Behavioral Finance Economics 437

Readings Daniel Kahneman, “Thinking: Fast and Slow” Michael Lewis, “The Undoing Project”

Imagine that one in every thousand athletes use steroids Imagine that one in every thousand athletes use steroids. Imagine also that the test for steroids has a 5 % false positive rate. If a particular athlete tested positive for steroids what is the probability that that athlete was a steroid user [0.001] [0.020] [0.65] [0.95]

A Dilemna US is preparing for the outbreak of an unusual foreign disease which is expected to kill 600 people Program A: 200 people will be saved Program B: 1/3 probability that 600 will be saved; 2/3 probability that no one will be saved

Regression to the mean Highly intelligent females tend to marry men who are less intelligent than they are The correlation between the intelligence scores of spouses is less than perfect (and men and women do not differ in intelligence on average)

Vagueness -- Game 1 Consider an Urn Containing: ½ red balls ½ green balls If you can pick a red ball you win $ 100, otherwise zero

Vagueness -- Game 2 Consider an Urn Containing red and green balls, But we have no idea how many of each If you can pick a red ball you win $ 100, otherwise zero

Insurance Distortions Flight Insurance …. $ 100,000 coverage in case of Terrorism $ 7.42 Anything but terrorism $9.00 Anything $ 7.44

Buy me a beer! From a resort From a small country town store

Fairness and “Reference Points” Shortage of cars develops Dealer raises prices $ 200 above list 71 % unfair Dealer has been selling these cars at a discount of $ 200 below list price. He now eliminates the discount Only 42 % unfair

Cutting wages A small co employs several people. Workers’ incomes have been about average for the community. Business is slow. Owners reduce the workers’ wages by 10 percent for the year 61 % unfair A small co employs several people. The workers have been receiving a 10% bonus each year. Business is slow. Owners eliminate the bonus for the year. 20 % unfair

Tipping Survey A restaurant you visit frequently, bill is $ 10, what is the tip? $ 1.28 on average A restaurant in another city that you do not intend to return to $ 1.27 on average

Another Example Can of insecticide costs $ 10 Same can but has no risk Current risk level 15 out of 10,000 (injured) What would you pay to eliminate the risk Result of survey $ 3.78 Same can but has no risk What price reduction would be okay to have a 1 in 10,000 risk? 77 % said they would refuse to buy the product at any price if the risk were increased

Anchoring (the bag of marbles) 50 red; 50 white Probability of drawing a red marble 90 red; 10 white Probability of drawing (with replacement) 7 red marbles in a row

Anchoring (the bag of marbles) 50 red; 50 white 50% Probability of drawing a red marble 90 red; 10 white 48% Probability of drawing (with replacement) 7 red marbles in a row 90 red; 10 white 52% Probability of drawing (with replacement) at least one white marble in 7 tries

Going to the UVA Basketball Game Paid $ 500 for a courtside ticket As you try to enter, you realize you have lost the ticket Someone offers to sell you another ticket for $ 500….would you buy it? You are on the way to the basketball game and have decided to pay $ 500 for a courtside ticket As you try to enter, you realize that you have lost two hundred dollar bills, but still have several left and can buy the ticket Would you still buy the ticket?

Another Dilemna Program C: If adopted 400 people will die Program D: 1/3 probability that no one will die and 2/3 probability that 600 people will die

Sunk Costs A man joins a tennis club and pays a $ 3000 yearly membership fee. After two weeks of playing, he develops a tennis elbow He continues to play (in pain) saying: “I don’t want to waste the $ 300”

Naïve Diversification Four Choices: Three Bond Funds One Stock Fund Put ¼ in each Four Other Choices Three Stock Funds One Bond Fund

Perceptions of “Randomness” - an example of “representativeness” In a population of families with exactly six children, which sequence of births is more likely: B B B G G G G B B G B G School A has 65 % boys, School B has 45 % boys You enter a class at random with 55 % boys Is this class more likely from School A or School B?

20 marbles, randomly divided among five children I II Alan 4 4 Ben 4 4 Carl 5 4 Dan 4 4 Ed 3 4 In many rounds of random assignment, which of these results is more likely?

The End