Revision: Homo Economicus

Question 1

Name the three conditions for rationality.

Answer 1

Completeness, continuity, and transitivity.

Question 2

What type of preferences does transitivity rule out? Provide a basic example.

Answer 2

Rules out “cyclical” preferences. Such as: A > B, B > C, and C > A.

Question 3

Suppose person X holds A and has cyclical preferences A > B, B > C, and C > A. Describe how X would spend money to increase their utility and name the fallacy.

Answer 3

X would spend a sum of money to trade A for B, the more to trade B for C, then more to trade C for A ad infinitum until broke. This is called the money pump.

Question 4

Describe continuity in terms of a bundle of different goods containing X and Y.

Answer 4

There exists another bundle of goods, containing one unit fewer of X and some more of Y, that is preferred to the original bundle.

Question 5

Is continuity an accurate assumption about real-life decision-making?

Answer 5

Not really. Consider a basket of goods with “health” and “safety”. It’s unlikely you’d find anyone willing to give up any amount of health for more safety, even though the axiom suggests rational agents would accept some trade-off.

The argument holds even less weight, when considering examples such as “health” and “apples”.

Question 6

Describe how a “lexicographic order” can lead to discontinuous preferences observed in real life that go against continuity.

Answer 6

An example of a lexicographic order is Olympic medals. Overall Olympic ranking is based, first, on how many gold medals each country has won then, in the case of a tie, on the number of silvers, and finally the number of bronzes.

This suggests there is no number of silver medals ever as good as one gold - a direct contradiction to continuity.

Question 7

Describe the axiom of completeness and what answer to a set of choices is supposedly rules out.

Answer 7

For any pair of options, A and B, either A preferred to B, B preferred to A, or the two are regarded as equally good. This rules out the “I don’t know” answer when a rational agent is presented with a choice.

Question 8

Is completeness a reliable axiom in real life?

Answer 8

No, incomplete information is a common problem in daily decision-making and is the crux of the “lemon and plum” thought experiment.

Question 9

Describe the basics of “utility maximisation”.

Answer 9

A rational agent will apply a numerical value to all options in a choice set. This value is known as utility, and a decision-maker that chooses the option with highest utility is known as a utility maximiser.

Question 10

How does utility maximisation tie into the three axioms of rationality; completeness, continuity, and transitivity?

Answer 10

Anyone whose preferences are consistent with completeness, continuity, and transitivity will behave as a utility maximiser.

Question 11

Utility-maximising problems with complete information seldom exist in reality; instead, utility maximisation under uncertainty is more common. What is the decision to make under these conditions?

Answer 11

Choose the option in the given choice set with highest expected utility.

Question 12

Describe how a “risk averse” individual would choose between two options that lead to the same average outcome but with different uncertainty.

Answer 12

A risk averse individual would always choose the less uncertain of the two choices. They would choose a guaranteed £5 payout over a 50:50 bet to gain either £0 or £10 despite the expected payout of each being £5.

Question 13

Imagine a utility maximiser is presented with either a guaranteed £5 or 50:50 bet between £0 and £10. They choose the guaranteed £5. What does this suggest about their preferences and utility profile?

Answer 13

The individual is risk averse and enjoys greater utility from a guaranteed £5 that a bet of equal expected value. A diminishing marginal utility to income .

Question 14

The St. Petersburg paradox poses an indefinite series of coin tosses. You start with a pot of £1; if heads, the pot doubles and you play again; if tails, you walk away with the pot. Describe how the expected value of this gamble contradicts utility maximisation under uncertainty.

Answer 14

The expected utility of this gamble is technically infinite, as summing all the expected payouts of an indefinite series is infinity! However, you would be hard pressed to find an individual to bet their life’s savings on the first toss, despite it technically being worth it.

Question 15

What economic concept acts as a solution to the St. Petersburg paradox - the infinite series betting game?

Answer 15

Decreasing marginal utility of income. Assume each win of the infinite game awards a fixed unit of income despite the pot doubling. As the game progresses, the utility derived from an additional victory is not worth the monetary risk.

Question 16

Describe what concept impacts a utility maximiser’s decision when time is a factor?

Answer 16

Discounting. Utility derived from a choice now may be less if received down the line.

For instance, your utility gained from spending £10 on hot pizza may warrant the expense, but if that same pizza was made to go cold and soggy before you could eat it, £10 may not be worth it.

Question 17

Describe the basic need for discounting in decision-making over time. What tool is often used to reflect discounting?

Answer 17

People generally prefer outcomes now than in the future. A small percentage value known as a “discount rate” is used to reflect decreasing utility over time.

Question 18

What use does discounting hold when comparing two options, one in the present and one in the future?

Answer 18

Discounting allows the future utility to be expressed as a “present value” and be compared to the option of the present.

Question 19

What school of thought argues against “homo economicus” - the utility rational maximiser?

Answer 19

Behavioural economics - a branch of experimental economics that applies psychology and neuroscience to rationality conditions to uncover where said conditions fail and what alternatives would be more realistic.

Question 20

Daniel Kahneman and Amos Tversky are pioneers in the field of behavioural economics. A branch of their study covers “framing and loss aversion”. Broadly describe how these two concepts impact decision-making.

Answer 20

Framing: People’s decisions are influenced by the way alternative choices are perceived, or “framed”. Positive or framing of the same choice can influence people’s choices.

Loss aversion: People place more weight on negative outcomes than positive ones. For instance, most people would reject a bet of losing or gaining £10 with equal probability as, despite the expected outcome being £0 and therefore logically viable.

Question 21

Daniel Kahneman and Amos Tversky posed the “certainty and regret” principles. Describe briefly how these ideas interact and influence behaviour unexpected of utility maximisation.

Answer 21

Certainty offered in one choice may cause regret-fearing decision-makers to play it safe when deciding on A or B, even if the expected value of the uncertain choice is higher.

For instance, given the choice between a guaranteed £30 and 80% chance of £40, most people choose the £30 despite the expected value of the uncertain choice being £32.

Question 22

Describe how “present bias” can influence decisions to be inconsistent with rationality.

Answer 22

One’s utility “now” holds greater weight than equally-valued utility in the future.

For instance, given a choice between an apple in 50 days or two apples in 51 days, most people will choose the latter as the utility is gained is heavily discounted. However, come the 49th day, people will often opt to forgo the second apple in order for early gratification, despite the choice not changing.

Question 23

Other than discounting, the idea of “time inconsistent” choices impact decision-making over time. Describe what time inconsistency means for decision-making and provide an example.

Answer 23

Time inconsistency means a persons choices are not fixed at the point they are made.

Imagine a smoker can quit now, or next week, or the week after, etc. They recognise the long-term benefits of not smoking, but don’t want to put up with seven days of cravings, so decide to quit next week. Next week rolls around, but the problem of cravings are still present.

Time inconsistent choices suggest the person may delay quitting smoking in this scenario.

Question 24

Behavioural economics isn’t a perfect theory compared to normative homo economicus. Describe two broad critiques.

Answer 24

External validity: Do people behave the same in lab conditions as in real life?

Hypothetical choices: How people behave under hypothetical scenarios and, say, when their own money is at risk could differ.