Problems

1. AJ pays full price to view The Avengers at the multiplex. After three minutes of viewing, he realizes that the movie is worse than anything he could be watching on TV at home. Yet, he stays to the end, “. . . because I paid $9 for the ticket.” What behavioral bias has AJ fallen victim to? Explain.

2. Connor and Marie are in a relationship with each other, a relationship punctuated by constant bickering and mistrust. “Connor,” Marie’s friends tell her, “is a jerk. Why on earth don’t you leave him?” To which Marie responds, “Silly, we’ve been together for 9 years! I can’t just throw away those years!” Explain how Marie has fallen victim to the sunk cost bias.

3. Lots of people pay high fees to join a gym in early January and then fail to work out more than a few times. Does this evidence provide support for or against the sunk cost bias? Explain your reasoning.

4. In a recent survey, two-thirds of respondents indicated that they were not saving enough for retirement. What behavioral bias can explain the willingness of individuals to knowingly underfund their future standard of living? Explain.

   This behavioral bias is known as the hyperbolic discounting bias. People place relatively more importance on current time periods rather than future periods when making economic decisions; that is, people choose to consume more today than save for retirement.

5. Economist Dean Karlan has opened stickk.com, a nonprofit entity that he calls a “commitment store.” Individuals attempting to achieve a goal (to lose weight, to quit smoking, to write daily in a journal, etc.) authorize stickk.com to charge them a prespecified amount if they fail to reach their goal (as determined by a third-party referee).

   1. What behavioral bias is stickk.com designed to help overcome?

      The site stickk.com helps individuals to overcome the hyperbolic discounting problem that leads to time inconsistency. Having specified their goals, individuals have an incentive to consistently achieve them in order to avoid incurring the penalty.

   2. Should they fail, subscribers are given the option of donating the fees to a charity they support or to an organization that they despise. Why might allowing the subscribers to direct their losses to a favorite charity weaken their resolve?

      If we assume that individuals are altruistic or generous, or exhibit warm glow, failing to meet their goals does not cost them as much since the fee is donated to an organization they hold in high regard. It is, therefore, more likely that individuals will “stick” to their commitment if they identify a charity they despise, since they will be more inclined to work hard to avoid the cost (ill-feeling) of having to contribute to it.

6. You are considering becoming a hedge-fund manager, and you will make your living by charging your clients a fee for managing their money. You are considering two payment schemes: a “no-load” scheme whereby you charge each client an annual fee that is a relatively high percentage of the amount of money you manage for them, or a “front-load” scheme in which you charge investors a very large one-time fee for each dollar they invest, followed by a very low annual fee.

   1. If your investors are overconfident in your ability to generate abnormally high returns, which scheme can potentially generate the highest profit for you? Explain.

   2. If your investors are a group of very conservative pessimists, which scheme can potentially generate the highest profit for you? Explain.

7. You are a personnel manager at a ball-bearing factory. You are considering two schemes to motivate your employees during a period of particularly brisk business. In Scheme A, you tell your employees, “If you increase your output by 10%, I will give you a $500 bonus at the end of the month.” In Scheme B, you tell your employees, “I am giving you a $500 bonus. But if you do not achieve 10% growth by the end of the month, I will withdraw it.”

   1. If your employees are completely rational, will they be motivated more by Scheme A, Scheme B, or will both schemes motivate them equally?

      Assuming completely rational employees, both schemes would motivate them equally because their expected value is identical.

   2. If your employees are swayed by the endowment effect, which scheme is likely to be most effective in motivating them? Explain your answer.

      Scheme B is likely to be more effective in the presence of the endowment effect; that is, employees will lose more utility from having the $500 withdrawn than they would gain from receiving Scheme A’s $500 bonus. Naturally, they would be inclined to work hard to achieve it in this case, so as to not lose what they believe they already own.

   3. Discuss the interplay of the endowment effect and framing bias inherent in this problem.

      The offers under Schemes A and B are essentially identical: Meet the 10% increase, you are $500 richer; fail to meet the 10% increase and you get nothing. Employees prefer Scheme A in terms of framing because most people are inclined to opt for scenarios that are framed as rewards rather than punishments. However, it would be more profitable for you and your factory to utilize Scheme B if you had reason to expect that the employees will be swayed by the endowment effect.

8. Where are you more likely to see racial discrimination: in the highly competitive financial services industry, or in the tobacco industry (where four firms control about 99% of the market share)? Explain your answer, drawing on your knowledge of market structures from Chapter 8, Chapter 9, and Chapter 11.

9. “The most heartfelt gifts are anonymous ones.” Explain this statement, drawing on your knowledge of utility functions that account for behavioral traits.

10. Consider the ultimatum game, a two-player game often played in experimental economics labs. In the ultimatum game, one player is given an amount of money and then instructed to give some arbitrary portion of it to an anonymous second player. The second player has the option of accepting the offer or rejecting it. If the second player rejects the offer, neither player gets anything.

    1. According to traditional economic theory (which assumes that individuals are self-interested utility maximizers), what should the first player offer the second?

    2. What does traditional economic theory suggest the second player should be willing to accept?

    3. In experimental settings, the first player often offers the anonymous second player about 50% of the initial amount. Is this result consistent with theory? Can we easily attribute this anomaly to something other than an innate sense of fairness? Explain.

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11. Consider the dictator game, a two-player game often played in experimental economics labs. In the dictator game, one player (the Dictator) is given an amount of money and then instructed to give some arbitrary portion of it to an anonymous second player. The second player must accept whatever the first player offers, if anything.

    1. According to traditional economic theory, what should the first player offer the second?

    2. In experimental settings, the average offer given to the second player is about 30% of the initial amount. Explain how such an offer might not be motivated by an innate sense of fairness.

12. One way of stating the Coase theorem is that “in the absence of transactions costs, the property right to an activity will be acquired by the party that values it most.” This suggests that if environmentalists initially value a wetlands more than a developer (who wants to convert that wetlands into a subdivision), then if the developer happens to acquire that land, environmentalists can save the wetlands by simply purchasing the wetlands from her. Explain how the existence of endowment effects may interfere with the process of bargaining and may potentially result in a less-than-optimal allocation of resources.

13. Identical twins Jo and Jerri have identical preferences; both love to go to football games, and both are looking forward to their alma mater’s homecoming. Jo bought her ticket in advance; Jerri plans to buy hers at the gate. On the day of the big game, a blizzard strikes. Explain, using the theories of behavioral economics, why Jerri is more likely to stay home than Jo. What bias is at work? Explain.

14. Jameel is offered two sets of choices.

    Choice A. Take a $100 check that can be cashed today, or a $200 certified check that can be cashed in two years.

    Choice B. Take a $100 certified check that can be cashed in six years, or a $200 check that can be cashed in eight years.

    1. Put yourself in Jameel’s shoes. Which option would you choose from Choice A? From Choice B?

    2. Jameel chooses the $100 check in Choice A, and the $200 check in Choice B. Explain how Jameel’s choices are not time consistent.

    3. Which systematic bias has Jameel fallen victim to?

15. You have just graduated from college and have two job offers doing identical work. Firm A offers you $40,000 per year and informs you that your coworkers will make the same. Firm B offers you $38,000 per year and informs you that your coworkers will make $35,000.

    1. Which job offer does economic theory predict you will take?

    2. When experimental subjects were asked which job would make them happier, well over half indicated that they preferred Firm B. Can you think of a systematic bias that might lead people to prefer a job that pays less for identical work? Explain.