Behavioral Economics, Problem Set #3

Behavioral Economics, Problem Set #3 /// J. R. West

Due: Before 9:30 AM on Thursday, May 27, 2021

NOTE: THIS IS DUE THE DAY OF TEST #2

You will turn this problem set in through Canvas. It must be formatted as a doc, docx, or pdf. (Please note that Microsoft pages is NOT acceptable, but you can save pages as a pdf.)

This problem set is worth 5.0 points. Problems 1, 3 and 5 are each worth .75 point, problems 2 and 4 are worth 1.0 each, and problem 6 is worth 1.25 for a possible total of 5.50 points.

Make certain all of your answers are in order, legible and show your calculations to receive full credit. The quality and thoroughness of your answers determines your grade. Your graphs must be done on graph paper, be neat, have the axes labeled, be consistent in scale and the graphs must be cut out and taped in the correct part of the problem. Graphs that are not in the right location, or put at the end of the problem set will receive NO credit. You may either write or type your problem set, or a combination of the two. If you choose to write your answers on this problem set, you must use either a different font, different color, or inset your answers so I do not need to reread the questions each time to find your answers, disguised in the same font!

You will complete and submit this problem set with your assigned group; one group member will turn in ONE copy with all of your names on the top of the problem set. The names should be: last name, first name.

        All sources must be cited. If you copy verbatim, YOU MUST USE QUOTATION MARKS. Any Internet or book source used must be cited. If you copy from or use a source and do not cite the source, you (and your group) will be given a 0 on that problem.

        You should understand the material and be able to explain it in your own words; minimal use of copying verbatim.

1. a.) Define anchoring and explain how this can affect our economic decisions.

    b.) Read Ch.6 (p. 119-135) in Dan Ariely’s book “Predictably Irrational. (This is book #5 on the reading list.) Dan Ariely and his team studied male heterosexual answers to 3 questions 1. Would you enjoy sex with someone you hate? 2. Would you slip a person a drug to increase the chance that he or she would have sex with you? 3. Would you always wear a condom? i.) What were the average answers in a calm state? ii.) And what were the average answers in a hot, aroused state?

    c.) Given the answers to b, what does Dan Ariely recommend parents and college campuses do?

    d.) i.) Cite the data Dan Ariely gives in Ch, 6 on the increased risks of teen drivers. ii.) What does Dan Ariely recommend to encourage safer driving among teenagers?

    e.) i.)Explain the confirmation bias. ii.) How can this impact stock traders? iii.) Using the confirmation bias, explain why Americans rarely change their minds on abortion.

    f.) i.) Explain the endowment effect.

        ii) Give an example using one of your possessions.

        iii.) Use the endowment concept to explain the behaviors of either dog owners or parents and why there are no overt online markets where you could trade your dog and/or child for someone else’s.

2. Read Ch. 4 on ‘The Cost of Social Norms’ (p. 75-102) in Dan Ariely’s book “Predictably Irrational. (This is book #5 on the reading list.)

    a.) Summarize the moral of Ariely’s funny Thanksgiving story.

    b.) Summarize in a table the results of the computerized circle dragging experiment where people were paid various amounts: $5, $.50 , and free.2

    c.) i.) Now draw another table to summarize the results when the circle draggers were paid with chocolate. 

ii.) What is the conclusion of the chocolates and other gifts?

    d.) In another experiment, the goal was to study how social norms become market norms. The groups rearranged scrambled sentences or had to put pieces into a square. i.) What was the observation on helpfulness among the groups? ii.) What else did the “salary” group do about seating?

    e.) Ariely includes observations on social exchanges compared to market exchanges. Explain the day care story.

    f.) Companies often try to mix the market with the social exchange. What are the advertising ploys used by State Farm and Home Depot? Cite another company and their advertising line that you have observed using the same tactics.

    g.) Why do companies see an advantage in mixing the social and the market exchanges in dealing with employees? (See p. 88-92 and 98-100)

    h.) Ariely has studied changing social market and social norms in education. What are his recommendations to improve the educational system?

