) don’t take a fair gamble?
Would have to be too risk averse to make everyday investment decisions. Even $500 is small when considering life-time savings and diminishing marginal utility is flat at this time.
What do we find about consumption smoohting
Neo: people smooth consumption over their lives so that permenant changes to future income is met weith changes in today’s consumption
Evidence: people tend not to do this - people’s consumption drops sharply towards end of pay period or following retirement. Even with announced wage agreements consumption tends not to decrease in anticipation
Behavioural: reference is current income. Consuming more in response to future increase makes them happy but cutting down on consumption is hard so they delay reducing it
What are 3 theories about determining reference points?
1) lagged consumption or endowment
2) aspirations and goals
3) social comparisons
The first two can be unifies in terms of recent expectations (subjects expect to keep what they receive so being endowed with a mug sets their reference points and expect to earn what they did in the previous year or fulfilling reasonable goals for these
What is the endowment effect?
fact that owners value a good more than otherwise identical non-owners. The fact that you own it makes it more valuable to you (manifestation of loss aversion)
What is intertemporal choice
Choice over time?
What is hyperbolic discounting?
People are short run impatience but long run patience, leading to self-control problems and inconsistency
How are choices over time made in neoclassical economics?
Interest rate is the relative price of consumption today versus tomorrow (Fisher Curve).
Samuleson proposed the discounted utility whereby people maximise utility across a lifetime but future periods are discounted on an exponential basis.
What does gamma represent
long run discount factor (only factor in neoclasssical). Represents the willingness to delay to delay gratification The smaller gamma is, the less people value future consumption relative to current consumption.
What is the key implication of exponential discounting
People are dynamically consistent (that is, when an agent makes a choice about the future, that choice is still the preferred option when the future arrives)
What are some problems with exponential discounting
1) in 10 periods, value at x^10 which is generally ridiculous
2) data shows that people are dynamically inconsistent
3) psychological workings distilled into just one parameter
What is the payday effect?
People spend a large proportion of their income immediately after getting paid and cut down consumption dramatically towards the end of the pay period rather than smoothing their consumption
Some people even take out expensive loans to finance current consumption
What is beta
Beta is the short run discount factor that captures the fact that people are impatient in the short run and have a preference for immediate gratification
What is commitment?
Tool to assist people is sticking with their initial plan rather than giving in to short-run impatience. Enables one to behave in a dynamic consistent way so we future decisions according to our current preferences.
What is a naive hyperbolic discounter?
Unaware of their lack of self control and believes that they will carry through with whatever plan they form
What is a sophisticated hyperbolic discounter?
Aware of their changing preferences in the future and perfectly anticipated their future behaviour and so plans while taking this into account. Aware of usefulness of commitment devices
How do sophisticated approach unpleasant tasks
realises that if she delays now, she will delay again later and only complete the task when it is very costly. Hence, her real choices are to undertake the task now of much later, which raises the current cost od delay. Hence, she performs the task earlier than a naive
How do sophisticated approach pleasant tasks?
Know that they do not have the patience to wait for long enough to get the highest reward and will end up giving up earlier
Why do both naive and sophisticated hit in each period
Naive thinks that they will hit today but never again as they in future periods, the cost of hitting outweighs the benefits. However, upon reaching the decision, the costs are heavily discounted so they make the same decision.
Sophisticated: recognises that they will continue to hit but because they make the decision when most impatient and because optimal behaviour today does not depend on what the person did in another period.
When doe people hit?
When b > Bc
But earlier selves only prefer when b > c
Properties on an optimal tax?
- Revenue neutral
- Optimal tax rate = (1 - B) harm
- Provides self control for those who are too impatient to provide it for themselves
What are the main problems with an optima tax
Exponential discounters are dynamically consistent and always consume the preferred amount - they are harmed by the tax despite acting optimally (provided no externalities)
Tax rate is often very high
Why isn’t there a market for commitment devices?
Market often has an incentive to break consumers’ self control and take advantage of short run impatience (bing gives solutions but also the problem)
Self control can be easier with price changes but with competition, there is an incentive to undercut.
What is libertarian paternalism?
