College 5

Question 1

What is a descriptive theory about?

Answer 1

How do people make decisions?

Question 2

What is a normative theory about?

Answer 2

How should people make decisions?

Question 3

Economists’ perspective: How much is a certain outcome worth?

Answer 3

• Desirability of outcome.
• Likelihood of obtaining outcome.
• If low on one, it loses worth.

Question 4

Three principles of outcome value

Answer 4

• Principle of diminishing sensitivity.
• Relativity principle.
• Principle of loss aversion.

Question 5

What is the principle of diminishing sensitivity?

Answer 5

• As value increases, the perceived increase of value decreases.
• Also known as ‘diminishing marginal returns’.

Question 6

What is the relativity principle?

Answer 6

Evaluation is relative to a neutral reference point.

Question 7

What is the principle of loss aversion?

Answer 7

• Losses loom larger than gains.
• We attach more value to the things we already own.
• … Because we do not want to lose what we already have, especially after longer ownership and physical possession.
  o The endowment effect.

Question 8

What is the expected value theory?

Answer 8

Economists’ perspective: how should people make decisions under uncertainty?

Question 9

What does the expected value theory argue?

Answer 9

They argue that people are

• Rational
• Self-centered
  o In every decision that we make, we only think about our own interest.
• Stable in their preferences
  o No matter the context, we always go for the same option because that is what we value to a certain extend.

Question 10

St. Petersburg Paradox

Answer 10

Imagine the following gamble

• A fair coin is tossed….
  o If heads appears you win 2 euros and the game continues.
  o If heads appears again, you win 4 euros and the game continues.
  o If heads appears again, you win 8 euros and the game continues.
  o Etc.
  o The first time tails appears, the game ends.
• How much should people be willing to pay as a buy in?
  o Expected value: (1/2 x 2) + (1/4 x 4) + (1/8 x 8) + … = 1 + 1 + 1 + … = an infinite amount of money
  o Yet almost no human being is willing to do that

Question 11

Bernoulli’s solution

Answer 11

“The determination of the value of an item must not be based on the price, but rather on the utility it yields. […] There is no doubt that a gain of one thousand ducats is more significant to the pauper than to a rich man though both gain the same amount.”

• Money has different “utility” (psychological value) based on various things, e.g., how much of it you already have.

When you’re in the desert, the first bottle of water is amazing. The second bottle, not so much.

Question 12

Diminishing marginal returns

Answer 12

The more (money) one has, the less worth it has.

Question 13

What was found in a study on cab drivers on diminishing marginal returns?

Answer 13

It is found that cab drivers, on a rainy day, often stop working in the afternoon because they have earned enough on that day. While logic would say they could better continue working, so that they can have a day off on a sunny day or have a buffer.

Question 14

What does diminishing marginal returns have implications for?

Answer 14

Achievement & motivation

Question 15

What is diminishing marginal returns also known as?

Answer 15

Principle of diminishing sensitivity

Question 16

The infamous indifference map

Answer 16

Two features with the same utility

• E.g., income and leisure
• Should be interchangeable
• Both have diminishing marginal utility

Question 17

Bernoulli’s error in the indifference map

Answer 17

Reference point is missing.

How much income and leisure do you already have?

Question 18

Endowment effect

Answer 18

We attach more value to the thing we already own.

Question 19

What did the article by Nash & Rosenthal (2014) show?

Answer 19

They manipulated the reference point and showed the endowment effect.

Question 20

What did the experiment by Nash & Rosenthal (2014) look like?

Answer 20

Two students can give their top three choices for a residence hall. One student gets her top choice (A), the other doesn’t (B).

The student that got her first choice is asked how much money she would be willing to accept to move to residence hall B The other student is asked how much money she would be willing to pay to get a spot in residence hall A.

They asked the same question after they had lived in their residence hall for two months.

Question 21

What are the results from the experiment by Nash & Rosenthal (2014)?

Answer 21

The student that was awarded her first choice rated the value 5.5 at first, and later at 6.2. The student that was denied her first choice rated the value of residence hall A as 2.5 at first and later as 2.2.

There is a big difference between how much you would be willing to pay or to accept. The student that has something to lose, values their residence hall much more than students that have something to gain.

The student that did not get their first choice, has started to grow towards their residence hall.

Question 22

What are the results from Nash & Rosenthal (2014) contrary to?

Answer 22

The results are contrary to expected value and expected utility because based on expected utility preference for the residence hall should have the exact same value or utility for both students.

Question 23

How is the relativity principle linked to the experiment with the residence halls?

Answer 23

• Evaluation is relative to a neutral reference point.
• Forfeiture vs. acquisition choice
  o Forfeiture: losing something
  o Acquisition: something to gain
• In the case of the student and their residence halls, the neutral reference point is the residence hall that they have vs. what they want.

Question 24

Imagine you can gamble by tossing a coin. With heads you win X euros, with tails you lose 10 euros. How high must X be for you to accept this bet? And if you repeat the bet 100 times?

Answer 24

A loss feels twice as much as a win might feel. A lot of people are asking for a lot of money for this bet.

