Chapter 5 Uncertainty and Consumer Behavior

©2005 Pearson Education, Inc. Chapter 52 Topics to be Discussed Describing Risk Preferences Toward Risk Reducing Risk The Demand for Risky Assets

©2005 Pearson Education, Inc. Chapter 53 Introduction Choice with certainty is reasonably straightforward How do we make choices when certain variables such as income and prices are uncertain (making choices with risk)?

©2005 Pearson Education, Inc. Chapter 54 Describing Risk To measure risk we must know: 1.All of the possible outcomes 2.The probability or likelihood that each outcome will occur

©2005 Pearson Education, Inc. Chapter 55 Describing Risk Interpreting Probability 1.Objective Interpretation Based on the observed frequency of past events 2.Subjective Interpretation Based on perception that an outcome will occur

©2005 Pearson Education, Inc. Chapter 56 Interpreting Probability Subjective Probability  Different information or different abilities to process the same information can influence the subjective probability  Based on judgment or experience

©2005 Pearson Education, Inc. Chapter 57 Describing Risk With an interpretation of probability, must determine 2 measures to help describe and compare risky choices 1.Expected value 2.Variability

©2005 Pearson Education, Inc. Chapter 58 Describing Risk Expected Value  The weighted average of the payoffs or values resulting from all possible outcomes Expected value measures the central tendency; the payoff or value expected on average

©2005 Pearson Education, Inc. Chapter 59 Expected Value – An Example Investment in offshore drilling exploration: Two outcomes are possible  Success – the stock price increases from $30 to $40/share  Failure – the stock price falls from $30 to $20/share

©2005 Pearson Education, Inc. Chapter 510 Expected Value – An Example Objective Probability  100 explorations, 25 successes and 75 failures  Probability (Pr) of success = 1/4 and the probability of failure = 3/4

©2005 Pearson Education, Inc. Chapter 511 Expected Value – An Example

©2005 Pearson Education, Inc. Chapter 512 Expected Value In general, for n possible outcomes:  Possible outcomes having payoffs X 1, X 2, …, X n  Probabilities of each outcome is given by Pr 1, Pr 2, …, Pr n

©2005 Pearson Education, Inc. Chapter 513 Describing Risk Variability  The extent to which possible outcomes of an uncertain event may differ  How much variation exists in the possible choice

©2005 Pearson Education, Inc. Chapter 514 Variability – An Example Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) The first job is based entirely on commission The second is a salaried position

©2005 Pearson Education, Inc. Chapter 515 There are two equally likely outcomes in the first job: $2,000 for a good sales job and $1,000 for a modestly successful one The second pays $1,510 most of the time (.99 probability), but you will earn $510 if the company goes out of business (.01 probability) Variability – An Example

©2005 Pearson Education, Inc. Chapter 516 Variability – An Example Outcome 1Outcome 2 Prob.IncomeProb.Income Job 1: Commission Job 2: Fixed Salary

©2005 Pearson Education, Inc. Chapter 517 Variability – An Example Income from Possible Sales Job Job 1 Expected Income Job 2 Expected Income

©2005 Pearson Education, Inc. Chapter 518 Variability While the expected values are the same, the variability is not Greater variability from expected values signals greater risk Variability comes from deviations in payoffs  Difference between expected payoff and actual payoff

©2005 Pearson Education, Inc. Chapter 519 Variability – An Example Deviations from Expected Income ($) Outcome 1 DeviationOutcome 2 Deviation Job 1 $2000$500$1000-$500 Job

©2005 Pearson Education, Inc. Chapter 520 Variability Average deviations are always zero so we must adjust for negative numbers We can measure variability with standard deviation  The square root of the average of the squares of the deviations of the payoffs associated with each outcome from their expected value

©2005 Pearson Education, Inc. Chapter 521 Variability Standard deviation is a measure of risk  Measures how variable your payoff will be  More variability means more risk  Individuals generally prefer less variability – less risk

©2005 Pearson Education, Inc. Chapter 522 Variability The standard deviation is written:

