Chapter 08 – Behavioral Economics
8-1
Chapter 08 – Behavioral Economics
McConnell Brue Flynn 21e
DISCUSSION QUESTIONS
1. Suppose that Joe enjoys and repeatedly does stupid things like getting heavily into debt and
insulting police officers. Do these actions constitute systematic errors? If he gets what he wants
each time, are his stupid actions even considered to be errors by economists? Explain. LO1
2. Why do behavioral economists consider it helpful to base a theory of economic behavior on the
actual mental processes that people use to make decisions? Why do neoclassical economists not
care about whether a theory incorporates those actual mental processes? LO1
3. Economist Gerd Gigerenzer characterizes heuristics as “fast and frugal” ways of reaching
decisions. Are there any costs to heuristics being “fast and frugal”? Explain and give an example
Chapter 08 – Behavioral Economics
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Answer: While heuristics are fast and frugal, they are not perfect. In particular, they
achieve high speed and low energy use at the cost of precision and accuracy. The brain
could employ other methods for reaching decisions that would on average reach better
results-but those methods would run more slowly and use more energy.
As an example of how a fast and frugal method for doing something comes at some cost
in terms of other attributes forgone, consider a bartender checking ID’s. A short glance
at a driver’s license and the person offering it will allow him to quickly and easily detect
obvious fakers. But if he wants to raise his accuracy rate and be able to detect and reject
more sophisticated fakers, he will have to carefully examine the ID and ask the person
offering it several questions to see if they seem legit. Doing so will take up both more
and more energy. It is slower and more costly than just giving ID’s a quick glance.
4. “There’s no such thing as bad publicity.” Evaluate this statement in terms of the recognition
heuristic. LO2
5. For each of the following cognitive biases, come up with at least one example from your own
life. LO2
a. Confirmation bias.
b. Self-serving bias.
c. The overconfidence effect.
d. Hindsight bias.
e. The availability heuristic.
f. The planning fallacy.
g. Framing effects.
6. Suppose that Ike is loss averse. In the morning, Ike’s stockbroker calls to tell him that he has
gained $1,000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes
an extra $1,000 in taxes. At the end of the day, does Ike feel emotionally neutral since the dollar
value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay?
Explain. LO3
Chapter 08 – Behavioral Economics
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consent of McGraw-Hill Education.
Answer: If Ike is loss averse he will feel losses more intensely than gains. This implies
that the increase in taxes of $1,000 will cause a greater level of disutility than the gain in
utility Ike derives from the $1,000 increase in his stock portfolio. In effect, because Ike is
loss averse, he worse off in terms of utility. If we use the intensity figure from the
textbook, the $1,000 loss is felt 2.5 more intensely than the $1,000 gain.
7. You just accepted a campus job helping to raise money for your school’s athletic program.
You are told to draft a fund-raising letter. The bottom of the letter asks recipients to write down a
donation amount. If you want to raise as much money as possible, would it be better if the text of
that section mentioned that your school is ranked third in the nation in sports or that you are better
than 99 percent of other schools at sports? Explain. LO3
8. In the early 1990’s, New Jersey and Pennsylvania both reformed their automobile insurance
systems so that citizens could opt for either a less-expensive policy that did not allow people to
sue if they got into accidents or a more-expensive policy that did allow people to sue if they got
into accidents. In New Jersey, the default option was the less-expensive policy that did not allow
suing. In Pennsylvania, the default option was the more-expensive policy that did allow suing.
Given those options, which policy do you think most people in New Jersey ended up with? What
about in Pennsylvania? Explain. LO3
9. Give an example from your own life of a situation where you or someone you know uses a
precommitment to overcome a self-control problem. Describe why the precommitment is useful
and what it compensates for. Avoid any precommitment that was mentioned in the book. LO4
10. What does behavioral economics have to say about each of the following statements? LO5
a. “Nobody is truly charitable–they just give money to show off.”
b. “America has a ruthless capitalist system. Considerations of fairness are totally ignored.”
c. “Selfish people always get ahead. It’s like nobody even notices!”
Chapter 08 – Behavioral Economics
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consent of McGraw-Hill Education.
Answer: Answers will vary.
a. Behavior economics would say that people often act in their own self-interests;
however, not exclusively. Economic transactions are heavily influenced by moral and
ethical factors.
b. Behavioral economics has studied moral and ethical factors that affect economic
behavior and fairness is among the most important. There is both field and experimental
evidence that fairness has a strong effect on people’s behavior. Examples: giving to
charity, obeying the law, and the outcomes of experimental games.
c. Experiments have shown that people are not exclusively selfish, and when people are
treated unfairly, they react very strongly.
