Review Questions

1. Characterize Homo economicus. How does he differ from a regular human being?

   Homo economicus, unlike the typical human, follows the principles and predictions of economics exactly. He knows what he wants and how to get it, and can solve any and every economic problem he faces (no matter how complicated) with no mistakes.

2. Define overconfidence.

   Overconfidence—a trait that afflicts the average human but not Homo economicus—is a person’s belief that his skill level or judgment is better than it actually is.

3. What does hyperbolic discounting lead consumers to prefer?

   Hyperbolic discounting leads consumers to prefer payoffs in the present to future payoffs, even if the future payoff is of greater monetary value.

4. Why is time consistency important in economic models?

   A time-inconsistent person’s actions differ across time. The choice he makes today is different from the choice he makes in the future and that fact makes self-control issues like a game theory battle between two different people. As a result, it is difficult to analyze his behavior using traditional economic theory and models.

5. How does the endowment effect contradict aspects of conventional economic theory?

   The endowment effect states that an individual’s perception of the value of an object is altered by owning the good. In other words, the pain a person suffers from giving up the object is greater than the pleasure he experienced when receiving it—a fact not taken into consideration in traditional economic models.

6. What is the importance of the reference point in loss aversion?

   Nominal loss aversion refers specifically to the instance when individuals care about the nominal—not inflation-adjusted—value of their loss, whereas loss aversion in the standard economic model assumes that consumers respond to real variables.

7. Describe one example of anchoring.

   Anchoring is the tendency to base a decision on the specific pieces of information that were given. As one possible example, a shopper who first looks at high-end designer dresses may be more likely to pay a high price for the dress she eventually purchases than the person who first checks out the bargain rack.

8. How does mental accounting affect individuals’ consumption decisions?

   Mental accounting describes a bias in which individuals divide their current and future assets into separate, nontransferable portions. Mentally apportioning income into separate purchasing and saving categories may affect how much a person spends and what he spends it on.

9. How do economists attempt to account for altruism in economic models?

   Economists account for the “warm glow” of altruism by incorporating generosity into the utility function, or allowing a person’s utility to depend on not only his own consumption but also the consumption of other people, such as his children.

10. In the opinion of the authors of this textbook, what tends to happen to irrational or biased actors in the market system?

    Irrational or biased actors tend to lose out to more rational, economically sound market participants. As a result, people who exhibit economic biases are often weeded out of the market.

11. Lab experiments allow economists to test economic theory while holding all other variables constant. What are some downfalls of lab experiments?

    Laboratories differ from real life in several key ways that make lab experiments potentially problematic. First, individuals’ behaviors tend to change when they know they are being watched by an experimenter. Second, the stakes of economic games played in the lab are much lower than those played in real life. In addition, participants are often asked to perform tasks in the lab that are foreign to them, and in real life, people do not assume away their cultural norms. Even so, lab experiments allow experimental economists to test and gain insights into many economic theories.

12. Contrast natural and field experiments. What are some advantages of each?

    A natural experiment is a situation in which, by chance, something happens that allows the researcher to learn about an economic question. A field experiment uses randomization, just as in the lab, but is carried out in real-world settings. Both natural and field experiments allow economists to examine economic actors in their natural environments, and field experiments, like lab experiments, give economists a degree of control over the way in which the theory is tested.