week 1 - Rationality, Irrationality and Rationalization + Transaction Utility

Question 1

what does behavioural economics focus on

Answer 1

• Systematic deviations from the best possible decision.
• How observed behaviour impacts allocation.
• The odds and ends of economic theory.

Question 2

what is the rational choice model

Answer 2

is the baseline microeconomic model and often defines how people should behave

Question 3

why can the rational choice model not work in some circumstances

Answer 3

unlike the rational choice model, there is no unifying theory of behavioural economics, it is an eclectic set of tools

Question 4

what are some uses of behavioural economics

Answer 4

• to reflect on own behaviour.
• Can be used by policymakers, firms, to exploit behavioural
  biases.
• to develop/modify/new theories.

Question 5

how is experimental economics used

Answer 5

In a controlled environment you can change certain parameters and keep everything else constant, internal vs. external validity

Question 6

what type of data is subjective and how is this measured

Answer 6

• The economics of happiness: one measures life satisfaction
  (experienced utility) through survey questions.
• Preferences (such as risk aversion) have been measured with survey instruments as well.

Question 7

what are the three types of economic models

Answer 7

1) rational
2) behavioural
3) procedurally rational (model that takes into account the particular reasoning an individual makes to come to a decision)

Question 8

what are the characteristics of the canonical rational model

Answer 8

• Utility-maximising or profit-maximising model.
• Utility is increasing in x1 and x2.
• Preferences are complete and transitive.
• Utility encodes peoples choices as a real number that corresponds to each possible combination of x1 and x2.

Question 9

what are the assumptions of the rational model

Answer 9

• We typically assume that people have well understood and stable preferences
• Individuals know the results of their choices.
• People will make the best possible choice.
• But we all have made choices we regret

Question 10

who first described the notion of bounded rationality and what is it

Answer 10

• Herbert Simon, individuals simplify their problems by:
• narrowing the set of possible choices,
• narrowing the characteristics they consider,
• simplifying the relationships between choices and outcomes.

Question 11

what condition must hold for individual utility maximisation

Answer 11

p1x1 + p2x2 ≤ y

Question 12

what assumptions does the canonical rational model have that are similar to the utility maximisation for individuals

Answer 12

Firms maximise revenues minus cost

Question 13

what does profict max look like for a firm

Answer 13

Max pf(x)−rx−c

Question 14

what is the revenue function denoted by

Answer 14

pf(x)

Question 15

what is marginal revenue

Answer 15

∂(pf(x))/∂x = p × ∂f(x)/∂x

Question 16

when are profits maximised

Answer 16

MR = MC
p∂f(x*)/∂x = r

Question 17

what is the principle of cost benefit analysis

Answer 17

• A choice should be made if the benefits outweigh the costs.
• If multiple choices are mutually exclusive, the choice with the
  highest net benefit should be taken.
• The central idea of equating marginal cost and marginal benefit (as in supply and demand) can be thought of as an application of CBA.
• So long as adding one more unit of consumption has a higher (marginal) benefit than the (marginal) cost of adding one unit of consumption, one should continue to consume more.

Question 18

what three behavioural anomalies can transaction utility explain

Answer 18

1. Sunk Cost Fallacy (only taking a couple of costs into account)
2. Flat Rate Bias (customers’ preference for flat rates rather than pay-per-use options)
3. Reference Dependent Preferences (variation in willingness-to-pay based on location)

Question 19

what is Thaler’s notion of “transaction utility” is defined as

Answer 19

The utility one receives for feeling they have received greater value in a transaction than what they have given away in paying for the good.

Question 20

what is the impact of fixed costs on consumers and firms

Answer 20

• no effect on firms as fixed costs do not affect output, only profits
• fixed costs can matter also for rational consumers

Question 21

how can linear pricing be seen as

Answer 21

(or charging a fixed amount for each unit) can be thought of as a two part tariff with the fixed part equal to zero

Question 22

what can flat rate pricing be seen as

Answer 22

fixed access fee (consumers can consume as much as they like for a fixed fee) is a two part tariff where the piece rate is zero.

Question 23

what is the two aprt tariff problem for a rational consumer

Answer 23

Max x1 ,x2 U(x1, x2)
s.t. p0x(bar)1 + p1x1 + p2x2 ≤ y

Question 24

when does sunk cost fallacy occur

Answer 24

when an individual tries to recover sunk costs by continuing an activity for which there is a negative return

Question 25

what did Arkes and Blumer find in their sunk cost fallacy experiment (and when)

Answer 25

1985
- Randomly offered 60 people different prices for theatre ticket bundles after they decided to order tickets.
- One group just got the full price.
- Some received a $2 discount (13%).
- Others received a $7 discount (47%).
- During the first five plays of the 10-plays season, those who paid more attended more plays.
- Effect vanishes for the last 5 plays.

Question 26

when modelling the sunk cost fallacy, when testing for rationality what should the individuals choice x1* depend on

Answer 26

their remaining budget constraint

Question 27

what is thaler’s model of transaction utility

Answer 27

U(x1, x2, z(x1, p0)) = u(x1, x2) + z(x1, p0)

s.t. p0xbar1 + p2x2

U, u and z are overall utility, utility from consumption and transaction utility respectively

Question 28

what is the solution to thaler’s model of transaction utility

Answer 28

∂u(x1, x2)/∂x1 + ∂z(x1, p0)/∂x1 = 0

Question 29

what is Kahneman and Tversky’s Model of Prospect Theory

Answer 29

• Utility is measured using gains and losses rather than on an absolute scale.
• Utility is concave in gains, i.e. diminishing marginal utility.
• Utility is convex in the region of losses, hence increasing marginal utility in the region of losses).
• This is typically called loss aversion.

Question 30

what do consumers maximise when deciding between a flat-rate subscription or pay-per-issue

Answer 30

Max x1,x2,δ∈{0,1} U(x1,x2)

s.t. δp0 +(1−δ)p1x1 +p2x2 ≤ y

• δ is an indicator taking one if one chooses a fixed price plan and zero when one chooses linear pricing

Question 31

what predictions can we deduce from the flat rate bias

Answer 31

• If we consume x1 then the total cost under linear pricing = p1x1, and p0 under a fixed tariff plan.
• Hence nobody under the linear plan should be consuming more than x1 = p0/p1.
• Similarly, nobody under the fixed tariff plan should be consuming less than x1 = p0/p1.
• In reality, people often prefer a flat rate price even though usage does not justify it.

Question 32

what is payment decoupling and give an example

Answer 32

• dissociating the payment from the actual consumption
• people might be reluctant to pay for a tram or taxi just to pick up toothpaste they forgot in weekly shop, but wouldn’t mind taking their car for that as fixed access costs (car, insurance) have already been paid

Question 33

what does context dependent preference refer to

Answer 33

• individuals use a reference point when making a decision

Question 34

what are the rational reasons for context dependent preferences

Answer 34

• the context conveys information
• context creates value

Question 35

If Alicia was a pie, what kind would she be?

Answer 35

A cutie pie