Psyc 184 Midterm 1

Economics

Study of rational choice under conditions of sarcity

Rational Choice

making self-interested chocies after weighing the costs and benefits of those choices. Rational agents always choose the action that is most self-satisfying.

Scarcity

occurs whenever there is an imbalance between what people want and what is freely available

Behavior economics

Study of choice under conditions of scarcity. Not always the best choice

Production possibilities frontier

a graph representing the maximum, efficient combinations of two goods an economy can produce given fixed resources and technology

oppurtunity cost

What you have to give up in order to gain another thing

Opportunity cost equation

OC = loss/gain

Do you want a lower number or a higher number for oppurtunity cost?

Lower

What do points inside vs outside the production possibilities curve indicate?

inside the curve = inefficient

outside the curve = unattainable

comparative advantage

the opportunity cost is lower for one person than for another

Opportunity cost equation for moving from one point to another

B - A loss/ B - A gain

Can overspecialization reduce output?

Yes, people can get sick of what they do or they feel that they’re not valued enough

Building bionicles study - How set up? results?

get paid to build legos - but amount decreases each lego you build

2 conditions: Meaningful (completed legos collected in a box), Sisyphean condition (completed legos disassembled in front of participants)

Results: lower amount of legos build for sysiphean condition

All for Naught study - How set up? Results?

get paid to find “ss” on a paper amongst random letters - pay decreases each time

Conditions: Acknowledged (participants wrote their name on the paper), ignored (participants did not write their name and was ignored), Shredded (No name, shredded paper in front of them)

Results: acknowledged had significantly more papers done per participant, ignored and shredded equal

Demand

behavior of buyers

Supply

behavior of sellers

What determines demand

Price of item

price of substitutes

price of complementary goods

tastes and preferences

income

expectations (for future)

Demand curve

slopes downwards - higher up the price is, the less willing buyers will buy

Changes in demand - price of substitutes increase

demand increase

Changes in demand - price of complementary goods increases

Demand decreases

Changes in demand - change in taste: suddenly you crave item

Demand increases

Changes in Demand - income increases

Demand increases for normal goods

Demand decreases for inferior goods

Changes in demand - price is expected to increase in the future

Demand increases

What determines supply?

Price of the item itself

Price of input goods

Technology

Expectations

Profit

Profit = revenue - costs

Supple curve

Slopes upwards because higher prices give sellers more incentive to push out more product

Changes in Supple - price of input increases

supply decreases

Changes in supply - technology improves

Supply increases

Changes in supply - Price is expected to increase in the future

Supply decreases

Market equilibrium

A situation when there is no incentive to change

Competitive market

A market with no monopolies

Determining new equilibrium - price of complementary goods increase

Demand decreases

New equilibrium - lower price and lower quantity sold

Determining new equilibrium - technology improves

Supply increases

New equilibrium - Lower Price and higher quantity sold

Determining new equilibrium - Price of substitutes increases

Demand increases

New equilibrium - Higher price and higher quantity sold

Determining new equilibrium - input prices increase

Supply decreases

New equilibrium - Higher price and lower quantity sold

Completely inelastic demand

Quantity does not change with price

perfectly elastic demand

Any increase in price causes quantity demanded to fall to sero

Completely inelastic supply

Quantity does not change with price

Perfectly elastic supply

Any decrease in price causes quantity supplied to fall to zero

Does a more horizontal line mean more or less elastic?

More elastic

Factors that obstruct market equilibria - traditional economics

Price ceiling

Price floor

Factors that obstruct behavioral economics

Prospect theory

endowment effect

Price ceiling

Maximum allowed price

Prospect theory

Utility is the value of an item in comparison to the value of an item in a different time

Losses weigh more heavily than gains

presented as an improvement to utility theory

Utility theory

Why do we prefer to have a variety of things rather than a ton of one thing?

Util

measure of consumer satisfaction

Total utility

total number of utils gained from consuming a particular quantity of a good

marginal utility

the additional number of utils gained from consuming an additional unit of good

Law of diminishing marginal utility

Total utility increases at a decreasing rate

Utility vs. prospect theory

Utility: Total utility increases at a decreasing rate

Prospect: Total utility increases at a decreasing rate, losses view heavier than gains

Weber-Fechner law

The just-noticeable difference in any variable is proportional to the magnitude of that variable. Small differences in price are noticeable in something that is priced low but not in high priced items.

The endowment effect

We value what we own more than what we do not own

No endowment for normal trades

If the item acquired is specifically meant to be traded, people are willing to give it up more easily than if it was just an item to use.

Explain a scenario when you would expect to get an endowment effect and a scenario when you would not expect to get an endowment effect.