3. a.) i.) Define “Framing.” ii.) Give two examples of framing.

    b.) i.) Explain “Prospect Theory”. ii.) Give two examples.

    c.) i.) Explain lack of selfcontrol, sometimes called lack of free will.

ii.) When might a person be lacking free will?

    d.) Read Case 3.1 on pages 104-5.

i.) Explain opponent process theory.

ii.) Explain what happens if a man uses anabolic steroids over time. (at least 3-4 sentences.)

iii.) Explain why it is challenging for addicts to abstain from use.

iv.) If addicts abstain for some time, what are the benefits and challenges?

v.) What is the summary phrase from Alcoholics Anonymous?

    e.) Look at Case 3.2, page 108, figure 3.7. Explain why this could be an excellent path for all people to follow when considering some of the incredibly dangerous synthetic street drugs.

4. a.) i.) ‘Explain ‘status quo bias.’ ii.) Give two examples.

    b.) i.) Explain the ‘power of free.’

ii.) Explain the quantity of free stuff most people will take when they are in a social situation or at work.

    c.) i.) Explain ‘mental accounting.’

ii.) Give 3 examples of mental accounting..

iii.) Explain how mental accounting can lead to suboptimal outcomes.

    d.) i.) Explain the phrase ‘you get what you pay for.’

ii.) Give two examples.

    e.) Explain why people tend to spend more money when they are using a credit card and tend to spend less when paying with cash.

    f.) Smart people can make stupid investments.

i.) Explain the Bernie Madoff ponzi scheme. You should look at the internet. Cite your source.

ii.) Explain the Enron scam and outcome. You should look at the internet. Cite your source.

    g) Explain the best way to handle paying your credit card bill and the worst way.

    h.) How can selective recall support bad investment decisions?

i.) Why is a preference for investing in salient firms (firms that have been prominently featured in the news) often a poor investment strategy?3

5. a.) i.) If an investor has multiple stocks showing a loss in their portfolio, and multiple stocks showing a gain, does the average investor “cut their losses and let their profits run?” Or, does the average investor sell the stock with a profit and let their losses run? Why?

ii.) Explain the ‘efficient market hypothesis.’

iii.) Does the stock market sometimes overreact?

    b.) i.) Explain the term ‘sunk cost.’

ii.) Give two examples.

iii.) Should sunk costs determine your future actions? Explain.

    c.) i.) Explain what it means to have equity in your house.

ii.) Explain both the attraction and the danger of using your house equity as an ATM.

    d.) Explain the winner’s curse at gambling or an auction.

    e.) i.) Explain time preference as regards receiving $50,000 this week vs. receiving $50,000 in 5 years.

ii.) Explain non-constant vs. constant discounting.

iii.) Explain preference reversal by looking at your evening self setting your alarm and placing it on the opposite side of the room compared to your morning self.

6. a.) i.) Explain Pareto efficiency.

ii.) Give an example of Pareto efficiency by assuming you have equally divided up a birthday cake among 12 children at the party, but then 4 more children arrive as you are putting cake on the plates.

iii.) Explain Pareto dominated.

    b.) i.) Explain the Prisoner’s Dilemma.

ii.) Draw a payoff matrix to illustrate the prisoner’s dilemma.

iii.) What is the likely outcome of the prisoner’s dilemma?

iv.) What is a Nash equilibrium?

v.) Which box in the prisoner’s dilemma represents a Nash equilibrium?

    c.) i.) Draw a payoff matrix for the Coke-Pepsi duopoly as shown on the board in class.

ii.) If Coke and Pepsi collude (which is illegal in the US,) what is the best outcome for the two of them?

iii.) If Coke cheats and lowers its price while Pepsi maintains a high price, what happens to their respective profits?

iv.) If Coke cheated and lowered its price, what will Pepsi do? What will their respective profits be?

v.) Which box represents a Nash Equilibrium?

vi.) Is this Nash equilibrium also Pareto efficient? Explain.

    d.) i.) Qwerty and Yuiop are playing the ultimatum game for $4,000. Briefly, explain the game.

ii.) If Qwerty offers Yuiop $.02 so Qwerty can keep $3,999.98, what will Yuiop likely say? Explain.

iii.) If Qwerty offers Yuiop $2,000.00, what will she likely say? Explain.

iv.) Is the first offer Pareto efficient? Explain.

v.) Is the second offer Pareto efficient? Explain