Semester 1 Exam Flashcards
Behavioural Economics
The joint influences of psychological and economic factors on individual behaviour
Bias
A systematic deviation from rational decision-making
Heuristic
The ‘fast’, automatic decision rule people use that results in the bias (i.e. rules of thumb’)
Utility
Captures pleasure with an outcome
Utility function
Summarises preferences of a consumer in terms of how much utility she gets from consuming an available/bundle of goods
Completeness
Ability to compare any 2 bundles
Transitivity
If A > B, B > C, then A >C
Consistency of Choices
If the individual can afford a certain bundle in 2 different budget sets, and they choose it in one, they shouldn’t prefer a less preferred bundle in another situation
Independence of Irrelevant Alternatives (IIA)
A choice between 2 options shouldn’t be affected by the presence of a third, unrelated option
Continuity
Preferences are smooth
Condorcet’s Paradox
Despite individuals having rational preferences, collective decisions can lead to a cyclical majority, where no single alternative emerges as the dominant choice
Money Pump Argument
A pattern of intransitive preferences causing a decision-maker to be willing to pay repeated amounts of money to have these preferences satisfied wicausesthout gaining any benefit
System 1 (Intuitive System)
Fast, automatic, effortless and error prone (e.g. crossing a road)
System 2 (Conscious Reasoning)
Slow, sophisticated, improved by learning and reliable (e.g. taking derivatives)
Priming Effect
When a person’s response to a later stimulus (e.g. word/image) is influenced by their exposure to a previous stimulus
Availability heuristic
The ease with which an idea comes to mind (when an unlikely event comes to mind, we tend to overestimate its occurrence - like winning the lottery)
Representativeness
Estimating the likelihood of an event by comparing it to an existing prototype (e.g. someone wearing a suit and tie - lawyer?)
Anchoring and adjustment
Start from a readily available number (the “anchor”) and shift up and down from that point
Context dependent preferences
An individual’s choices and preferences can vary depending on the specific circumstances/context in which a decision is made
Mental accounting
How people categorise and treat money differently based on subjective criteria (e.g. the source of the money or its intended use), even though all money is technically interchangeable
Marginal Rate of Substitution (MRS)
The rate at which a consumer is willing to give up one good in exchange for an additional unit of another good
Transaction utility
Happiness individuals gain from the process of making a purchase (separate to the utility they get from consuming the good itself)
Reference Dependent Preferences
Individual evaluates outcomes relative to a reference point, and then classify gains and losses
Status quo bias
Effect that people are biased in favour of choosing the status quo in decision problems
Reference point
Probabilistic beliefs held in recent past about outcomes
Endowment Effect
Endowing someone with a good changes their valuation of the good (makes it worth more)
Personal Equilibrium
When the option they expect to buy is what they choose
The consumer has rational expectations about their reference point (the reference point plays a crucial role as it reflects their expectations of what they will buy)
Loss aversion
Losses loom larger than gains
Reference dependence
The carriers of value are gains and losses defined relative to a reference point
Diminishing sensitivity
The marginal value of both gains and losses decreases with their size
Preference reversals
Violations of the axioms of preferences (completeness and transitivity)
People’s preferences between options change depending on how those preferences are elicited
Joint Evaluation
Options are presented simultaneously
Separate Evaluation
Options are evaluated in isolation
Reference structure
A collection of preference relations indexed by a reference state, >r
Bait and Switch
- A good is advertised at a too-low price
- A similar (better quality but more expensive) good is offered instead
- Baited good sets the reference point and make the consumer less sensitive to price differences for the higher priced good
Coase Theorem
If someone owns X and is indifferent between keeping it or trading it for Y, then if someone owns Y, he should be indifferent between keeping or trading it for X
Wealth effects
If I become really wealthy and leisure is a normal good, then I demand more of it
Substitution Effect
Stronger and I work more on those days where wage is high
“within-subject” designed experiment
Same subject is treated with 2 different conditions and then his/her behaviour is compared again (e.g. IIA)
“between-subject” designed experiment
Each individual is exposed to only treatment
Different subjects are treated with 2 different conditions and then their behaviour is compared
Compromise Effect
The tendency to choose non-extreme options
Decoy Effect
When consumers are faced with many alternatives, they often experience choice overload
Consider-then-choose decision process
Consumers often choose products by first forming a consideration set and then choosing from among considered products
Consideration set
A subset of options a consumer evaluates when making a decision
Menu dependent utility
A person’s utility from choosing an option not only depends on the characteristics of the selected item itself but also on the set of alternatives (“the menu”) available at the time of the decision
Salience theory
An attribute is salient when it arises among others relative to the average level of it in the choice set
Weber-Fechner Law
Quantifying the perception of change in a given stimulus
Reason based choice
Focuses on the reasons people use when making choices, rather than assuming choices are made by maximising overall utility
Disjunction effect
A tendency for people to want to wait to make decisions until information is revealed, even if the information is not really important for decision, and even if they would make the same decision regardless of the information
Shapes of utility function
Risk averse - concave
Risk neutral - linear
Risk loving - convex
Lottery
Gives you a probability of winning a number of prizes
Expected Utility
The utility from an outcome is weighted by the probability of the outcome
Archimedean Axiom
No lottery is infinitely good or bad
Independence Axiom
Preferences between 2 options should remain consistent when both of the options are mixed with a third option in the same proportion
Narrow framing
Such observed risk aversion to small scale gambles implies unrealistic risk aversion over large stakes
St Petersburg Paradox
A rational person should pay an infinite amount of money to play this game
In reality, people are only willing to pay a modest fee (around £10)
Probability weightings
0-5% - possibility effect
47.5-52.5% - meh effect
95-100% - certainty effect
Prospect THeory
Shows how people decide between alternatives that involve risk and uncertainty
Demonstrates that people think in terms of EU relative to a reference point rather than absolute outcomes
Allais Paradox
A paradox of decision-making that usually elicits responses inconsistent with EU theory
It is an example of the certainty effect
Certainty effect
Choices in which decision makers display an irrational preference for outcomes with certainty
Regret Theory
Someone’s preference for a gamble depends upon the other possible options that may be chosen
Social Preferences
A person doesn’t only care about the material resources allocated to her but also about the material resources allocated to relevant references agents
Nash equilibrium
No player can obtain a higher payoff by choosing a different strategy
Ultimatum game
A sequential game where 2 parties interact anonymously and only once, so reciprocation is not an issue
Inequality Aversion
People don’t like inequality
Dictator game
Like the ultimatum game but player 2 has no choice so that the proposed allocation is always implemented
Inequity Aversion
Inequity emerges in competitive environments
