BEE3049 Behaviour, Decisions and Markets Miguel A. Fonseca

Some announcements Course information (slides, notes, etc.) – 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.

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.

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;

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.

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.

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: ~

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.

Rational Choice Transitivity is the toughest requirement for rationality. Why is it necessary? Suppose John’s 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!

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?

Utility Functions The first critique of rational choice came from Maurice Allais. –Consider the following choices: Choice 1 AB Prob£ £ 1£

Utility Functions CD Prob£ £ 0.1£500.11£ £0.89£0 Choice 2

Allais’ Paradox If you picked A in choice 1, then: –U(100) > 0.1 U(500) U(100) U(0) –Which means 0.11 U(100) > 0.1 U(500) U(0) Picking C in choice 2 means –0.1 U(500) U(0) > 0.11 U(100) U(0) –Which means 0.1 U(500) U(0) > 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?

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.

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.

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;

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.

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

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

Prospect Theory Individuals seem to react differently depending on the context: –Risk averse when dealing with gains –Risk seeking when dealing with losses.

Prospect Theory Gains Losses -+ U(X)

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

Mental Accounts Imagine the following situations: A.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. B.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% (N=88) of subjects were willing to drive to the other store in A, but only 29% (N=93) in B

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

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