Exploring Behavioral Economics

1. Richard Thaler is an economist who has argued that people are not rational in the way that economic theory assumes that they are.

a) Find out who he is by searching on the internet.
b) Two concepts that he has help publicize are the "status quo bias" and "loss aversion." Search the internet to discover how these concepts are defined and, if possible, give examples.
c) Why do these concepts present problems for the way economists usually develop the theory of rational consumer choice?

2. In the Odyssey, the hero Odysseus wants to hear the song of the sirens that lures all sailors who hear it to their deaths. Odysseus is able to hear it and avoid death by having his crew tie him to the mast and promise not to obey any of his orders while near the island. The crew avoids temptation by stopping up their ears with beeswax. Economists see in this story a metaphor for the conflict that many of us have between our impulsive selves, which is concerned only for the moment, and our more reflective selves, which takes a longer-run view of our welfare. Odysseus' solution is to have his reflective self make a pre-commitment that limits the choice of his impulsive self. See if you can see something similar in the following situations.

a. Every spring people in the U.S. compute their income taxes. Many people are delighted when they find that they are getting a refund. Why should the refund be a cause of sorrow rather than a cause for rejoicing?
One large company that prepares taxes returns offers its customers an "instant tax rebate." This tax rebate is actually a loan that is repaid when the U.S. government issues the rebate payment. The loan carries a rather high rate of interest, but because it is a very short-term loan, the cost of the loan in dollars does not seem very large. Does the pattern of overpaying taxes throughout the year and then borrowing against the rebate make any sense? Why do so many people do it?1
b. Many years ago, before credit cards and when people were much poorer than they are today, people would enrolled in Christmas savings plans that paid no interest. These plans were agreements with a retailer (usually) to put aside a dollar or two a week for several months, but there was a heavy penalty if a person missed a payment. The idea was that if all the payments were made, the person would have accumulated enough to buy Christmas presents. Why would anyone enter into an agreement that only has penalties and no rewards, and that could be accomplished simply by putting a dollar or two in the cookie jar each week?
c. John Hatfield is saving for his dream vehicle, a $20000 motorcycle. He puts money into a separate "motorcycle" account and now has $7000 in it earning 2.5% interest. His wife recently became ill and incurred $4000 in medical bills not covered by insurance. The Hatfields have paid this bill using their credit card that charges 15% interest.
i) Are the Hatfields behaving rationally according to the logic of economics? Explain.
ii) Do substantial numbers of people act like the Hatfields? What evidence do you have?
iii) How would the ideas of quasi-rationality explain the way the Hatfields are managing their finances?

3. On Monday you lost $100 at 10:00 in the morning. At 3:00 in the afternoon you found the $100 again. Would you end the day slightly happy, slightly sad, or neutral? On Tuesday you found a $100 at 10:00 in the morning but at 3:00 in the afternoon you lost it. Would you be happier or sadder at the end of the day Tuesday than you had been at the end of the day on Monday? Is your answer the answer you would get from economics, noting that in both days you came out even?

4. A favorite promotional device of retailers is the buy-one-get-something-free promotion. For example, if you buy a computer, you might get a free printer and a free camera. Can you think of examples of this promotion that you have seen recently?
Our rational side should see that there is nothing free. The products are bundled and the price is for the bundle. Why then does this promotion keep being used?

5. There have been experiments in which half of a class is randomly given coffee mugs and then the students are allowed to trade. We would expect that people who place little value on the mugs would want to sell them if they received them, and that people who placed more value on them would be willing to buy them if they did not receive them. What would the best guess be about what percentage of the mugs would be exchanged if people act in the way economists expect?
In fact, few mugs were exchanged. How could we explain this failure to trade based on the ideas of quasi-rationality?

6. In experiments people are offered a choice of two tickets, one that has a 9/10 chance of earning $3.00 and the other with a 1/10 chance of earning $30. Most people will choose the first ticket. However, when people are asked what the fair prices of these two tickets are, most will price the second one higher than the first. Are people consistent here? How might we explain this result?

1A tax preparer told me that the instant loan is arranged through a bank and is not granted by the tax-preparing company. Also, she said that the instant loans are far more common with clients who are getting money that they never paid to the government, such as money from the Earned Income Tax Credit, rather than getting a refund of withheld tax. Can you see how the concept of loss aversion explains the difference?

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