©2005 Pearson Education, Inc. Chapter 523 Standard Deviation – Example 1 Deviations from Expected Income ($) Outcome 1 DeviationOutcome 2 Deviation Job 1 $2000$500$1000-$500 Job

©2005 Pearson Education, Inc. Chapter 524 Standard Deviation – Example 1 Standard deviations of the two jobs are:

©2005 Pearson Education, Inc. Chapter 525 Standard Deviation – Example 1 Job 1 has a larger standard deviation and therefore it is the riskier alternative The standard deviation also can be used when there are many outcomes instead of only two

©2005 Pearson Education, Inc. Chapter 526 Standard Deviation – Example 2 Job 1 is a job in which the income ranges from $1000 to $2000 in increments of $100 that are all equally likely Job 2 is a job in which the income ranges from $1300 to $1700 in increments of $100 that, also, are all equally likely

©2005 Pearson Education, Inc. Chapter 527 Outcome Probabilities - Two Jobs Income 0.1 $1000$1500$ Job 1 Job 2 Job 1 has greater spread: greater standard deviation and greater risk than Job 2. Probability

©2005 Pearson Education, Inc. Chapter 528 Decision Making – Example 1 What if the outcome probabilities of two jobs have unequal probability of outcomes?  Job 1: greater spread and standard deviation  Peaked distribution: extreme payoffs are less likely that those in the middle of the distribution  You will choose job 2 again

©2005 Pearson Education, Inc. Chapter 529 Unequal Probability Outcomes Job 1 Job 2 The distribution of payoffs associated with Job 1 has a greater spread and standard deviation than those with Job 2. Income 0.1 $1000$1500$ Probability

©2005 Pearson Education, Inc. Chapter 530 Decision Making – Example 2 Suppose we add $100 to each payoff in Job 1 which makes the expected payoff = $1600  Job 1: expected income $1,600 and a standard deviation of $500  Job 2: expected income of $1,500 and a standard deviation of $99.50

©2005 Pearson Education, Inc. Chapter 531 Decision Making – Example 2 Which job should be chosen?  Depends on the individual  Some may be willing to take risk with higher expected income  Some will prefer less risk even with lower expected income

©2005 Pearson Education, Inc. Chapter 532 Risk and Crime Deterrence Attitudes toward risk affect willingness to break the law Suppose a city wants to deter people from double parking Monetary fines may be better than jail time

©2005 Pearson Education, Inc. Chapter 533 Risk and Crime Deterrence Costs of apprehending criminals are not zero, therefore  Fines must be higher than the costs to society  Probability of apprehension is actually less than one

©2005 Pearson Education, Inc. Chapter 534 Risk and Crime Deterrence - Example Assumptions: 1.Double-parking saves a person $5 in terms of time spent searching for a parking space 2.The driver is risk neutral 3.Cost of apprehension is zero

©2005 Pearson Education, Inc. Chapter 535 Risk and Crime Deterrence - Example A fine greater than $5.00 would deter the driver from double parking  Benefit of double parking ($5) is less than the cost ($6.00) equals a net benefit that is negative  If the value of double parking is greater than $5.00, then the person would still break the law

©2005 Pearson Education, Inc. Chapter 536 Risk and Crime Deterrence - Example The same deterrence effect is obtained by either  A $50 fine with a 0.1 probability of being caught resulting in an expected penalty of $5 or  A $500 fine with a 0.01 probability of being caught resulting in an expected penalty of $5

©2005 Pearson Education, Inc. Chapter 537 Risk and Crime Deterrence - Example Enforcement costs are reduced with high fine and low probability Most effective if drivers don’t like to take risks

©2005 Pearson Education, Inc. Chapter 538 Preferences Toward Risk Can expand evaluation of risky alternative by considering utility that is obtained by risk  A consumer gets utility from income  Payoff measured in terms of utility

©2005 Pearson Education, Inc. Chapter 539 Preferences Toward Risk - Example A person is earning $15,000 and receiving 13.5 units of utility from the job She is considering a new, but risky job  0.50 chance of $30,000  0.50 chance of $10,000

