Week 5 - Econs vs Humans Flashcards
Descriptive theories
How do people make decisions?
Psychologist’s perspective
* Prospect theory
Normative theories
How should people make decisions
Economist’s perspective
* Expected value theory
* Expected utility theory
Prospect theory
Three principles of outcome value:
1. Principle of diminishing sensitivity
* As value increases, the perceived increase of value decreases
* Also known as diminishing marginal returns
2. Relativity principle
* Evaluation is relative to a neutral reference point
3. Principle of loss aversion
* Losses loom larger than gains
Expected Value Theory
Economist’s perspective
* How should people make decisions
- Desiribality of outcome
- Likelihood of obtaining outcome
St. Petersburg Paradox vs Expected Value Theory
A fair coin is tossed (rule –> with every flip the money you can win doubles):
1. If head appears you win € 2,00 and the game continues
2. If heads appears again, you win € 4,00 and the game continues
3. The first tail appears, the game ends
How much should people be willing to pay as buy in?
* Expected value: (1/2 x € 2) + (1/4 x € 4) + (1/8 x € 8,00) + …. = 1+1+1+1+1+1 = infinite money (after a really long time, the average winnings increases enourmously, but this proces is very slow)
Expected utility
- Objective value
- Subjective value
When you are thirsty, one water bottle is great, but two waterbottles are not twice as great
Bernoulli’s perspective on expected utility
Then determination of the value of an item must not be based on the price, but rather on the utility it yields. A gain of thousand ducats is more significant to the pauper than to a rich man.
Diminishing marginal returns
The more one has, the less worth it has
What implications does diminishing marginal returns have
It influences achievement and motivation. For returns/rewards to be valuable, you have to find the sweet spot between value x effort
Bernoulli’s error
He describes certain utility points to certain values. This would mean that these utilities are the same for every person.
10.000 should have a certain subjective value. So everyone should be similarly happy if they are at the same utility point. But that is not the case, how happy people will be at this utility point is also determined by other factors.
The economist’s infamous indifference map
Two features with the same utility
* Income and leisure
* Both have diminishing marginal utility
* Should be interchangeable
People should be indifferent about
1. Giving up income to gain leasure
2. Giving up leasure to gain income
Are we truly indifferent about leisure or income?
A person gets to choose between either an extra day of vacation each month, or a € 10.000 raise. Both choices have the same expected value. After 12 months they can decide to switch, e.g. switching from raise to vacation days.
2 options:
1. Stick with the raise: no gains, no losses
2. Switch to vacation days: gain 12 extra days, lose 10.000 in salary
People will not switch (endowment effect)
Weaknesses of the indifference map
- It does not feel right to switch (Kahneman study)
- Reference point is missing
* How much income and leisure do you already have
Endowment effect: we attach more value to the things we already own (people won’t switch in the Kahneman study)
Which theory is the following quote of Aristotle related to “most things are differently valued by those who have them and by those who wish to get them: what belongs to us…always sees very precious to us”
The endowment effect
Rosenthal - Endowment effect experiment
- Condition 1: 1st choice residence hall A, awarded residence hall A, WTA (Willing to accept to move to your second option) for residence hall A
- Condition 2: 1st choice residence hall A, awarded residence hall B, WTP for residence hall A (how much would you be willing to pay to move for your 1st option after all)