11. Do people playing the dictator game show only self-interested behavior? How much
divergence is there in the splits given by dictators to the other player? LO5
12. Evaluate the following statement. “We shouldn’t generalize from what people do in the
ultimatum game because $10 is a trivial amount of money. When larger amounts of money are
on the line, people will act differently.” LO5
13. LAST WORD What do you think of the ethics of using unconscious nudges to alter people’s
behavior? Before you answer, consider the following argument made by economists Richard
Thaler and Cass Sunstein, who favor the use of nudges. They argue that in most situations we
couldn’t avoid nudging even if we wanted to because whatever policy we choose will contain
some set of unconscious nudges and incentives that will influence people. Thus, they say, we
might as well choose the wisest set of nudges.
Chapter 08 – Behavioral Economics
REVIEW QUESTIONS
1. Which of the following are systematic errors? LO1
a. A colorblind person who repeatedly runs red lights.
b. An accountant whose occasional math errors are sometimes on the high side and sometimes on
the low side.
c. The tendency many people have to see faces in clouds.
d. Miranda paying good money for a nice-looking apple that turns out to be rotten inside.
e. Elvis always wanting to save more but then spending his whole paycheck, month after month.
2. Identify each statement as being associated with neoclassical economics or behavioral
economics. LO1
a. People are eager and accurate calculators.
b. People are often selfless and generous.
c. People have no trouble resisting temptation.
d. People place insufficient weight on future events and outcomes.
e. People only treat others well if doing so will get them something they want.
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3. Label each of the following behaviors with the correct bias or heuristic. LO3
a. Your uncle says that he knew all along that the stock market was going to crash in 2008.
b. When Fred does well at work, he credits his intelligence. When anything goes wrong, he
blames his secretary.
c. Ellen thinks that being struck dead by lightning is much more likely than dying from an
accidental fall at home.
d. The sales of a TV that is priced at $999 rise after another very similar TV prices at $1,300 is
placed next to it at the store.
e. The sales of a brand of toothpaste rise after new TV commercials announce that the brand “is
preferred by 4 out of 5 dentists.”
4. Erik wants to save more, but whenever a paycheck arrives, he ends up spending everything.
One way to help him overcome this tendency would be to: LO4
a. Teach him about time inconsistency.
b. Tell him that self-control problems are common.
c. Have him engage in precommitments that will make it difficult for his future self to overspend.
5. Many proposers in the ultimatum game offer half to the responder with whom they are paired.
This behavior could be motivated by (select as many as might apply): LO5
a. Fear that an unequal split might be rejected by a fair-minded responder.
b. A desire to induce the responder to reject the offer.
c. A strong sense of fairness on the part of the proposers.
d. Unrestrained greed on the part of the proposers.
Chapter 08 – Behavioral Economics
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consent of McGraw-Hill Education.
Answer: a and c.
Proposers who offer half to their responders are likely motivated by either of two desires.
The first is that they are genuinely fair-minded and wish to share equally. The second is
that they are not fair-minded but still offer half in order to avoid offending the sense of
fairness of the responders with whom they are paired. The nice thing about the Dictator
Game is that it removes the possibility of rejection. Thus, if we see dictators offering
half, we know that they must be truly fair-minded because they do not have to worry
about the possibility of rejection.
PROBLEMS
1. One type of systematic error arises because people tend to think of benefits in percentage terms
rather than in absolute dollar amounts. As an example, Samir is willing to drive 20 minutes out
of his way to save $4 on a grocery item that costs $10 at a local market. But he is unwilling to
drive 20 minutes out of his way to save $10 on a laptop that costs $400 at a local store. In
percentage terms, how big is the savings on the grocery item? On the laptop? In absolute terms,
how big is the savings on the grocery item? On the laptop? If Samir is willing to sacrifice 20
minutes of his time to save $4 in one case, shouldn’t he also be willing to sacrifice 20 minutes of
his time to save $10? LO2
2. Anne is a bargain-minded shopper. Normally, her favorite toothpaste costs the same at both of
her local supermarkets, but the stores are having competing sales this week. At one store, there is
a bonus offer: buy 2, get 1 free. At the other store, toothpaste is being sold at 40 percent off.
Anne instantly opts for the first offer. Was that really the less-expensive choice? (Hint: Is “buy
2, get 1 free” the same as 50 percent off?) LO2
Chapter 08 – Behavioral Economics
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consent of McGraw-Hill Education.
Answer: Anne made the wrong choice because she – like most consumers – erroneously
believes that “buy 2, get 1 free” is equivalent to a 50 percent discount. To see what’s
going on, assume a price of $1 per tube of toothpaste. In that case, “buy 2, get 1 free”
implies that Anne would pay $2 for three tubes. That comes out to 67 cents per tube (=$2
divided by three tubes), which implies that “buy 2, get 1 free” is the same as a 33 percent
discount (because 67 cents per tube is 33 percent less than $1 per tube). By contract, the
other store’s offer of “40 percent off” would mean that the tubes that normally sell for $1
each are now only 60 cents each. So it would definitely be better to for “40 percent off”
rather than “buy 2, get 1 free”.
