978-1260152616 Chapter 8 Solution Manual

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

CHAPTER 8

DECISION MAKING

Chapter Overview

We can go a long way in economics by assuming that people act rationally to

maximize their utility. Real people, though, make economic decisions in

complicated, unexpected, and sometimes nonoptimal ways. Behavioral

economics shows us that, in practice, we need a broader understanding of

“maximizing utility” in order to build models that predict many of the quirky

things people do. Understanding these human tendencies can help us to

avoid common decision-making pitfalls. It can also help us to design products

and policies that allow people to make better choices.

Although the behaviors explored in this chapter can be viewed as biases or

mistakes, they are the sort of mistakes that can be corrected. We’ve also

discussed some strategies designed to help people reach their intended

goals and make better choices. In a later chapter (Chapter 23, “Public Policy

and Choice Architecture”) we’ll return to some of these issues as we think

about business ideas and public policies that help people make good choices

and stick to their goals.

Learning Objectives

LO 8.1: Explain how time inconsistency accounts for procrastination and

other problems with self-control.

LO 8.2: Explain why sunk costs should not be taken into account in deciding

what to do next.

LO 8.3: Identify the types of opportunity cost that people often undervalue,

and recognize why undervaluing them distorts decision making.

LO 8.4: Explain why fungibility matters in financial decision making.

Chapter Outline

OPENING STORY: WHEN IS $20 NOT QUITE $20?

Dealing with Temptation and Procrastination

Time Inconsistency, Competing Selves, and Commitment (LO 8.1)

BOX FEATURE: REAL LIFE – GIVE MORE TOMORROW

BOX FEATURE: REAL LIFE – TAKE OUT A CONTRACT ON YOURSELF

Thinking Irrationally about Costs

The Sunk-Cost Fallacy (LO 8.2)

Undervaluing Opportunity Costs (LO 8.3)

Forgetting about Fungibility (LO 8.4)

Creating Mental Categories for Money

BOX FEATURE: WHAT DO YOU THINK? – CREDIT-CARD CATEGORIES: MORE

REALISTIC OR MORE CONFUSING?

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

BOX FEATURE: REAL LIFE – THE METHOD-OF-PAYMENT EFFECT

Beyond the Lecture

Writing Assignment: Time Inconsistency, Competing Selves, and

Commitment (LO 8.1)

Ask students to write a brief essay regarding a topic where their short-term

and long-term goals conGicted. What advice do they have to help deal with

time inconsistency problems? Some suggestions could include longer-term

goals like good grades, a successful career, getting healthier, etc. This can

also be used for a discussion in class or in an online environment.

Class Discussion: The Sunk-Cost Fallacy (LO 8.2)

Have students review this brief article on sunk costs in sports. It specifically

discusses the New York Jets player personnel decisions. Ask the students to

consider the following:

1. What should a team do if they cannot recover past costs for a player

and do not think the player adds to the team going forward?

2. How can psychological factors play a role in the decision to consider

sunk costs in current decisions (even if economists say that this is a

bad idea)?

Class Discussion and Video: Great Examples and Research Related

to This Chapter (LO 8.1)

The beginning of this chapter hints at some work done by social psychologist

Dan Gilbert. It may cost a bit of class time, but consider showing the

somewhat lengthy video of a TED talk done by Gilbert. The video illustrates

time inconsistency, bias in decision making, and the general impatience of

people wanting benefit immediately. You may want to watch the video in its

entirety first to see if you want to just show certain clips during your class

(for example, you’ll probably want to skip the Q&A at the end).

Class Discussion: Undervaluing Opportunity Costs (LO 8.3)

Have students view this short video about the Broken Window Fallacy and

discuss the topic of opportunity costs with students.

1. While a natural disaster does lead to increased spending as individuals

must 5x and replace many items, why does this not add to overall

wealth?

2. What is the opportunity cost associated with replacement spending?

Clicker Questions

There are three main purposes to clicker questions. First, they are a great

way to do a quick and instant “on demand” test of student understanding of

the material. You can cover material, and instantly get feedback on student

comprehension. You can see whether you need to explain certain topics

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

again, or move on to the next subject. Second, they are a great method to

break up the class and take a moment away from lecture. It gets the

students actively involved. Finally, certain clicker questions can be framed in

a “discussion” manner, in which you can invite students to talk about the

possible right answer with their peers. You can instruct students to convince

their classmate of a right or wrong answer.

1. Why does time inconsistency happen in behaviors? [LO 8.1]

A. Because people tend to be very patient and can easily wait for rewards

Feedback: We tend to discount the future. We place a large emphasis on

costs and benefit today, and not think about future costs and benefit that

may seem far away.

