CHAPTER 31: Behavioral Economics
TRUE/FALSE
1. Psychologists and behavioral economists argue that preferences are “discovered,” as opposed to a
preexisting guide to choice.
2. According to behavioral economists, rational consumers are able to make decisions when faced with
many choices because preferences are complete.
3. In a study by financial economists Brad Barber and Terrance Odeank of stock portfolio management
techniques and returns, men trade more frequently on average than women, and as a result of more
active management, men’s portfolios grow at a higher rate of return than women’s.
4. If a tennis player were truly randomizing over which half of the court to serve to, she would never
serve to the same side of the court 5 times in a row.
5. Under hyperbolic discounting, a person discounts the long term future more heavily than the near term
future.
6. The following statement is a defense of conventional models of consumer behavior against the
objections of behavioral economists: Even if many participants in a market do not behave rationally,
those who consistently maximize utility will have the greatest effect on market prices and outcomes.
7. If a coin is tossed, and the results are 6 consecutive tails (TTTTTT), this is conclusive evidence that
the coin is not a fair coin.
8. In practice, people tend to accept too many large risks (such as forgoing life insurance) and avoid too
many small risks (such as losing or breaking a cell phone).
9. People find it easier to commit to saving for retirement from next year’s salary as opposed to current
salary. This behavior is consistent with hyperbolic discounting of income.
10. Deb plans and prepares her meals 1 month in advance. Scott eats out for lunch every day. According to
observations from behavioral economics, Scott will eat more varied meals than Deb.
MULTIPLE CHOICE
1. Professor Bob has an incredibly messy office, and really wants to change but just can’t. Professor Bob
just read his first book about behavioral economics. To help him keep his office more neat, Professor
Bob could hire
a.
an expensive office consultant to set up an organizational scheme. Because the
consultant’s visit was so expensive, Professor Bob will not want to lose his investment.
b.
a very expensive custodial service that will clean and bill Professor Bob only when his
office needs cleaning.
c.
somebody to clean his office once a week for the entire year whether it needs it or not.
d.
a sarcastic graduate student to make fun of him when his office becomes messy.
e.
All of the above would be equally effective in changing Professor Bob’s behavior.
2. Which of the following is NOT an example of the anchoring effect (i.e., choices are affected by
spurious information)?
a.
The French and British governments completed construction of the Concorde because they
had so much money tied up in research and development that would have been wasted if
the project were cancelled.
b.
People are reluctant to sell stock they have received as a gift even if they would not have
chosen to purchase the stock.
c.
Investors purchase shares of a stock on plausible rumors of increased future earnings.
d.
Investors liquidate common stock and hold cash because they fear that the stock market
will fall because the American League won the World Series.
e.
a. and c. are correct.
3. Which of the following are examples of the framing effect?
a.
Campus “Public Interest Research Groups” receive more operating funds from student
registration fees when the default choice is to contribute but a box must be checked to opt
out versus a default of not contributing but checking a box to contribute.
b.
Shoppers often purchase extended service and warranty plans even though expected losses
are much smaller than the cost of the plans.
c.
In a repeated classroom experiment, half the class was randomly picked to receive an iPod
Shuffle of music from the 1970s. The average value placed on the Shuffle is consistently
higher for students who received the Shuffle than for those who didn’t.
d.
A busy executive who wants to exercise more joins a bicycling club where fellow
members will exert pressure upon him if he doesn’t go biking.
e.
All of the above.
4. An article in the October 15, 2005, edition of the Wall Street Journal described the popularity with
New York lawyers and stock brokers of a new gym that hires ex-Marines as fitness trainers. The gym
is run with a boot camp motif. Which of the following behavioral economic concepts would help
explain the existence of this gym?
a.
Time inconsistency between desires when purchasing gym membership and desires when
it is time to work out
b.
The effect of spurious information on decision making
c.
Increasing the cost of deviating from self control
d.
Positive framing
e.
a. and c.
5. A house was for sale for 9 months with no offers at $350,000. It was taken off the market, and relisted
1 month later at $399,500 and sold in 2 weeks. Which of the following behavioral economic concepts
could explain this scenario?
a.
Hyperbolic discounting of housing values
b.
Time inconsistency of preferences
c.
Spurious information
d.
Framing effects
e.
Fairness norms
6. People who have recently become unemployed often believe the national unemployment rate is higher
than it actually is. Behavioral economists would attribute this to
a.
the anchoring effect.
b.
the law of small numbers.
c.
time inconsistency of preferences.
d.
fairness norms.
e.
hyperbolic discounting.
7. A couple planning to get married wants to do all that they can to make their marriage last. To help,
they should consider having
a.
a very lavish and expensive wedding.
b.
a prenuptial agreement specifying how assets will be divided among them in case of
divorce.
c.
an agreement in which all jointly held assets are donated to charity in case of divorce.
d.
an inexpensive wedding in Las Vegas.
e.
an Elvis impersonator marry them in Las Vegas.