Policy that helps those with sub-optimal behaviour without significantly hurting those who are behaving optimally
What is the SMarT Plan?
Contributions begin after delay (combat short run impatience) and after pay rise (combat loss aversion). The plan was voluntary and it was easy to switch out
What are the three main components of intertemporal choice?
1) what gives a person utility at a particular moment
2) how they intergrate or trade off those utility concurring at different times
3) what they predict about future utility
Define anticipatory utlity
utility derived now from anticipating the future. Implications for timing of events with an optimal delay for positive events (time to savour) and incentive to get unpleasant event over with (or delay indefinitely)
What are some examples of priming
Strength of anticipatory feelings is partly dependent on situational factors. For example, people filling out forms when having to wait for lollies displayed more impatience for other things
What effect does anticipatory utility have on information gathering?
Possessing information affects people’s utility so people tend to avoid information that would make them upset (e.g. people are less likely to find out the results of health tests if they think it may be negative)
What is the anticipatory utility formula
If not finding out
first period au + probability good + p bad
If does than p = probability that news is good p f(1) + (1-p)f(0) < f(p)
Being overoptimistic increases utility, which is what data shows
Define ego utility
utility derived from beliefs about one’s own traits and abilities without regard to a specific event.
Tend to be biased about traits that are important to us
What affects ego utility bias
- objective feedback (ambiguous can make worse)
- expertise increases bias
- feeling control makes worse
Why does betting on horses increase towards the end of the day?
People are loss averse
Most people fall behind their reference point during the day and are more willing to take risks to have a shot at regaining ground against their reference point (also diminishing sensitivity)
Why don’t people stick with bets on their own weight loss
Dynamic Inconsistency
People tend to think they will stick to their plans and goals of being healthy but can’t resist the immediate gratification of unhealthy choices.
What does the mug experiment show?
Endownment effect
The price non-owners are willing to pay for the mug tends to be much lower than the amount sellers are willing to accept as having the mug means it will feel like a loss.
When trading is available, way less people utilise this than neoclassical theory would suggest
Why is preferring $500 for sure than $1000 with 50% probability (or preferring to lose $1000 with 50% probability over $500 for sure) an example of diminishing sensitivity
More sensitive t gaining the first $500 than to the potential of gaining the second and averse to losing the first.
More sensitive to losing the first $500 than the additional $500 and are willing to risk the 2nd to avoid the loss
Why doe workers work less hours in response to temporarily high wages?
Reference dependence
Have a daily income target that is met quicker when wage rates are higher and so can leave early as staying longer is not worth as much
What are 3 characteristics of pricing patterns?
1) sticky: often unchanged for months
2) Focal: competitors often charge identical prices for competing but not identical products
3) Uniform retailers selling multiple products (like theaters) sell for the same price
Lesson: loss aversion can create price equilisation across both time and products (increasing means consumers feel a loss and may switch while lowering won’t add as much demand)
In the reference dependence equation v (c - r), what does v capture?
Captures loss aversion (2 if negative but 1 if positive) but does not capture diminishing snesitivity
What is the lagged consumption theory for reference point determination?
Reference is interpreted as the status quo (have no not have the product). A generalisation is that lagged consumption or endowment is the reference point.
reference = (1 - y)r + y c - 1
Incorporates adaptations with changes having large effect initially but fading in influence as the point adjusts
What is the goals theory for reference determination?
People can fall short of aspirations, which effects happiness. They can fall behind ideal self (dejection) or out-self (agitation)
What is the Social Comparisons theory of reference point determination?
People compare their outcomes to others around them. This explains the Easterlin Paradox wherein controlling for factors such as income and hours, happiness increases with income withing but not between countries (and not over time)
What is the Recent Expectations theory of reference point determination?
Combines the lagged consumption / endowment and goals theories. The reference for outcome sis recent expectations about these outcomes, including your reasonable goals. Factors include:
- status quo expectation of recent prices
- market prices
- reasonable goals
- attachment effect (only have endowment effect f you expect to keep it)
What is the default effect?
Tendency for people to stick with the option they have been automatically assigned to. Explained by naive hyperbolic discounting as it predicts procrastination