2. What is an example of time inconsistency in decision making? [LO 8.1]

D. Angela drops a college course that she thinks she will fail

Feedback: It involves changing your current behavior from your planned

behavior.

3. James and Maria are in line at a fancy restaurant. The host announces the

wait will be another 45 minutes. James wants to leave. Maria says “We

should stay because we’ve already been waiting for 30 minutes”. Maria is:

[LO 8.2]

A. Being rational

Feedback: You can’t get that 30 minutes back, no matter what. The 30

minutes should not factor into your decision about waiting another 45

minutes or not!

4. Which of the following is the most likely example of undervaluing

opportunity costs? [LO 8.3]

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

A. Amanda buys a grill, but thinks of the other goods she could have bought

with the money instead

Feedback: He’s overvaluing items that he owns. There is large opportunity

cost of holding on to the cars instead of selling them. Someone could have

paid him a lot of money for the collection.

5. Since money is fungible, people can set aside money to purchase a good

later. What is a possible result from this action? [LO 8.1, LO 8.4]

A. People may reduce time inconsistency and spend as they intended

Feedback: A good discussion question for your students. Either of the

scenarios good happen! The purpose of setting money aside is the hope that

answer [A] occurs, but this may not always be the case.

Solutions to End-of-Chapter Questions and Problems

Review Questions

1. Describe a situation from your own experience in which you are time

inconsistent. What have you done (or might you do) to accomplish the goals

of your future-oriented self? [LO 8.1]

Answer: I am forever setting (and breaking) fitness goals. My future-

oriented self wants to exercise more. I put exercise times in my calendar,

but when the day and time rolls around, I often decide that I am too busy

2. You have a friend who is always resolving to improve her grades, but who

never seems to 5nd time to study. Explain to her how time inconsistency

might be aOecting her choices, and suggest some steps she might take to

meet her goal. [LO 8.1]

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

Answer: Your friend wants to study in order to improve her grades, but

not because she enjoys studying. She makes plans to study in the future,

3. You’ve already paid to get into an all-you-can-eat buOet and have enjoyed

several plates of food. You’re not really hungry anymore, but feel you ought

to eat more to get the full value from the buOet. Does this inclination make

sense? Explain why or why not. [LO 8.2]

Answer: This decision does not make sense. The money you paid for the

buOet is a sunk cost and should not factor in your decision about whether

4. Alda is willing to pay $2,000 to visit her favorite cousin over spring break.

A month ago, she booked a trip costing $1,200. Spring break has arrived, but

Alda needs one day to finish an important paper before she goes. Alda could

cancel her trip and get a refund of $800. Or, she could pay an additional

$1,000 (on top of the $1,200 she already paid) to rebook the trip for two

days later. Explain what Alda should do. [LO 8.2]

Answer: The $400 that can’t be refunded is sunk. The opportunity cost of

5. Suppose your art history professor has a small personal art collection,

including some works by a famous artist. She bought this artist’s paintings at

modest price, before he became well known. One of the paintings is now

worth $2 million. When you ask the professor whether she would buy it now

for $2 million, she says she wouldn’t. Is the professor’s decision making

consistent? Why or why not? [LO 8.3]

Answer: Your professor’s decision making is not consistent. Your

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

6. Chandra received a gift certi5cate that covers three salsa dance lessons.

After the first lesson, Chandra decided that she doesn’t like salsa, yet she

still plans to go the next lesson because it doesn’t cost her anything.

Evaluate Chandra’s logic. [LO 8.3]

Answer: Chandra is undervaluing the opportunity cost of her time. It is

7. You have a friend who runs up a balance on his credit card by buying new

furniture to replace the furniture he has. The interest rate on the balance is

15 percent per month. The furniture store oOers a layaway plan with monthly

payments equivalent to an interest rate of 10 percent per month. Explain to

your friend how he could manage his finance more sensibly. [LO 8.4]

Answer: The layaway plan costs your friend less than paying for furniture

on his credit card. If your friend doesn’t have the cash upfront for

8. Dora and Vicki are bartenders. Dora prefers her tips in cash because she

can have the money right away. Credit-card tips don’t get paid to bar staO

until the payments are processed, which can take a few days. Vicki still

prefers for her customers to put her tip on their credit card. Why might Vicki

have this preference? [LO 8.4]

Answer: Vicki probably prefers her customers to tip her on their credit

Problems and Applications

1. In which of the following cases is time inconsistency likely to be at work?

[LO 8.1]

a. A child plans to become a doctor when he grows up, but a month later

reads a book about 5re5ghters and decides to become a 5re5ghter instead.

b. A student keeps intending to finish reading War and Peace—next week.

c. A parent plans to enroll his child in art class but enrolls her in dance class

instead.