You would expect to get an endowment effect if you were to give people items to personally keep and use whereas if you gave people items specifically made to be traded then you would not get an endowment effect. For example, if during a faire I spun a wheel to attain a free item and I got a lollipop whereas my brother got a bouncy ball, I would not likely trade with my brother because I already own a lollipop and losing that lollipop would mean much more than gaining a bouncy ball. In a different scenario where we were given tokens with varying prices that can be traded in for a monetary amount but we did not know the value of our tokens, I would more likely trade with others to attempt to get a token with a higher amount.

What about prospect theory allows it to explain the endowment effect?

Prospect theory allows the explanation for the endowment effect because prospect theory states that losses weigh more heavily than gains. Meaning that once already owning an item, losing that item has more of an impact than losing the item in a proposed trade — one you did not own. Which explains the endowment effect which is people value what they own more than what they do not.

What is likely to affect the elasticity of supply and demand?

Necessity, if consumers needs an item (medication, baby formula, gas), they are likely to keep buying that item even if prices rise a lot. Availability of substitutes - if there are other things that can replace what you need then if the prices spike, you don’t need to keep buying this product. Availability of resources for supply - no matter if a Picasso painting was $2 or $20,000,000, there would still be the same amount of supply being pushed out.

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

It can be a self-fulfilling prophecy because if the prices are expected to increase in the future then buyers will want to buy the stuff now increasing demand and suppliers will want to supply less causing demanders to be willing to pay more for limited supply — ultimately increasing the price due to behaviors caused by a prophecy. For example, toilet paper during covid. The prices were expected to go up which caused a ton of people to buy in bulk leading to excess demand causing suppliers to increase the prices.

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

The demand curve is downwards sloping because the higher the price, the less willing people are to buy that item. The supply curve is upward sloping because suppliers are not willing to push out product if it won’t produce high profit.

What happened in the building Bionicles study? What does it tell us about keeping

workers motivated and productive?

During the building bionicles study, participants were expected to build bionicles for a profit that decreased after every one completed. There were two conditions, meaningful were the completed bionicles were carefully placed in a box and sysiphean where the completed bionicles were disassembled right in front of participants. The study results showed that people in the meaningful condition were more motivated to build more bionicles. This study tells us that if workers don’t feel valued at work and they feel that no one cares about what they make or do then they are much less willing to do that work. If you want your workers to produce the best results then you need to make them feel valued.

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

good?

Production possibilities curves can lead to the conclusion that specialization is good because it reaches maximum outcome with least opportunity costs and allows for a new point beyond the production possibilities curve of just one person which was previously unattainable leading to the belief. It shows that if we have a comparative advantage over another person for making a specific thing we should only make that thing to maximize profit. Production possibilities curves help us visualize comparative advantages and also just opportunity costs.

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?

In a competitive market where there is excess supply, suppliers will compete with each other to sell their products at the lowest price just because they need to get rid of it. In a competitive market where there is excess demand, demanders will compete with each other to buy at the highest price because they are willing to pay more for what they need. A situation with excess supply or demand is not equilibrium because it creates a situation where there is incentive to change — prices will either go up or down depending on who gets the short end of the stick.

Compare and contrast utility theory and prospect theory.

Utility theory states that number of utils gained between each item decreases and that explains why we prefer to have a variety of things rather than a ton of one item and prospect theory states the same in terms of the more you have something, the less utils you’ll gain but with additional of the clause that losses weigh more heavily than gains. Utility theory is about the happiness you get from gaining items while prospect theory points out the other considerations like losses when making decisions.

What is the difference between Humans and Econs?

Econs are these fictional people created by economists that will behave based on economist predictions. They’re model humans for economist. Humans make their own decisions, they “misbehave'“ in economists eyes.

What is the difference between normative and descriptive theories?

Normative theory tell you the right way to think about some problem with logical consistency - rational choice theory. Employed by econs.

Descriptive theory in contrast is more people’s behaviors influenced by their feelings and emotions.

What are supposedly irrelevant factors (SIFs), and how does the fact that they often are

not irrelevant pose problems for traditional economic theory? What are some examples

of SIFs?

SIFs are things that abstract models made by economists that base the analysis of imaginary econs overlook. In theory SIFs are something a rational person shouldn’t care about when making an economic decision

The fact that they are often not irrelevant poses problems for traditional economic theory because economists can’t accurately predict behavior.

Some examples of SIFs are going to the hungry and buying more than you typically would, buying two items rather than one because the second item is half off even though you don’t need two. Buying something that’s pink even though it costs more because you like the color.

Why does diminishing marginal utility of wealth predict risk aversion?