©2005 Pearson Education, Inc. Chapter 540 Preferences Toward Risk - Example Utility at $30,000 is 18 Utility at $10,000 is 10 Must compare utility from the risky job with current utility of 13.5 To evaluate the new job, we must calculate the expected utility of the risky job

©2005 Pearson Education, Inc. Chapter 541 Preferences Toward Risk The expected utility of the risky option is the sum of the utilities associated with all her possible incomes weighted by the probability that each income will occur E(u) = (Prob. of Utility 1) *(Utility 1) + (Prob. of Utility 2)*(Utility 2)

©2005 Pearson Education, Inc. Chapter 542 Preferences Toward Risk – Example The expected is: E(u) = (1/2)u($10,000) + (1/2)u($30,000) = 0.5(10) + 0.5(18) = 14  E(u) of new job is 14, which is greater than the current utility of 13.5 and therefore preferred

©2005 Pearson Education, Inc. Chapter 543 Preferences Toward Risk People differ in their preference toward risk People can be risk averse, risk neutral, or risk loving

©2005 Pearson Education, Inc. Chapter 544 Preferences Toward Risk Risk Averse  A person who prefers a certain given income to a risky income with the same expected value  The person has a diminishing marginal utility of income  Most common attitude towards risk Ex: Market for insurance

©2005 Pearson Education, Inc. Chapter 545 Risk Averse - Example A person can have a $20,000 job with 100% probability and receive a utility level of 16 The person could have a job with a 0.5 chance of earning $30,000 and a 0.5 chance of earning $10,000

©2005 Pearson Education, Inc. Chapter 546 Risk Averse – Example Expected Income of Risky Job E(I) = (0.5)($30,000) + (0.5)($10,000) E(I) = $20,000 Expected Utility of Risky Job E(u) = (0.5)(10) + (0.5)(18) E(u) = 14

©2005 Pearson Education, Inc. Chapter 547 Risk Averse – Example Expected income from both jobs is the same – risk averse may choose current job Expected utility is greater for certain job  Would keep certain job Risk averse person’s losses (decreased utility) are more important than risky gains

©2005 Pearson Education, Inc. Chapter 548 Risk Averse Can see risk averse choices graphically Risky job has expected income = $20,000 with expected utility = 14  Point F Certain job has expected income = $20,000 with utility = 16  Point D

©2005 Pearson Education, Inc. Chapter 549 Income ($1,000) Utility The consumer is risk averse because she would prefer a certain income of $20,000 to an uncertain expected income = $20,000 E A C D Risk Averse Utility Function F

©2005 Pearson Education, Inc. Chapter 550 Preferences Toward Risk A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value Constant marginal utility of income

©2005 Pearson Education, Inc. Chapter 551 Risk Neutral Expected value for risky option is the same as utility for certain outcome E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000 E(u) = (0.5)(6) + (0.5)(18) = 12 This is the same as the certain income of $20,000 with utility of 12

©2005 Pearson Education, Inc. Chapter 552 Income ($1,000) 1020 Utility A E C The consumer is risk neutral and is indifferent between certain events and uncertain events with the same expected income. Risk Neutral

©2005 Pearson Education, Inc. Chapter 553 Preferences Toward Risk A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value  Examples: Gambling, some criminal activities Increasing marginal utility of income

©2005 Pearson Education, Inc. Chapter 554 Risk Loving Expected value for risky option – point F E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000 E(u) = (0.5)(3) + (0.5)(18) = 10.5 Certain income is $20,000 with utility of 8 – point C Risky alternative is preferred

©2005 Pearson Education, Inc. Chapter 555 Income ($1,000) Utility The consumer is risk loving because she would prefer the gamble to a certain income. Risk Loving 3 A E C 8 18 F 10.5

©2005 Pearson Education, Inc. Chapter 556 Preferences Toward Risk The risk premium is the maximum amount of money that a risk-averse person would pay to avoid taking a risk The risk premium depends on the risky alternatives the person faces