But if you repeat this bet 100 times with X higher than 10, you are guaranteed to make money, considering it’s a 50% chance every time.

Question 25

The principle of loss aversion

Answer 25

Same principle of diminishing marginal returns applies also to losses.

But losses loom LARGER than gains (negativity bias).

And there is a neutral reference point.

Question 26

What principle or theory does the following belong to? “If you have already lost 10.000 euros, the extra 1.000 euros doesn’t hurt as much to lose.”

Answer 26

The principle of loss aversion

Question 27

When placing bets, when do we prefer the safe option and when the risky option? And how can this be explained by theory?

Bet 1:

• Option A = 100% chance to win 500 euros
• Option B = 50% chance to win 1000 euros

Bet 2:

• Option A = 100 % chance to win 5 euros
• Option B = 0,1% chance to win 5000 euros

Bet 3:

• Option A = 100% chance to lose 500 euros
• Option B = 50% chance to lose 1000 euros

Bet 4:

• Option A = 100% chance to lose 5 euros
• Option B = 0,1% chance to lose 5000 euros

Answer 27

Most people choose the safer option A in Bet 1 but the riskier option B in Bet 2.

This flips when we’re talking about losses. In Bet 3 most people choose the riskier option B and in Bet 4 most people choose the safer option A.

Both wins and both losses have the same expected values. But the utility of 1000 euros is relatively low compared to 500 euros (diminishing marginal returns). Which explains loss aversion.

Question 28

How do people make medical decisions under uncertainty? And how can this be explained?

Outbreak of unknown Asian Disease.
If you do nothing, 600 people are expected to die.

Do you choose treatment A or B?

Treatment A: saves 200 lives.
Treatment B: probability of 1/3 that all 600 lives will be saved and probability of 2/3 that no lives will be saved.

Do you choose treatment C or D?

Treatment C: 400 people die.
Treatment D: probability of 1/3 that no one will die and probability of 2/3 that 600 people will die.

Answer 28

Treatment A: saves 200 lives (72% chose this option).
Treatment B: probability of 1/3 that all 600 lives will be saved and probability of 2/3 that no lives will be saved (28% chose this option).

Treatment C: 400 people die (22% chose this option).
Treatment D: probability of 1/3 that no one will die and probability of 2/3 that 600 people will die (78% chose this option).

But: treatments A and C are exactly the same, as well as treatments B and D. Why the sudden change? –> loss aversion.

Question 29

Political decisions under uncertainty

Answer 29

When in uncertainty people choose the riskier option. They choose expected utility over expected performance.

E.g., Trump was chosen over Clinton even though Clinton was a safer option.

Question 30

What tactic is used in the following: Mattresses with 100 night trial, you already have it, you don’t want to lose it.

Answer 30

The endowment effect

Question 31

What tactic is used in the following: Netflix showing you what you miss out on if you stop your subscription.

Answer 31

Loss aversion

Question 32

People have difficulty interpreting very low and very high chances. What are the implications of this?

Answer 32

Very low chances are overestimated

• For gains people become risk seeking (lotteries).
  o 0.1% to win 5.000 euros
• For losses, people become risk averse (insurances).
  o 0.1% to lose 5.000 euros

Question 33

When do people become risk averse?

Answer 33

When there is fear of disappointment or fear of large loss people accept an unfavorable settlement.

E.g., cashing out with stocks or paying insurance.

Question 34

When do people become risk seeking?

Answer 34

When they have hope to avoid loss or hope of a large gain people reject a favorable settlement.

E.g., taking part in lotteries or gambling.

Question 35

What is the experiment by Wohl et al. (2014) on economic threat?

Answer 35

Newspaper article: Global financial crisis will soon hit students. The current financial crisis would result in additional tuition fees and greater difficulty securing loans. An investment in higher education may not even be enough to secure the few positions available in this unstable economic climate.

Control condition: newspaper article on money production at the Royal Canadian Mint.

Subjects received 10 dollars for participation.

Opportunity to participate in a study on gambling.

Question 36

What were the results of the experiment by Wohl et al. (2014) on economic threat?

Answer 36

Under economic threat, more people chose to gamble!

48% vs. 23% in the control condition.

“No threat vs. economic threat” has an effect on “Amount wagered”
This effect is moderated by “Perceived need to engage in financial risk-taking”

When traditional moneymaking routes are not available, alternate routes (e.g., gambling) need to be considered.

Question 37

What can you say about the following statement: “People try to maximize their outcomes.”

Answer 37

It depends.

When it concerns gains, only to a certain point (e.g., taxi drivers).

We do want to avoid losses.

Question 38

What can you say about the following statement: “People attach less value to new things than to things they already have.”

Answer 38

Yes

Question 39

What can you say about the following statement: “People are more risk averse when their economic prospects look grim.”

Answer 39

No

Question 40

What can you say about the following statement: “People are consistent in their preferences.”

Answer 40

No/ it depends (both are correct).

Your preferences flip around based on:

• Low vs. high probabilities
• Wins vs. losses