Homework 3 Behavioral Economics (ECO23/PSY23) Udayan Roy Fall 2014 Please indicate your answers on the answer sheet at the end of this document. This homework is due in class on November 3. Status Quo Effect 1. In the examples discussed in class when people selecting an investment or a policy learned of the current state (status quo) of the investment or policy they were a. b. c. d. e. More likely to stick with the status quo, even if they hadn’t initially chosen it More likely to stick with the status quo, but only if they had initially chosen the status quo Less likely to stick with the status quo Unaffected by the status quo, unless there were significant costs to change More likely to prefer a change than if they did not know of the status quo 2. One reason, discussed in class, why people avoid making a decision to take a new action (or embrace change) even when such decisions are rational is that a. Taking no action usually leads to better outcomes b. Tax consequences for selling losing securities are expensive c. Regret is much greater for negative outcomes that result from one’s own action than for negative outcomes that were merely preventable d. People are driven by their expectations of a future experience e. We acclimate to any level of hedonic experience if given enough time 3. In the section “Defending the status quo” in chapter 28 of his book “Thinking, Fast and Slow,” the psychologist Daniel Kahneman explains why reform of laws and government policies is usually difficult to achieve. His explanation is as follows: a. Our laws and government policies serve the interests of the elites. Consequently, the elites are unlikely to allow any change to those laws and government policies. b. In a democracy, the views of all voters must be considered. As agreement (on any issue) becomes less likely when more people are involved, change is difficult to achieve in a democracy. c. As we tend to have a natural respect for our ancestors and elders, we tend to think that the laws and government policies that were put in place in the past are far better than contemporary ideas for reform. d. It would be rare for a typical reform proposal to have only benefits and no costs. Even if the expected benefits are larger than the expected costs, loss aversion makes the costs look very scary. Consequently, most reform proposals get rejected. 4. In the section “Defending the status quo” in chapter 28 of his book “Thinking, Fast and Slow,” the psychologist Daniel Kahneman explains why negotiations are inherently difficult. His explanation is as follows: a. Rational people seek to maximize their own personal welfare. Therefore nobody wants to give up anything. This leads to stalemate. b. Each side equates accepting the other side’s proposal—no matter how reasonable—as surrender. This leads to stalemate. c. When one side offers concession X and, in return, asks the other side to make concession Y, loss aversion makes it think that X is more significant than Y, even though a neutral person may consider both concessions to be roughly equal in significance. Conversely, the other side—again, because of loss aversion—considers the concession that it is being asked to make (Y) to be a lot more significant than the concession its opponent is offering (X). In this way, loss aversion makes each side think the other side is crazy. d. None of the above. Kahneman actually argues that negotiations are usually very easy. 5. The status quo bias is the result of which of the following aspects of our personalities? (There are two correct answers below. Show both.) a. b. c. d. Anchoring Diversification bias Lack of attention Loss aversion 6. The consequences of the status quo bias include: a. b. c. d. Unwillingness to embrace reform of our laws and government policies Unwillingness to compromise in negotiations Willingness to accept the default outcome even when other available outcomes are superior All of the above Diversification bias 7. Diversification bias is a. The persistent willingness to expend effort or money to keep options open, even when the options themselves are of no value. b. The tendency to underestimate our future desire for “hot state” choices when we are in a “cold state” c. The tendency to underestimate our future willingness to give up immediate gratification for long term benefit. d. A behavior that is initially enjoyable, but ultimately reduces the ability to experience enjoyment from other things so that total utility falls. e. The tendency to overweight the importance of similar nearby items in estimating value 8. Diversification bias refers to the a tendency to a. b. c. d. e. get better returns from a diversified portfolio of investments predict that we will refuse temptation when we are predicting while in a “cold” state diversify our choices and options, even when it is disadvantageous focus exclusively on the best possible outcome develop expertise over time 9. What does Prof. Dan Ariely’s “keeping doors open” experiment tell us about human nature? 2 a. We hate losing an option even if it is unnecessary (in the sense that it is no better than the other options that will remain) b. We hate losing an option even if we would never use it (because it is inferior to our other available options) c. We hate losing an option even when we would have to take costly measures to retain it d. All of the above e. None of the above. Explain ______________________________________ 10. When people are asked to choose from a long menu of (perhaps hard-to-compare) options, they tend to get overwhelmed by the complexity of the task, and end up choosing a little of everything. This behavioral tendency is referred to as a. b. c. d. anchoring hyperbolic discounting the diversification bias projection bias 11. In an experiment discussed in class, university employees were randomly assigned to two groups. Those in Group 1 were asked how they would invest their retirement money between (a) a mutual fund that invested only in stocks and (b) a mutual fund that invested only in bonds. Those in Group 2 were asked how