©2005 Pearson Education, Inc. Chapter 557 Risk Premium – Example From the previous example  A person has a.5 probability of earning $30,000 and a.5 probability of earning $10,000  The expected income is $20,000 with expected utility of 14

©2005 Pearson Education, Inc. Chapter 558 Risk Premium – Example Point F shows the risky scenario – the utility of 14 can also be obtained with certain income of $16,000 This person would be willing to pay up to $4000 (20 – 16) to avoid the risk of uncertain income Can show this graphically by drawing a straight line between the two points – line CF

©2005 Pearson Education, Inc. Chapter 559 Income ($1,000) Utility Here, the risk premium is $4,000 because a certain income of $16,000 gives the person the same expected utility as the uncertain income with expected value of $20, A C E G 20 Risk Premium F Risk Premium – Example

©2005 Pearson Education, Inc. Chapter 560 Risk Aversion and Income Variability in potential payoffs increases the risk premium Example:  A job has a.5 probability of paying $40,000 (utility of 20) and a.5 chance of paying 0 (utility of 0).

©2005 Pearson Education, Inc. Chapter 561 Risk Aversion and Income Example (cont.):  The expected income is still $20,000, but the expected utility falls to 10 E(u) = (0.5)u($0) + (0.5)u($40,000) = 0 +.5(20) = 10  The certain income of $20,000 has utility of 16  If person must take new job, their utility will fall by 6

©2005 Pearson Education, Inc. Chapter 562 Risk Aversion and Income Example (cont.):  They can get 10 units of utility by taking a certain job paying $10,000  The risk premium, therefore, is $10,000 (i.e. they would be willing to give up $10,000 of the $20,000 and have the same E(u) as the risky job

©2005 Pearson Education, Inc. Chapter 563 Risk Aversion and Income The greater the variability, the more the person would be willing to pay to avoid the risk, and the larger the risk premium

©2005 Pearson Education, Inc. Chapter 564 Risk Aversion and Indifference Curves Can describe a person’s risk aversion using indifference curves that relate expected income to variability of income (standard deviation) Since risk is undesirable, greater risk requires greater expected income to make the person equally well off Indifference curves are therefore upward sloping

©2005 Pearson Education, Inc. Chapter 565 Risk Aversion and Indifference Curves Standard Deviation of Income Expected Income Highly Risk Averse: An increase in standard deviation requires a large increase in income to maintain satisfaction. U1U1 U2U2 U3U3

©2005 Pearson Education, Inc. Chapter 566 Risk Aversion and Indifference Curves Standard Deviation of Income Expected Income Slightly Risk Averse: A large increase in standard deviation requires only a small increase in income to maintain satisfaction. U1U1 U2U2 U3U3

©2005 Pearson Education, Inc. Chapter 567 Reducing Risk Consumers are generally risk averse and therefore want to reduce risk Three ways consumers attempt to reduce risk are: 1.Diversification 2.Insurance 3.Obtaining more information

©2005 Pearson Education, Inc. Chapter 568 Reducing Risk Diversification  Reducing risk by allocating resources to a variety of activities whose outcomes are not closely related Example:  Suppose a firm has a choice of selling air conditioners, heaters, or both  The probability of it being hot or cold is 0.5  How does a firm decide what to sell?

©2005 Pearson Education, Inc. Chapter 569 Income from Sales of Appliances Hot Weather Cold Weather Air conditioner sales $30,000$12,000 Heater sales12,00030,000

©2005 Pearson Education, Inc. Chapter 570 Diversification – Example If the firm sells only heaters or air conditioners their income will be either $12,000 or $30,000 Their expected income would be:  1/2($12,000) + 1/2($30,000) = $21,000

©2005 Pearson Education, Inc. Chapter 571 Diversification – Example If the firm divides their time evenly between appliances, their air conditioning and heating sales would be half their original values If it were hot, their expected income would be $15,000 from air conditioners and $6,000 from heaters, or $21,000 If it were cold, their expected income would be $6,000 from air conditioners and $15,000 from heaters, or $21,000

