midterm 1 study guide

Explain a scenario when you would expect to get an endowment effect and a scenario when you wouldn't expect to get an endowment effect

endowment effect: subscribe to a 30-day free trial for a streaming service

• after finishing trial, you wouldn’t be willing to unsubscribe since you’ve already taken ownership of it

no endowment effect: have a 20 dollar bill in wallet

• you know it’s a regular bill and it’s going to be used/traded to buy something —> no emotional attachment to it

What about prospect theory allows it to explain endowment effect?

prospect theory: losses are especially psychologically impactful

• seen in endowment effect where giving up something would put you in the steep loss region

  • getting something what you don’t have yet would put you in gain region —> isn’t as psychologically impactful

What is likely to affect elasticity of supply and demand?

elasticity of demand: if that product is a necessity (e.g. an EpiPen)

elasticity of supply: how easily producers can produce the product (e.g. an original Picasso painting)

Why can expectations about future prices be a self-fulfilling prophecy?

knowledge of future prices changes current behaviors in a way that pushes price to the expected

• prices expected to go up in future —> consumers buy rn with lower price —> push demand up

• producers want to supply more when prices are higher —> reduce current supply

  • new equilibrium: higher price

Why is the demand curve downward sloping and the supply curve upward sloping?

demand: consumers are willing to buy more products when prices are lower

supply: producers are more willing to supply more when prices are higher

What happened in the building Bionicles study? What does it tell us about keeping workers motivated and productive?

participants paid to build Legos, paid less for every new one they build

• two conditions: meaningful and Sisyphean condition

• meaningful: completed Bionicles put in a box

• Sisyphean: disassembled in front of participants

• participants in meaningful built more than the ones in the Sisyphean

• —> workers need to find meaning in task to be motivated and productive

How can production possibilities curves lead to the conclusion that specialization is good?

different people have different PPCs, reflects different opportunity costs

• through trade and specialization —> can move to a previously unattainable point

Describe what happens in a competitive market when there is excess supply or excess demand? Why is a situation with excess supply or demand not an equilibrium?

excess supply: more quantity supplied than quantity demanded —> sellers compete with each other

excess demand: more quantity demanded than quantity supplied —> consumers compete with each other

equilibrium: no incentive to change

• in excess supply or demand, consumers or sellers have incentives to adjust behaviors

Compare and contrast utility theory and prospect theory

both deals with concept of utility: happiness

utility theory: people make choices to maximize utility

prospect theory: utility is evaluated with respect to a reference point

What is the difference between Humans and Econs?

Econs: fictional creatures that economist models replace humans with

• Unlike Econs, Humans do a lot of misbehaving

What is the difference between normative and descriptive theories?

Normative theories: how people should behave if they were perfectly rational

Descriptive theories: how people actually behave in the real world

What are supposedly irrelevant factors (SIFs), and how does the fact that they often are not irrelevant pose problems traditional economic theory? What are some examples of SIFs?

SIFs: things that in theory that shouldn’t affect a rational person’s behaviors, but in reality does.

traditional economic theories: as long as errors caused by SIFs are random, they will cancel each other out and can be ignored

• errors don’t cancel out because they are systematic, not random

Examples:

• preferring exam scores to be out of 132 instead of 100 even if the percentage is the same

  • buying a big portion for Tuesday when shopping for groceries on Sunday because you’re hungry

Why does diminishing marginal utility of wealth predict risk aversion?

Diminishing marginal utility of wealth: utility increases as one gets wealthier but at a decreasing rate

• risk aversion: utility lost from losing certain amount of wealth > utility from gaining that same amount

What is the "as if" critique from traditional economics?

Even if people aren’t capable of solving complex problems that economists assume they can handle, they behave “as if” they can.

What is a preference reversal, and why do they pose a problem for traditional economic models?

Preference reversal: phenomenon was revealed when subjects were induced to say that they preferred option A over B and then again that they preferred option B over A.

• traditional economic models assumes that everyone has well-defined/consistent preferences —> models are inaccurate

Traditional economists often say that if the stakes are high enough people will respond rationally. How is this criticism incompatible with the argument that learning is also important for rational responding?

learning requires repetition and feedback

• low stake items allow this opportunity

• high stake decisions are usually rare and often only get one-shot at making

Why does having sales tend to make consumers happier than instead having an “everyday low pricing” strategy?

People prefer to see the deal they’re getting

• with everyday low pricing, amount of money you save is small and largely invisible

What is a sunk cost?

Money that has already been spent and can’t be recovered

What contributed to people no longer paying off their home mortgages as quickly as possible and being reluctant to having mortgage debt?

mortgage brokers made process of refinancing easier, allowing homeowners to borrow against increased home equity

• used homes like ATMs to finance consumption like cars —> less reluctant to carry mortgage debt

Why are people risk seeking for losses?

pain of sure loss feels worse than potential gain of a gamble

What is a principal-agent model, and how does this relate to Thaler's planner and doer model?

Principal-agent model: principal (employer) wants something done and agent (employee) takes actions to achieve it

• problem: agent’s interest might differ from principal’s —> act in ways that don’t align with principal’s goals

Panner and doer: planner is like principal, cares about future, doer is like the agent, focuses on the present

Why are systematic errors/biases in judgment more of a problem for traditional economic models than random errors/biases in judgment?

random errors cancel out over time, whereas systematic errors in judgement cause economic models to consistently mispredict behavior

low-hanging-fruit principle

low fruit is easier to get and will be collected first

• explains why opportunity cost tends to increase with increased output

Adam Smith’s pin factory illustrates

increased specialization —> greater productivity

traditional economics vs behavioral economics

traditional: choices are always rational

behavioral: choices aren’t always rational

why greater specialization ≠ greater output

work on task too long —> lose meaning —> lose motivation

supply

upward sloping

• quantity supplied increases with increasing price

demand

downward sloping

• quantity demanded decreases with increasing price

excess supply

sellers compete against each other until price decreases

excess demand

cosnumers compete against each other until price increases

transaction utility vs acquisition utility

transaction: difference between reference price and actual price paid

acquisition: perceived value of product’s feature and performance

permanent income hypothesis

consumption depends on long-term expected income, not current income

life-cycle hypothesis

people plan consumption and savings over lifetime

Robert Barro’s model (Ricardian Equivalence)

consumers are forward-looking and anticipate future tax increases (government)

endowment effect doesn’t apply for

normal trades

• e.g. buying groceries

points on PPC

inside curve: inefficient

on curve: efficient

outside: unattainable

• reached by specialization