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ECON2013

Problem Set 2

        You should attempt to answer all questions. Answers must be converted to a pdf document with the file name: u12345678ECON2013PS1.pdf (where u12345678 is your ANU id) and uploaded to Turnitin by the submission deadline. Please keep a copy of tasks completed for your records. Late submission without prior approval of Simon Grant will attract a mark of zero.

1. (30 points) Explain each of the following findings/curiosities briefly using concepts from the "Departures from Rational Choice" lectures

(a) (10 points) In an internal study, employees in an company agreed to fill out a short questionnaire for $5. At the end of the survey, respon-dents were offered a chance to exchange their $5 for a gift. Some em-ployees could exchange the money for a key-ring with a USB-memory stick, and some employeses could exchange the money for their choice of a key-ring with a USB-memory stick, or a pen inscribed with the company's logo, or a voucher for a coffee from the company's canteen. Among the employees who were offered three options for exchange, 45 percent chose to keep the money. Of the employees who were only offered one option, 30 percent chose to keep the money. Explain these differences in the observed (average) willingness to exchange.

(b) (10 Points) Sister Printers is an on-line only enterprise. It used to sell just two kinds of printers, a lower-end model for $129 and a higher-end one for $179. The lower-end model had a lower profit-margin than the higher-end model. The company then decided to add an even higher-end printer ($279) to its product line, hoping to sell more units. As it turned out, almost nobody purchased this new printer. Explain why Sister Printers decided to keep carrying the $279 printer at a loss.

(c) (10 points) A television infomercial promoting the Shamwow spends the first ten minutes trying to convince the viewer it is "infinitely better than cotton rags or clumps of paper towels for mopping up spills and keeping surfaces spick and span." It then tells you that for $19.98 you can order a regular pack of four shamwows. It finishes the infomercial by saying if you order in the next ten minutes you can get a jumbo pack of six shamwows for just $1 more. Nobody orders the regular pack. Explain why the infomercial "wastes" air-time offering the regular pack that nobody ends up ordering.

2. (40 Points) This question asks you to think about an experiment related to the endowment-effect. In this experiment half of the participants were randomly given mugs, while the other half were given pens. After the participants looked at both items, the experimenter offered to exchange each mug for a pen plus 5 cents, and each pen for a mug plus 5 cents. Only 12% of those who originally received a mug, and 10% of those who originally received a pen, chose to exchange it for the other item plus 5 cents.

(a) (10 Points) What would the standard (neoclassical) model from mi-croeconomics predict should be the outcome of this experiment? Ex-plain in words.

(b) (10 points) Explain the experimental results in terms of a reference-dependent phenomenon.

The rest of this question asks you to think about this experiment in terms of value functions. Suppose the three dimensions of choice are mugs, pens, and money, with mugs being dimension 1, pens being di-mension 2, and money being dimension 3 (with "money" interpreted as corresponding to expenditure on "all other goods"). Denote quanti-ties in mugs, pens, and money by x1; x2;and x3, respectively. Denote the three reference points in the three dimensions by r1; r2; and r3, respectively. Suppose an individual with reference points r1; r2; and r3 evaluates the bundle (x1; x2; x3) using the function:

(c) (5 points) Recall in lectures, we said a value function v over a single good exhibited loss aversion if  for all z > 0. We shall say that V (z1; z2; z3) which is defined over changes in the consumption of the three goods "mugs", "pens" and "all other goods", exhibits loss aversion if

That is, V (z1; z2; z3) exhibits loss aversion in mugs, in pens and in money.

Show that V (z1; z2; z3) indeed exhibits loss aversion( in mugs, in pens and in money).

(d) (5 points) Argue that the reference point of a participant in the experiment who is randomly allocated a mug is r1 = 1 and r2 = r3 = 0. Given this reference point, would this participant exchange the mug for a pen plus $2?

(e) (5 points) What is the reference point of an owner of a pen? That is what is r1; r2;and r3 for an owner of the pen? How much would a pen owner have to be paid to be willing to exchange her pen for a mug?

(f) (5 points) Suppose a mug owner loses $5 just before her selling price is elicited,and does not adjust her reference point in money to this situation. Would she exchange her mug for a pen plus $2? Explain the intuition.

3. (30 points) Explain the following phenomena using the idea that the carrier of value for an individual is a function of the change in his or her situation from a reference point by answering the following three questions: (i) what outcome is being evaluated in a reference-dependent way? (ii) what is the reference point?; and (iii) what feature of the value function explains the phenomenon, and how?

(a) (6 points) On the residential housing market, each seller sets an initial "asking price" for her house that can be substantially different from the final sale price. Controlling for the current market value of their house, sellers set a higher asking price, and eventually receive a higher sale price, if the housing market has gone down since they bought their house. (Houses of such sellers sit on the market for a longer time.)

(b) (6 points) After losing a bet, people often want to go "double or nothing". Winners of bets are often more reluctant to do so.

(c) (6 points) Half of the subjects in an experiment were asked to imagine that they were at the Apple Store to buy a keyboard case for their iPad for $125, and then learned that they could buy the same caser $5 cheaper at JB HiFi. However, the nearest JB HiFi store was a 20 minutes drive away. 30% said they would drive to the JB HiFi store. The other half of the subjects were asked the same question, except they were told the keyboard case cost $15. This time, 70% reported that they would drive to the other store to save $5.

(d) (6 points) Small investors tend to hold on to losing stocks (stocks that have gone down in value relative to the purchase price) and sell winning stocks (stocks that have gone up in value relative to the purchase price).

(e) (6 points) Some bidders enter an auction on Ebay planning to bid little for an item, but when they are the top bidder for a while and then are outbid, they end up bidding more (a type of "auction fever").