©2005 Pearson Education, Inc. Chapter 572 Diversification – Example With diversification, expected income is $21,000 with no risk Better off diversifying to minimize risk Firms can reduce risk by diversifying among a variety of activities that are not closely related

©2005 Pearson Education, Inc. Chapter 573 Reducing Risk – The Stock Market If invest all money in one stock, then take on a lot of risk  If that stock loses value, you lose all your investment value Can spread risk out by investing in many different stocks or investments  Ex: Mutual funds

©2005 Pearson Education, Inc. Chapter 574 Reducing Risk – Insurance Risk averse are willing to pay to avoid risk If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss

©2005 Pearson Education, Inc. Chapter 575 The Decision to Insure

©2005 Pearson Education, Inc. Chapter 576 Reducing Risk – Insurance For the risk averse consumer, guarantee of same income regardless of outcome has higher utility than facing the probability of risk Expected utility with insurance is higher than without

©2005 Pearson Education, Inc. Chapter 577 The Law of Large Numbers Insurance companies know that although single events are random and largely unpredictable, the average outcome of many similar events can be predicted When insurance companies sell many policies, they face relatively little risk

©2005 Pearson Education, Inc. Chapter 578 Reducing Risk – Actuarially Fair Insurance companies can be sure total premiums paid will equal total money paid out Companies set the premiums so money received will be enough to pay expected losses

©2005 Pearson Education, Inc. Chapter 579 Reducing Risk – Actuarially Fair Some events with very little probability of occurrence such as floods and earthquakes are no longer insured privately  Cannot calculate true expected values and expected losses  Governments have had to create insurance for these types of events Ex: National Flood Insurance Program

©2005 Pearson Education, Inc. Chapter 580 The Value of Information Risk often exists because we don’t know all the information surrounding a decision Because of this, information is valuable and people are willing to pay for it

©2005 Pearson Education, Inc. Chapter 581 The Value of Information The value of complete information  The difference between the expected value of a choice with complete information and the expected value when information is incomplete

©2005 Pearson Education, Inc. Chapter 582 The Value of Information – Example Per capita milk consumption has fallen over the years The milk producers engaged in market research to develop new sales strategies to encourage the consumption of milk

©2005 Pearson Education, Inc. Chapter 583 The Value of Information – Example Findings  Milk demand is seasonal with the greatest demand in the spring  Price elasticity of demand is negative and small  Income elasticity is positive and large

©2005 Pearson Education, Inc. Chapter 584 The Value of Information – Example Milk advertising increases sales most in the spring Allocating advertising based on this information in New York increased profits by 9% or $14 million The cost of the information was relatively low, while the value was substantial (increased profits)

©2005 Pearson Education, Inc. Chapter 585 Demand for Risky Assets Most individuals are risk averse and yet choose to invest money in assets that carry some risk  Why do they do this?  How do they decide how much risk to bear? Must examine the demand for risky assets

©2005 Pearson Education, Inc. Chapter 586 The Demand for Risky Assets Assets  Something that provides a flow of money or services to its owner Ex: homes, savings accounts, rental property, shares of stock  The flow of money or services can be explicit (dividends) or implicit (capital gain)

©2005 Pearson Education, Inc. Chapter 587 The Demand for Risky Assets Capital Gain  An increase in the value of an asset Capital loss  A decrease in the value of an asset

©2005 Pearson Education, Inc. Chapter 588 Risky and Riskless Assets Risky Asset  Provides an uncertain flow of money or services to its owner  Examples Apartment rent, capital gains, corporate bonds, stock prices Don’t know with certainty what will happen to the value of a stock

©2005 Pearson Education, Inc. Chapter 589 Risky and Riskless Assets Riskless Asset  Provides a flow of money or services that is known with certainty  Examples Short-term government bonds, short-term certificates of deposit

