week2a - Utility maximization ECON 404 Behavioral Economics 1 Econ 404 Brian W Rogers 2015 by Brian W Rogers Roadmap Equilibrium Rationality Beliefs

week2a - Utility maximization ECON 404 Behavioral Economics...

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© 2015 by Brian W. Rogers ECON 404 Behavioral Economics Utility maximization
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Econ 404 – Brian W. Rogers 3 Roadmap •Equilibrium Rationality Beliefs Collective versus individual outcomes •Choices and the model of utility maximization
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Econ 404 – Brian W. Rogers 4 Recap of Thursday •Economic models of multiple agents involve equilibrium •Understanding how equilibrium definitions relate to rationality is imperative to understanding the role of behavioral considerations within economics •Nash equilibrium is more than individual rationality Issue 1: rationality of others (p-Beauty contest) Issue 2: multiplicity (coordination game) …
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Econ 404 – Brian W. Rogers 5 Rationality in the p-Beauty Contest: Nagel (1995) •Most people do not choose the equilibrium action p=1/2 p=2/3 •What would a rational player do if she foresaw these outcomes?
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Econ 404 – Brian W. Rogers 6 Coordination game •Two Nash equilibria? (ET, ET) and (ND, ND) •What should a rational player choose? •There is no clear answer Rationality alone is not enough 2, 1 0, 0 0, 0 1, 2 Friend 1 Friend 2 Eiffel Tower Notre Dame Eiffel Tower Notre Dame
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Econ 404 – Brian W. Rogers 7 Beliefs in equilibrium •Equilibrium requires also that beliefs about others’ play is accurate How such beliefs come about is not obvious But it has solid foundations, under certain conditions •Both ET and ND are equilibrium actions in the coordination game But not all outcomes are equilibrium outcomes! (ET, ET) is an equilibrium (ET, ND) is not
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Econ 404 – Brian W. Rogers 8 Implications (and not) of equilibrium •Nash equilibrium in the Prisoners’ Dilemma is about the difference between individual rationality – our main assumption, and Collective rationality (Pareto efficiency), which occurs only under special circumstances •Key point: (Individual) rationality need not imply (collectively) good outcomes!
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Econ 404 – Brian W. Rogers 9 Fire! •Fire in a theater game: •Dominant strategy: rush •(This is PD again) 9 10 0 5 You Everyone else Orderly Rush Orderly Rush
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Econ 404 – Brian W. Rogers 10 Market panics • If the market is going to crash, it is perfectly rational to get your money out first • Put differently: sell off to those who are still ignorant • Bank run: if a bank is potentially insolvent, a rational investor probably takes her money out quickly If everyone does this the bank will, in fact, fail! Standard model of bank runs (Diamond and Dybvig 1983) • An economic crisis need not be inconsistent with models of rational behavior Self-fulfilling prophecy
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Econ 404 – Brian W. Rogers 11 Rational expectations and crises •Suppose we could predict the timing of a crisis •Some model is repeatedly proven correct (oracle) •“Stock market will fall 20% next week.” •What should you do?
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