BEE3049 Behaviour, Decisions and Markets

1
BEE3049Behaviour, Decisions and Markets

• Miguel A. Fonseca

2
Some announcements

• Course information (slides, notes, etc.)
• http//people.ex.ac.uk/maf206/bdm.htm
• Main textbook
• Markets, Games Strategic Behavior, C.A. Holt,
  2006
• Available in the library (3 copies) or you may
  purchase a copy.
• I may also indicate supplementary readings for
  each topic.

3
More announcements

• There will be two classes per week
• 1 lecture and 1 seminar
• The seminar will be dedicated to
• Solving and/or discussing homework
• Running experiments related to the material.

4
Coursework and Evaluation

• Every week I will propose one or more discussion
  questions.
• These questions will be the basis of one of your
  assignments
• You must pick one of them and write an essay
  which must not exceed 1,000 words
• This essay must be handed in no later than
  12/01/2009
• This essay counts for 10 of your final mark

5
Coursework and Evaluation

• Dieter Balkenborg will have another assignment in
  the last 5 weeks of the course.
• (This assignment will also be worth 10 of your
  mark.)
• There will be a final exam, which will determine
  the remaining 80 of the mark for the course.
• Given this is the first year we are running this
  course, we will provide a mock exam before the
  Christmas Break.

6
Rational Choice Fundamentals

• At the core of every phenomenon studied by
  Economics lies a choice problem.
• In other words all the economic theory underlying
  phenomena like stock market prices or charity
  giving is based on two basic axioms
• Transitivity, and
• Completeness.

7
Preference relations

• Choice theory assumes individuals preferences can
  be fully described by a preference relation
  , which can be applied to any two objects.
• A B should read A is at least as good as B.
• From this relationship we can derive two more
  important relations
• Strict preference
• Indifference

8
Rational Choice

• An individual is rational if his/her preference
  relation possesses the two following properties
• Completeness A B or B A (or both)
• Transitivity if A B and B C, then B C.
• Completeness basically requires an individual to
  always be able to state a preference between two
  objects.
• It is tough because a rational agent should be
  able to state a preference between any pair of
  objects in order to make a choice, even if that
  choice is purely hypothetical.

9
Rational Choice

• Transitivity is the toughest requirement for
  rationality. Why is it necessary?
• Suppose Johns preferences are such that he
• Apples oranges, oranges pears and pears
  apples.
• This means that
• John would pay 1p to trade an orange for an
  apple
• He would then pay 1p to trade an apple for a
  pear
• He would then pay 1p to trade a pear for an
  orange!
• John would end up paying 3p for his original
  orange!

10
Rational Choice (cont)

• If preferences are rational, it can be shown that
  there is a function, u(x) for which the following
  is true
• If A B, then u(A) u(B)
• Utility functions are the building block for
  analysing choice, either individually or in a
  strategic setting.
• Does this mean that our choices always conform to
  the postulates of rational choice?

11
Utility Functions

• The first critique of rational choice came from
  Maurice Allais.
• Consider the following choices
• Choice 1

12
Utility Functions

• Choice 2

13
Allais Paradox

• If you picked A in choice 1, then
• U(100) gt 0.1 U(500) 0.89 U(100) 0.01 U(0)
• Which means 0.11 U(100) gt 0.1 U(500) 0.01 U(0)
• Picking C in choice 2 means
• 0.1 U(500) 0.9 U(0) gt 0.11 U(100) 0.89 U(0)
• Which means 0.1 U(500) 0.01 U(0) gt 0.11 U(100)
• So, picking A and C is inconsistent w/ rational
  theory.
• Can you show why the same is true for B and D?

14
Ellsberg paradox

• A second critique of rational choice came from
  Ellsberg.
• He argued that individual decisions would violate
  expected utility theory if probabilities were not
  exactly known.

15
Ellsberg Paradox

• Consider the following case
• An urn contains three types of balls, yellow, red
  and black such that
• There are 30 red balls
• There are 60 balls which may be yellow or black.
• Now, you must choose one of two options
• A) Pick a ball if it is red you earn 100
• B) Pick a ball if it is black you earn 100.

16
Ellsberg Paradox

• Suppose now I offer you a different proposition
• C) Pick a ball if it is either red or yellow,
  you get 100
• D) Pick a ball if it is either black or yellow,
  you get 100

17
Ambiguity aversion

• The evidence from this experiment points to the
  fact that people are ambiguity averse.
• That is, they dislike situations in which they
  are unable to assign concrete probabilities.

18
Prospect Theory

• Imagine the UK is preparing for the outbreak of
  an epidemic, expected to kill 600 people
• If program A is adopted, 200 people will be saved
• If program B is adopted, there is one third
  probability that 600 people will be saved and two
  thirds probability that no people will be saved

19
Prospect Theory

• Imagine the UK is preparing for the outbreak of
  an epidemic, expected to kill 600 people (N 155
  subjects)
• If program C is adopted, 400 people will die
• If program D is adopted, there is one third
  probability that nobody will die and two thirds
  probability that 600 people will die

20
Prospect Theory

• Individuals seem to react differently depending
  on the context
• Risk averse when dealing with gains
• Risk seeking when dealing with losses.

21
Prospect Theory
U(X)
Gains
Losses
-

22
Prospect Theory

• The Value function V(X), where X is a prospect
• Is defined by gains and losses from a reference
  point
• Is concave for gains, and convex for losses
• The value function is steepest near the point of
  reference Sensitivity to losses or gains is
  maximal in the very first unit of gain or loss
• Is steeper in the losses domain than in the gains
  domain
• Suggests a basic human mechanism (it is easier to
  make people unhappy than happy)
• Thus, the negative effect of a loss is larger
  than the positive effect of a gain

23
Mental Accounts

• Imagine the following situations
• you are about to purchase a stereo for 125 and a
  CD for 15. The salesman mentions that the CD is
  on sale for 10 at another branch of the store 20
  minutes away by car.
• you are about to purchase a CD for 15 and a
  stereo for 125. The salesman mentions that the
  stereo is on sale for 120 at another branch of
  the store 20 minutes away by car.
• 68 (N88) of subjects were willing to drive to
  the other store in A, but only 29 (N93) in B

24
Framing and Mental Accounts

• Three potential framing options, or accounts
• Minimal (considers only differences between local
  options, such as gaining 5, disregarding common
  features)
• Topical (considers the context in which the
  decision arises, such as reducing the price of
  the calculator from 15 to 10)
• Comprehensive (includes both jacket and
  calculator in relation to total monthly expenses)
• People usually frame decisions in terms of
  topical accounts thus the savings on the
  calculators are considered relative to their
  prices in each option

25
Loss Aversion The Endowment Effect(Thaler,
1980)

• It is more painful to give up an asset than it is
  pleasurable to buy it, an endowment effect
• Thus, selling prices are higher than buying
  prices, contrary to economic theory
• There is a status quo bias (Samuelson and
  Zeckhauser 1988) since disadvantages of leaving
  the current state seem larger than advantages,
  for multi-attribute utility functions