©2005 Pearson Education, Inc. Chapter 590 The Demand for Risky Assets People hold assets because of the monetary flows provided To compare assets, one must consider the monetary flow relative to the asset’s price (value) Return on an asset  The total monetary flow of an asset, including capital gains or losses, as a fraction of its price

©2005 Pearson Education, Inc. Chapter 591 The Demand for Risky Assets Individuals hope to have an asset that has returns larger than the rate of inflation  Want to have greater purchasing power Real Return of an Asset (inflation adjusted)  The simple (or nominal) return less the rate of inflation

©2005 Pearson Education, Inc. Chapter 592 The Demand for Risky Assets Since returns are not known with certainty, investors often make decisions based on expected returns Expected Return  Return that an asset should earn on average  In the end, the actual return could be higher or lower than the expected return

©2005 Pearson Education, Inc. Chapter 593 Investments – Risk and Return ( )

©2005 Pearson Education, Inc. Chapter 594 The Demand for Risky Assets The higher the return, the greater the risk Investors will choose lower return investments in order to reduce risk A risk-averse investor must balance risk relative to return  Must study the trade-off between return and risk

©2005 Pearson Education, Inc. Chapter 595 Trade-offs: Risk and Returns Example An investor is choosing between T-Bills and stocks: 1.T-bills – riskless 2.Stocks – risky Investor can choose only T-bills, only stocks, or some combination of both

©2005 Pearson Education, Inc. Chapter 596 Trade-offs: Risk and Returns Example R f = risk-free return on T-bill  Expected return equals actual return on a riskless asset R m = the expected return on stocks r m = the actual returns on stock Assume R m > R f or no risk averse investor would buy the stocks

©2005 Pearson Education, Inc. Chapter 597 Trade-offs: Risk and Returns Example How do we determine the allocation of funds between the two choices?  b = fraction of funds placed in stocks  (1-b) = fraction of funds placed in T-bills Expected return on portfolio is weighted average of expected return on the two assets

©2005 Pearson Education, Inc. Chapter 598 Trade-offs: Risk and Returns Example Assume, R m = 12%, R f = 4%, and b = 1/2

©2005 Pearson Education, Inc. Chapter 599 Trade-offs: Risk and Returns Example How risky is the portfolio?  As stated before, one measure of risk is standard deviation  Standard deviation of the risky asset,  m  Standard deviation of risky portfolio,  p  Can show that:

©2005 Pearson Education, Inc. Chapter 5100 Trade-offs: Risk and Returns Example We still need to figure out the allocation between the investment choices A type of budget line can be constructed describing the trade-off between risk and expected return

©2005 Pearson Education, Inc. Chapter 5101 Trade-offs: Risk and Returns Example Expected return on the portfolio, r p increases as the standard deviation,  p of that return increases

©2005 Pearson Education, Inc. Chapter 5102 Trade-offs: Risk and Returns Example The slope of the line is called the price of risk  Tells how much extra risk an investor must incur to enjoy a higher expected return

©2005 Pearson Education, Inc. Chapter 5103 Choosing Between Risk and Return If all funds are invested in T-bills (b=0), expected return is R f If all funds are invested in stocks (b=1), expected return is R m but with standard deviation of  m Funds may be invested between the assets with expected return between R f and R m, with standard deviation between  m and 0

©2005 Pearson Education, Inc. Chapter 5104 Choosing Between Risk and Return We can draw indifference curves showing combinations of risk and return that leave an investor equally satisfied Comparing the payoffs and risk between the two investment choices and the preferences of the investor, the optimal portfolio choice can be determined Investor wants to maximize utility within the “affordable” options

©2005 Pearson Education, Inc. Chapter 5105 Choosing Between Risk and Return Expected Return,R p U 2 is the optimal choice since it gives the highest return for a given risk and is still affordable RfRf Budget Line RmRm R*R* U2U2 U1U1 U3U3

