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Study Notes for Midterm 1

Study Notes for Midterm 1 - Study Notes for Midterm 1 Econ...

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Unformatted text preview: Study Notes for Midterm 1 Econ 330 – Economic Behavior and Psychology Spring 2010 Some General Thoughts on the Midterm: I will not throw any big mathematical/model curve‐balls at you. The models will be what you’ve seen and the basic math will be what I’ve done in class and what you’ve had to do for the problem sets. When I ask for an answer, I will often ask you to explain the intuition for the answer. When I do that, what I’m asking you to do is interpret your answer in words and in a way that a smart social scientist (but not necessarily an expert in behavioral economics) could understand. Our equations (whether expected utility of wealth or prospect theory) are really a language. You should be able to read them and interpret them in words. I will likely present you will some situations or examples from real studies in places. Don’t panic when I do that – realize that I am probably asking you to think in the framework of either reference dependence (prospect theory). Outline of things to study: 1. General gain‐loss framing. a. Be able to recognize gain‐loss frames and have a sense of what their impacts will be. b. Think about how to articulate what the implicit reference point might be when people are presented with a hypothetical situation. 2. Reference Dependence (Prospect Theory) a. Loss Aversion i. What is it? ii. How is it represented in the prospect theory model (i.e., λ)? iii. Endowment effect. When you possess something (like a mug, or a house), it becomes part of your reference point. At that point, giving it up becomes a “loss”. Before you had the thing, however, it’s value to you was a “gain”. The difference between the two means that you value something more once you have it than you did before you had it, and that’s the endowment effect. It is caused by a change in reference point that comes from having the item coupled with loss aversion. iv. If I told you someone had simple prospect theory preferences with linear value functions in gain‐loss, could you infer the coefficient of loss aversion from choices between gambles? Could you predict attitudes to gambles if I told you what the coefficient of loss aversion was? v. Do you understand the difference between narrow‐bracketing and broad‐ bracketing and how it affects choice under risk for a loss‐averse person? Why does narrow bracketing often make people seem more risk averse? vi. How loss aversion helps explain the behavior of the cab drivers and more generally the effect of setting income targets. vii. How it helps explain unwillingness to sell houses or stocks that are losers. viii. Do you understand Thaler’s arguments in his mental accounting paper? In particular, do you understand (and remember) his arguments for how gains and losses should be segregated and combined? Also, do you have a sense of why an understanding of mental accounting is important for applying prospect theory? ix. Do you understand why aversion to very small risks (e.g., turning down positive‐ expected value gambles or buying insurance against small risks like cell phones breaking) is not consistent with the diminishing marginal utility of wealth and why that aversion is then one of the motivations for having a model like prospect theory? b. Diminishing sensitivity i. What is it? ii. How is it represented in the prospect theory model? iii. How it helps explain taking on unfavorable risks when you are in a position of a loss. (The reason that gamblers like to bet on unlikely winners, with high potential payoffs, at the end of the day when they are losing). iv. How it combines with probability weighting to generate the four‐fold‐pattern‐ of‐risk‐preferences. Note, I will not ask you anything very tricky on that, but would like you to be able to state those predictions and have a basic understanding of the forces driving them. 3. Contrast Effects a. Can you describe what a contrast effect is? Can you give examples from class or the Ariely chapter? ...
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