they would invest their retirement money between (a) a mutual fund that invested only in stocks and (c) a balanced mutual fund that spent half its money on stocks and half in bonds. a. The first group chose a fifty-fifty split between (a) and (b). The second group invested entirely in (c). This behavior is in line with the rational individual model of standard economics. b. Both groups chose fifty-fifty splits. This behavior is in line with the rational individual model of standard economics. c. Both groups chose fifty-fifty splits. This is non-standard behavior that is referred to as the 1/n heuristic d. Both groups chose fifty-fifty splits. This is a predictable irrationality. As a result of its nonrational choices, the second group is likely to be excessively invested in stocks. e. Both answers (c) and (d) are true. 12. In an experiment discussed in class, students were randomly assigned to two groups. At the end of week 1, those in Group 1 were asked to pick one snack (from a list of six snacks) for consumption then and there. This was repeated in the two following weeks. On the other hand, those in Group 2 were asked, at the beginning of the first week, to pick the snacks that they would consume at the end of weeks 1, 2, and 3. a. The typical student in Group 1 ate the same snack in all three weeks, whereas the typical student in Group 2 selected a variety of snacks for the three weeks. This shows diversification bias: we think we like variety even when we actually don’t. b. The typical student in Group 2 ate the same snack in all three weeks, whereas the typical student in Group 1 selected a variety of snacks for the three weeks. This shows diversification bias: we think we like variety even when we actually don’t. 3 c. The typical student in Group 1 ate the same snack in all three weeks, whereas the typical student in Group 2 selected a variety of snacks for the three weeks. This shows that we actually do not have a diversification bias. d. The typical student in Group 2 ate the same snack in all three weeks, whereas the typical student in Group 1 selected a variety of snacks for the three weeks. This shows that we actually do not have a diversification bias. Self-Control 13. Our ability to stick to the plans we make is often quite weak. This lack of self-control can be traced to the following predictable irrationalities: a. b. c. d. e. Anchoring Hyperbolic discounting Diversification bias Availability bias Both (b) and (d) Hyperbolic Discounting 14. _____ is the additional future happiness that can compensate for the loss of one unit of happiness in the present. a. b. c. d. Anhedonia The interest rate The discount rate The hyperbolic discount rate 15. For Alice, suppose the loss of one unit of present happiness can be compensated by the gain of 1.07 units of future happiness. Alice’s discount rate is ______. a. b. c. d. e. 0.03 0.07 1.07 3 7 16. For Alice, suppose the loss of one unit of present happiness can be compensated by the gain of 1.03 units of future happiness. And for Bob, suppose the loss of one unit of present happiness can be compensated by the gain of 1.07 units of future happiness. Who is more patient? a. b. c. d. Alice, because her discount rate is higher Alice, because her discount rate is lower Bob, because his discount rate is higher Bob, because his discount rate is lower 17. On October 1, Juan is asked the following two questions: (a) Would you give up $1.00 today if you are guaranteed $1.07 tomorrow? and (b) Would you give up $1.00 on November 1 if you are 4 guaranteed $1.07 on November 2? Under the assumptions of standard economics, Juan will ______. But the experimental evidence obtained by behavioral economists suggests that Juan will _____. a. b. c. d. e. Give the same answer to both questions; be more likely to say “yes” to (a) and “no” to (b) Give the same answer to both questions; be more likely to say “no” to (a) and “yes” to (b) Be more likely to say “no” to (a) and “yes” to (b); give the same answer to both questions Be more likely to say “yes” to (a) and “no” to (b); give the same answer to both questions Be more likely to say “no” to (a) and “yes” to (b); be more likely to say “yes” to (a) and “no” to (b) 18. An individual is said to show hyperbolic discounting when his discount rate is ____. a. High for decisions that affect today’s consumption, but low for decisions that affect consumption in the somewhat distant future b. Low for decisions that affect today’s consumption, but high for decisions that affect consumption in the somewhat distant future c. High for all decisions (irrespective of whether they affect today’s consumption or future consumption) d. Low for all decisions 19. An example of projection bias is a. Wanting fun, “low brow” movies right now, but serious, “highbrow” movies when picking for next week. b. Choosing a health snack for delivery next week, then asking to change to a sugary, unhealthy snack when it is actually delivered. c. Being more likely to think we will want a high calorie snack next week if we are asked when we are hungry, than if we are asked when we are full. d. An addict’s willingness to forego more money for an immediate hit than predicted one week prior. e. All of the above 20. Projection bias is a. The persistent willingness to expend effort or money to keep options open, even when the options themselves are of no value. b. The tendency to underestimate our future desire for “hot state” choices when we are in a “cold state” c. The tendency to underestimate our future willingness to give up immediate gratification for long term benefit. d. A behavior that is initially enjoyable, but ultimately reduces the ability to experience enjoyment from other things so that total utility falls. e. The tendency to overweight the importance of similar nearby items in estimating value 5 ANSWER SHEET Homework 3 Behavioral Economics (ECO23/PSY23) Udayan Roy Fall 2014 NAME: __________________________________________ DATE: ___________________________________________ 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 6