8. Nash equilibria can be used to make predictions about human behavior in noncooperative games.
Behavioral game theory studies actual human interaction, and has found inconsistencies between
observed human behavior and Nash-predicted behavior. Which of the following is NOT an
inconsistency pointed out by behavioral economists?
a.
In ultimatum games, proposers should always offer to give responders the minimum
possible split, regardless of whether it is perceived as “unfair” or not.
b.
In ultimatum games, offers perceived as “unfair” are frequently rejected.
c.
In ultimatum games, responders are less likely to turn down “unfair” offers if the dollar
amount is large.
d.
Third party observers of ultimatum games will frequently punish what they perceive as
“unfair” divisions, even at a cost to themselves.
e.
In ultimatum games, men tend to receive more favorable divisions, particularly when
divisions are proposed by women.
9. In the movie The Hunt for Red October, Captain Ramius (Sean Connery) leaves a letter for the Soviet
Navy announcing that he intends to defect to the United States. As a result, the Soviet Navy launches a
massive effort to find and sink Ramius’s ship, the Red October. In announcing that he was intending to
defect, Capt. Ramius’s actions could be explained as
a.
an act of irrationality.
b.
a step to remove the option of return to the Soviet Union, thereby increasing the likelihood
of a successful defection to the West.
c.
a spurious piece of information that might affect behavior.
d.
part of the process of discovering his preferences.
e.
an attempt at randomizing behavior to make his adversaries less certain of his true
intentions.
10. Using lessons learned from behavioral economists, which of the following would be most likely to
increase retirement savings?
a.
Specifying that all retirement contributions are to be made by personal check only
b.
Allowing customers to make contributions of any amount whenever they desire
c.
Enabling automatic deductions from paychecks, but allow customers to make as many
changes to the amount as they like without cost or obligation
d.
Allowing customers to commit to an increasing portion of their paycheck being
automatically deposited in retirement savings in future years
e.
Charging service fees for contributions under $100
11. With several additional mutations, the bird flu, whose victims to date are mostly poultry, could
become a global epidemic. Suppose there are 2 possible courses of action public health officials could
take. For treatment A, the lives of 1 million people out of the 10 million affected would be saved. For
treatment B, 90% of those infected would not be helped and would die. If infected persons were given
a choice between treatments A and B, which of the following scenarios would most likely occur?
a.
Treatment A is more effective than treatment B. More people will choose treatment A.
b.
Treatment A is less effective than treatment B. More people will choose treatment A.
c.
Treatment A is more effective than treatment B. More people will choose treatment B.
d.
Treatment A and treatment B are equally effective. More people will choose treatment A.
e.
Treatment A and treatment B are equally effective. Equal numbers of people will choose
each treatment.
12. A stingy health maintenance organization (HMO) gives its customers diagnosed with cancer a choice
between surgery and radiation therapy, but not both. The brochure they send to their customers
describes surgery as 80% successful, but says that 2 out of 10 patients who choose radiation will die. If
customers were given a choice between surgery and radiation therapy, which of the following
scenarios would most likely occur?
a.
Surgery is more effective than radiation. More customers will choose surgery.
b.
Surgery is less effective than radiation. More customers will choose surgery.
c.
Surgery is less effective than radiation. More customers will choose radiation.
d.
Surgery and radiation are equally effective. More customers will choose surgery.
e.
Surgery and radiation are equally effective. Equal numbers will choose each treatment.
13. In an experiment on risk aversion and inconsistency, a group of people were given the following
choice: A) Lose $100 with certainty, or B) 50% chance to win $50, 50% chance to lose $200. Which
of the following scenarios is most accurate and would most likely occur?
a.
A majority chose option A. Option A has a lower expected loss.
b.
A majority chose option B. Option A has a lower expected loss.
c.
A majority chose option A. Option B has a lower expected loss.
d.
A majority chose option B. Option B has a lower expected loss.
e.
Roughly equal numbers chose A and B, because they have equal expected losses.
14. In an experiment on risk aversion and inconsistency, a group of people were given the option to accept
or reject the following gamble: 50% chance to win $150, 50% chance to lose $100. Which of the
following scenarios is most accurate and would most likely occur?
a.
A majority accepted the gamble. People who chose the gamble can expect to gain from it.
b.
A majority rejected the gamble. People who chose the gamble can expect to gain from it.
c.
A majority accepted the gamble. People who chose the gamble can expect to lose from it.
d.
A majority rejected the gamble. People who chose the gamble can expect to lose from it.
e.
People were evenly split between accepting and rejecting the gamble. Expected winnings
from the gamble are zero.
15. In an experiment on risk aversion, a group of people were given the following choice: A) Lose $100
with certainty, or B) 50% chance to win $50, 50% chance to lose $200. An overwhelming majority
chose option B. This can be best explained by which of the following?
a.