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

d. A beginning piano player plans to practice three times a week but

frequently practices only once a week.

Answer: Time inconsistency is likely to be at work for b. A student keeps

2. You would like to save more money. Which of the following strategies will

help you overcome time inconsistency? [LO 8.1]

a. Deciding how much you need to save.

b. Setting up a savings account.

c. Putting reminders in your calendar to make deposits.

d. Enrolling in an automatic-transfer program that will move a specified

amount of money from your checking account to your savings account each

month.

Answer: d. While a, b, and c are all good ideas, none of them will

override your present-oriented self who prefers spending over savings. d

3. You’re seated at a banquet that is beginning to become boring. Which of

the following pieces of information are relevant to your decision to stay or go

somewhere else? [LO 8.2]

a. Another party is happening at the same time, and you’ve heard that it’s

fun.

b. The dinner you were served was only so-so.

c. You haven’t eaten dessert yet, and it looks delicious.

d. You paid $30 to attend the banquet.

e. The other party you could attend has a cover charge of $10.

Answer: a, c, and e. The only relevant information is current or future

costs and benefit. The fact that the dinner was so-so and you paid $30

4. You just spent $40 on a new movie for your collection. You would have

preferred the director’s cut but discovered when you got home that you

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

bought the theatrical version. The store you bought the movie from has an

“all sales 5nal” policy, but you could resell the movie online for $30. The

director’s cut sells for $50. By how much would you need to value the

director’s cut over the theatrical version for it to make sense for you to sell

the version you bought and buy the director’s cut? [LO 8.2]

Answer: The opportunity cost of the director’s cut is $20. The $40 cost of

the theatrical version has already been spent, but you can recoup $30 of

5. Suppose you’re bowling with friends. You’ve already played one game and

are trying to decide whether to play another. Each game costs $6 per person,

plus a one-time rental fee of $5 for the bowling shoes. It would take another

hour to play the next game, which would make you late to work. Missing an

hour of work would mean that you would lose pay at a rate of $12 per hour.

Based on this information, how much would you have to enjoy the next

bowling game, expressed in terms of dollars, to play another game? [LO

8.3]

Answer: You would have to place a value on your enjoyment of the next

6. During a holiday party at work, you pay $2 to buy a raUe ticket for a 160-

gigabyte iPod. You win the drawing. Based on a little research online, you

discover that the going rate for a hardly used 160-gigabyte iPod is $200.

[LO 8.3]

a. What was the opportunity cost of acquiring the iPod?

b. What is the opportunity cost of choosing to keep the iPod?

Answer:

7. Jamie is saving for a trip to Europe. She has an existing savings account

that earns 2 percent interest and has a current balance of $4,500. Jamie

doesn’t want to use her current savings for the vacation, so she decides to

borrow the $1,500 she needs for travel expenses. She will repay the loan in

exactly one year. The annual interest rate is 5 percent. [LO 8.4]

a. If Jamie were to withdraw the $1,500 from her savings account to 5nance

the trip, how much interest would she forgo?

b. If Jamie borrows the $1,500, how much will she pay in interest?

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Chapter 08 – Behavioral Economics: A Closer Look at Decision Making

c. How much does the trip cost her if she borrows rather than dips into her

savings?

Answer:

a. Interest forgone = $1,500 x (0.02) = $30.

8. Suppose you have accumulated a credit card balance of $500, at an

annual interest rate of 10 percent. You are also planning to open a new

savings account that accumulates interest at an annual rate of 3 percent. You

just got your paycheck and have $200 that you can use either to pay down

your debt or open your savings account. [LO 8.4]

a. If you use the full $200 to pay down your debt, what will your credit card

balance be in one year? Assume no additional credit card payments during

this time.

b. If, instead, you put the full $200 into your savings account, what will be

the balance in your savings account in one year, assuming you make no

additional deposits during this time? What will your credit card balance be,

assuming you make no additional payments during this time because your

payment requirements have been deferred for one year?

c. In one year, how much money will you have lost if you deposit the $200 in

your savings account compared to paying down your credit card?

Answer:

a. Credit Card balance at the beginning of the year: $500 – $200 = $300.

b. The balance in your savings account will be $200 x (1 + 0.03) = $206.

c. Interest expense on the original credit card balance = $500 x (0.10) =

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