The shape of the diminishing utility of wealth graph — increasing but curving downwards — suggests that your total happiness increases at a decreasing rate the wealthier you get. This can predict risk aversion because say you have $0 and someone offers you 100% chance of $1000 or 50% chance of $2000, you would choose the $1000 because that first thousand is worth a lot more than the second. Therefore, leading you to avoid risk of not getting anything.

What is the “as if” critique from traditional economics?

The ‘as if’ critique is a critique of behavior economics by traditional economics. The traditional economics say even if humans don’t understand these complex theories/analyses created by traditional economists they will behave as if they do. Saying even if they don’t understand the most rational approach they will do so anyways and reach a rational solution.

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

models?

Preference reversal is the preference of different choices depending on situation (how choices are presented and the circumstances). This poses a problem of traditional economics because they assume if the stakes are higher, people would make rational decisions but that isn’t the case. Even when stakes are high, people are unpredictable. Also this poses a problem for traditional economist because predictions rely on stability ad consistency between choices and if the choices are different depending then decisions can’r be optimized because there’s no stable preference.

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?

This criticism is incompatible with the argument that learning is also important for rational responding because psychologists suggest that people learn during situations that occur frequently and when you get immediate feedback. So if you’re in a grocery store and make a bad purchase, you are likely to learn from that because buying that item occurs frequently that the feedback, spending the money come immediately. When in a high stakes situation like buying a house, people are likely to make bad decisions or will not always react the most rationally because that is an event that does not happen frequently and therefore you have not learned the optimized strategy.

Why does having sales tend to make consumers happier than instead having an

“everyday low pricing” strategy?

Items being on sale are more enticing because the perceived quality of the good is that of the original price and it’s at a cheaper price so it is perceived as a bang for your buck whereas with everyday low pricing, the good is perceived as a lower quality good because of it’s lower original cost which is why people gain more utils from sales than just cheap items.

What is a sunk cost?

a sunk cost is money being spent that cannot be retrieved. For example, going to a casino and spending $1000 and not winning anything. Or paying for a concert but it’ll be in the rain. Economists have a theory that sunk costs will be ignored by humans but it’s not, a concert you’ve paid for but it started raining, theres a chance you’d still go even if economist say otherwise.

What contributed to people no longer paying off their home mortgages as quickly as

possible and being reluctant to having mortgage debt?

Tax reform 1986 - Reagan presidency - that made only mortgage loans tax deductible which gave incentive to banks and brokers to refinance mortgage loans for other things out side of paying for mortgage.

Why are people risk seeking for losses?

because according to the prospect loses are more detrimental than gains, however, the feelings of the loss decrease the more you lose. For example, if you were gambling and you already lost $500, you would be more willing to lose another $500 in hopes of regaining what you’ve lost. This is because that first $500 feels more detrimental than the next so people aremore likely to take the chance to get back to no loss at all.

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

model?

Principle-agent model describes relationship between principle (boss) and agent (employee) and how the principle sets a set of rules that the agent has to follow and the agent tries to maximize profit with minimal effort.

This relates to Thaler’s planner and doer model because the planner (principle) focuses on the future and the doer (agent) focuses on the present. The planner will influence the doer in regards to whats best for the future through incentives/punishment or rules/discretion but the doer will have their own conflicts of interest similar to the principle-agent theory where the principle has the best future outcome in mind while the agent will focus on theirselves and their interests could conflict.

Why are systematic errors/biases in judgment more of a problem for traditional

economic models than random errors/biases in judgment?

Truly random errors/biases can be averaged out to zero in multiple sample deeming the economic models fully rational whereas systematic errors cannot be averaged out and suggests that there are other factors at play deeming the models to be irrational.

Why is having a coupon for 50% off the next ski visit likely to be a better pricing strategy

than 50% off today?

It is a better strategy because with the same day 50% off, the buyer was already ready to pay full price and even if they thought that was super nice, it doesn’t guarantee customer loyalty because they have no incentive to come back. With having a coupon for the next ski trip, customers were still expecting to pay full price but this offer seems generous and now they’re more likely to come back.

How are perceptions of price fairness likely to be affected by what other competitors do?

Perceptions of Price Fairness: Perceptions of price fairness can be influenced by what other competitors do through the principle of reference pricing.

If competitors set prices at a certain level, consumers might use those prices as a reference point to evaluate the fairness of the price offered by another competitor. Additionally, if competitors engage in price wars or follow similar pricing strategies, it can affect consumers' perceptions of fairness and influence their purchasing decisions.

According to traditional economics, how should taxi drivers decide how many hours to work each day? What do they actually do?

Taxi drivers should work more hours on days that make more or are busier rather than days that don’t pay as much but instead they set a quoto and stop when it is met meaning they work less on good days than bad days, effectively not maximizing profit.