People have a greater aversion to loss than to risk.
b.
Option B has a smaller expected loss than option A.
c.
This behavior is consistent with risk aversion with losses.
d.
Option B has an expected gain as opposed to certain loss with option A.
e.
This behavior violates the Weak Axiom of Revealed Preference.
16. In the 1960s dark comedy classic Dr. Strangelove, the Soviet Union constructs a Doomsday Machine
that will destroy all life on earth automatically if the Soviet Union is attacked. The Doomsday Machine
can never be turned off or disabled. Which of the following would best explain why the Soviets would
build the Doomsday Machine?
a.
This is a completely irrational action.
b.
This is an example of the use of spurious information to influence outcomes.
c.
This is an example of the negative framing effect.
d.
By removing the choice of whether or not to retaliate, the Soviets increase the chance that
the United States will not attack.
e.
The Soviets would gain utility from destroying all life on earth.
17. In a study of individually held stock portfolios over time, gains were much more likely to be realized
than losses. Fifteen percent of all gains were realized in the time period, while only 10% of losses
were. Subsequently, the rising stocks that were sold outperformed the losing stocks that were held.
Behavioral economists would explain this as
a.
aversion to losses.
b.
overconfidence as exhibited in excessive trading.
c.
the framing effect (losses vs. gains).
d.
a departure from sound financial practices.
e.
All of the above.
18. A substantial majority of Americans have inadequate retirement savings. Behavioral economists
attribute this to
a.
time inconsistency of preferences.
b.
lack of self-control.
c.
preferences between current and future consumption that are still being discovered.
d.
framing effects.
e.
a. and b. are both correct.
19. Consider 2 identical twins, Scott and Rich. Scott is a professional wrestler who will earn lots of
income when he is young and will retire by age 40. Rich is a manager who expects to earn high
income in his 50s and 60s. The life cycle theory of savings would predict that Scott should save while
he is young to smooth consumption over his lifetime, and Rich should borrow against his future
earnings when he is young. If Scott and Rich are typical savers, which of the following scenarios is
most likely to be observed?
a.
Scott will save a substantial portion of his wrestling income but Rich will not borrow
against future earnings to boost consumption when he is young.
b.
Scott will save a substantial portion of his wrestling income and Rich will borrow against
future earnings to boost consumption when he is young.
c.
Scott will spend his wrestling income when he is young and Rich will not borrow against
future earnings to boost consumption when he is young.
d.
Scott will spend his wrestling income when he is young and Rich will borrow against
future earnings to boost consumption when he is young.
e.
There are no typical patterns of saving.
20. 401(K) plans, which automatically deduct a portion of earnings from each paycheck and deposit it in a
retirement account with penalties for early withdrawal, are a popular form of saving for retirement.
Which of the following would not be a benefit of such plans, according to behavioral economists?
401(K) plans
a.
help with self-control problems by making deductions automatically.
b.
help with self-control problems by making it more difficult to use savings for
non-retirement purposes.
c.
are an example of excess risk aversion and over insurance.
d.
help overcome time inconsistency of preferences.
e.
bring savings more in line with the life cycle theory of savings and consumption.
21. If Fred were to consume $1,050 1 year from now, he would consider this as good as spending $1,000
today. He would consider $1,628.89 of consumption 10 years into the future equivalent to $1,000 of
consumption today. If the interest rate is 5%, Fred preferences
a.
are consistent with exponential discounting.
b.
are consistent with hyperbolic discounting.
c.
are consistent with geometric discounting.
d.
are inconsistent.
e.
violate the Weak Axiom of Revealed Preference.
PROBLEM
1. Suppose you and a complete stranger must split $100 in even dollar increments. You propose a split,
and the stranger with whom you are splitting the $100 either accepts or rejects. If she rejects, you both
receive nothing.
a. What is the Nash equilibrium for this game?
b. The Nash equilibrium solution is not frequently observed in practice. Explain why.
2. A new DVD of lectures on the topic of macro economics and personal hygiene is being marketed on
the Internet as a remedy for insomnia. As an experiment, the marketing firm wants to direct half of
Web hits to a page that advertises the DVD as 90% successful in inducing sleep while the other half
are directed to a page that advertises the DVD as failing to induce sleep 10% of the time. Would you
expect equal numbers of sales from the 2 advertising approaches? Explain.
3. John is doing very well in Intermediate Micro economics, but hires a graduate student to spend 1 hour
a week with him to do workbook problems together. John always gets every problem correct without
help from the graduate student, but he insists on continuing the relationship. Is there a behavioral
economic explanation of why this is rational? Explain.
4. According to a recent New York Times article, “Bank of America debit card customers can agree in
advance to round up their purchases to the next dollar, putting the extra cents into a savings account.”
Why might customers want to commit to this mechanism rather than make deposits to their savings
accounts on their own?