©2005 Pearson Education, Inc. Chapter 5106 Choosing Between Risk and Return Different investors have different attitudes toward risk If we consider a very risk averse investor (A)  Portfolio will contain mostly T-bills and less in stock, with return slightly larger than R f If we consider a riskier investor (B)  Portfolio will contain mostly stock and less T-bills, with a higher return R b but with higher standard deviation

©2005 Pearson Education, Inc. Chapter 5107 The Choices of Two Different Investors Expected Return,R p Given the same budget line, investor A chooses low return/low risk, while investor B chooses high return/high risk. UAUA RARA UBUB RfRf Budget line RmRm RBRB

©2005 Pearson Education, Inc. Chapter 5108 Investing in the Stock Market In 1990’s many people began investing in the stock market for the first time  Percent of US families who had directly or indirectly invested in the stock market 1989 = 32% 1998 = 49%  Percent with share of wealth in stock market 1989 = 26% 1998 = 54%

©2005 Pearson Education, Inc. Chapter 5109 Investing in the Stock Market Why were stock market investments increasing during the 90’s?  Ease of online trading  Significant increase in stock prices during late 90’s  Employers shifting to self-directed retirement plans  Publicity for “do it yourself” investing

©2005 Pearson Education, Inc. Chapter 5110 Behavioral Economics Sometimes individuals’ behavior contradicts basic assumptions of consumer choice  More information about human behavior might lead to better understanding  This is the objective of behavioral economics Improving understanding of consumer choice by incorporating more realistic and detailed assumptions regarding human behavior

©2005 Pearson Education, Inc. Chapter 5111 Behavioral Economics There are a number of examples of consumer choice contradictions  You take at trip and stop at a restaurant that you will most likely never stop at again. You still think it fair to leave a 15% tip rewarding the good service.  You choose to buy a lottery ticket even though the expected value is less than the price of the ticket

©2005 Pearson Education, Inc. Chapter 5112 Behavioral Economics Reference Points  Economists assume that consumers place a unique value on the goods/services purchased  Psychologists have found that perceived value can depend on circumstances You are able to buy a ticket to the sold out Cher concert for the published price of $125. You find out you can sell the ticket for $500 but you choose not to, even though you would never have paid more than $250 for the ticket.

©2005 Pearson Education, Inc. Chapter 5113 Behavioral Economics Reference Points (cont.)  The point from which an individual makes a consumption decision  From the example, owning the Cher ticket is the reference point Individuals dislike losing things they own They value items more when they own them than when they do not Losses are valued more than gains Utility loss from selling the ticket is greater than original utility gain from purchasing it

©2005 Pearson Education, Inc. Chapter 5114 Behavioral Economics Experimental Economics  Students were divided into two groups  Group one was given a mug with a market value of $5.00  Group two received nothing  Students with mugs were asked how much they would take to sell the mug back Lowest price for mugs, on average, was $7.00

©2005 Pearson Education, Inc. Chapter 5115 Behavioral Economics Experimental Economics (cont.)  Group without mugs was asked minimum amount of cash they would except in lieu of the mug On average willing to accept $3.50 instead of getting the mug  Group one had reference point of owning the mug  Group two had reference point of no mug

©2005 Pearson Education, Inc. Chapter 5116 Behavioral Economics Fairness  Individuals often make choices because they think they are fair and appropriate Charitable giving, tipping in restaurants  Some consumers will go out of their way to punish a store they think is “unfair” in their pricing  Manager might offer higher than market wages to make for happier working environment or more productive worker

©2005 Pearson Education, Inc. Chapter 5117 Behavioral Economics The Laws of Probability  Individuals don’t always evaluate uncertain events according to the laws of probability  Individuals also don’t always maximize expected utility  Law of small numbers Overstate probability of an event when faced with little information Ex: overstate likelihood they will win the lottery

©2005 Pearson Education, Inc. Chapter 5118 Behavioral Economics Theory up to now has explained much but not all of consumer choice Although not all of consumer decisions can be explained by the theory up to this point, it helps us understand much of it Behavioral economics is a developing field to help explain and elaborate on situations not well explained by the basic consumer model