3. The coffee shop near the local college normally sells 10 ounces of roasted coffee beans for
$10. But the shop sometimes puts the beans on sale. During some sales, it offer “33 percent
more for free”. Other weeks, it takes “33 percent off” the normal price. After reviewing the
shop’s sales date, the shop’s manager finds that “33 percent more for free” sells a lot more coffee
than “33 percent off.” Are the store’s customers making a systematic error? Which is actually
the better deal? LO2
Chapter 08 – Behavioral Economics
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4. Angela owes $500 on a credit card and $2,000 on a student loan. The credit card has a 15
percent annual interest rate and the student loan has a 7 percent annual interest rate. Her sense of
loss aversion makes her more anxious about the larger loan. As a result, she plans to pay it off
first-despite the fact that professional financial advisors always tell people to pay off their
highest-interest-rate loans first. Suppose Angela has only $500 at the present time to help pay
down her loans and that this $500 will be the only money she will have for making debt payments
for at least the next year. If she uses the $500 to pay off the credit card, how much interest will
accrue on the other loans over the coming year? On the other hand, if she uses the $500 to pay
off part of the student loans, how much in combined interest will she owe over the next year on
the remaining balances on the two loans? By how many dollars will she be better off if she uses
the $500 to completely pay off the credit card that than partly paying down the student loans?
(Hint: If you owe X dollars at an annual interest rate of Y percent, your annual interest payment
will be X*Y, where they interest rate, Y, is expressed as a decimal.) LO3
5. ADVANCED ANALYSIS In the algebraic version of prospect theory, the variable x
represents gains and losses. A positive value for x is a gain, a negative value for x is a loss, and a
zero value for x represents remaining at the status quo. The so-called value function, v(x), has
separate equations for translating gains and losses into, respectively, positive values (utility) and
negative values (disutility). The gain or loss is typically measured in dollar while the resulting
value (utility or disutility) is measured in utils. A typical person values gaines (x > 0) using the
function v(x) = x^0.88 and losses (x < 0) using the function v(x) = -2.5*(-x)^0.88. In addition, if
she stays at the status quo (x = 0), then v(x) = 0. First use a scientific calculator and the typical
person’s value functions for gains and losses to fill out the missing spaces in the nearby table.
Then answer the questions below. LO3
Chapter 08 – Behavioral Economics
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Gain or
Loss
Total Value of Gain or Loss
Marginal Value of Gain or Loss
-3
-6.57
-2
-2.10
-1
-2.50
-2.50
0
0.00
1
1.00
2
1.84
3
0.79
a. What is the total value of gaining $1? Of gaining $2?
b. What is the marginal value of going from gaining $0 to gaining $1? Of going from
gaining $1 to gaining $2? Does the typical person experience diminishing marginal
utility from gains?
c. What is the marginal value of going from losing $0 to losing $1? Of going from losing
$1 to losing $2? Does the typical person experience diminishing marginal disutility from
losses?
d. Suppose that a person simultaneously gains $1 from one source and loses $1 from
another source. What is the person’s total utility after summing the values from these
two events? Can a combination of events that leaves a person with the same wealth as
they started with be perceived negatively? Does this shed light on status quo bias?
e. Suppose that an investor has one investment that gains $2 while another investment
simultaneously loses $1. What is the person’s total utility after summing the values from
these two events? Will an investor need to have gains that are bigger than her losses just
to feel as good as she would is she did not invest at all and simply remained at the status
quo?
Answer: The completed table should look like this:
Gain or
Loss
Total Value of Gain or Loss
Marginal Value of Gain or Loss
-3
-6.57
-1.97
-2
-4.60
-2.10
-1
-2.50
-2.50
0
0.00
–
1
1.00
1.00
2
1.84
0.84
3
2.63
0.79
Chapter 08 – Behavioral Economics
a. The total value of gaining $1 is 1.00 utils. The total value of gaining $2 is 1.84 utils.
b. The marginal value of going from gaining $0 to gaining $1 is 1.00 utils (= 1.00 – 0.00
utils). The marginal value of going from gaining $1 to gaining $2 is 0.84 utils (= 1.84
6. Ted has always had difficulty saving money. So on June 1st, Ted enrolls in a Christmas
savings program at his local bank and deposits $750. That money is totally locked away until
December 1st so that Ted can be certain that he will still have it once the holiday shopping season
begins. Suppose that the annual rate of interest is 10 percent on ordinary savings accounts (that
allow depositors to withdraw their money at any time). How much interest is Ted giving up by
pre-committing his money into the Christmas savings account for six months instead of
depositing it into an ordinary savings account? (Hint: If you invest X dollars at an annual interest
rate of Y percent, you will receive interest equal to X * Y, where the interest rate Y is expressed
as a decimal.) LO4