Final exam econ 115 practice.pdf

# 3 layers of economic models 1 top layer standard

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3 layers of economic models 1. top layer – standard economic models : utility maximization, discounted utility, expected utility. These models are simple and can be derived from axioms (assumptions about choices). 2. bottom layer – data . Data is obtained from laboratory and natural (field) experiments. 3. medium layer --- compromise behavioral models , such as prospect theory, hyperbolic discounting, multi-self models. 2 kinds of experimental data Modeling individual choices

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The two most general concepts that economists use to model individual choices are •Preferences •Choice functions (choice correspondences) Both concepts are defined on a set X that includes all alternatives (payoffs, consumptions) that may become feasible in relevant observations/experiments. Preferences An agent weakly prefers x to y (x is weakly preferred to y, x is at least as good as y) if the agent is willing to choose x in the menu B = {x, y}, that is, when only x and y are feasible. In this case, write x ≥ y. If the agent is willing to choose x, but not y, in the menu {x, y} then x is strictly preferred to y. In this case, write x > y. If x ≥ y and y ≥ x, then the agent is indifferent between x and y. Write x~y. Implications of utility maximization Completeness: Agent is always willing to compare and choose between any two alternatives x and y. Transitivity: If x is better than y, and y is better than z, then x is better than z. Circular preferences are not allowed. Reflexivity and Invariance: If options x and y are the same, then the agent should be willing to choose either of them. Framing (language) should not matter! Independence of Irrelevant Alternatives : If x is chosen over y, then y cannot be chosen over x if another option z becomes feasible. No context effects! 1/n heuristics is common in retirement accounts. 1/n Heuristic violates utility theory. People avoid extremes . For example, they do not like buying the cheapest (or the most expensive) in an assortment of products. People follow social rules of behavior that can depend on the feasible menu.(no apple>1 apple, 1 apple>2 apples) Empirical anomalies • choice avoidance : people avoid and defer complex choices. More options on the savings plans can decrease and delay participation. More flexibility can make people less happy. • inattention, errors, confusion: shipping costs, fine print, paperwork, even voting forms… • framing: the language and the presentation of the choice problem matters. Free options attract much more attention than even very cheap ones. -complexity can lead to choice avoidance Behavioral Issues with Utility Maximization Complexity (more options, more difficult decision) Inattention & confusion (shipping costs, fine print, financial news) Framing (keywords; organic/wholesome etc) The Power of Free! Option
Attention reasoning b/t x and y options (context effect) 1/n Heuristic flipping a coin (common in retirement accounts) Context Effects -People avoid extremes-Follow social rules (apple ex.)- -Choice Avoidance “To do nothing is within the power of all men” - Samuel Johnson

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