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85 Cards in this Set
- Front
- Back
Rationality & Preferences |
-Preferences determined exogenously -Stable preferences, with a ranking of alternatives -Preferences are complete -Preferences are transitive - Preferences only change with new information |
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Rationality & The Future |
-We consider our utility in the future when making present decisions -We “discount” the future in a consistent, logical way -We accurately assess probabilities and “Bayesian update” |
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Rationality & Choices |
-We treat money as fungible, and ignore sunk costs -We evaluate costs and benefits, and maximize utility -We think marginally -We don’t make choices that make us worse off |
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Where does the demand curve come from? |
Demand curve comes from the tangent line that doesn’t cut under the indifference curve (these derived from utility functions) |
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Income Effect |
price goes down, you feel richer |
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Substitution Effect |
buy what you get relatively cheaper |
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Consumer Theory |
-Stable, consistent preferences -We respond rationally to price changes |
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Producer Theory |
-Marginal costs and revenues accurately forecasted -Opportunity cost consistently and accurately factored in -No overconfidence/mispricing -Profit maximizationSupply curve derives from marginal cost curve for P.C. firm (area on MC above AVC, this is the supply curve) |
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Deviations from Rational Model |
-Nonstandard preferences -Nonstandard beliefs -Nonstandard decision making -People do much better on recurring, everyday choices than on major decisions, such as selection of spouse, occupation, or retirement plan |
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Altruism |
-People sympathize more with a known victim than not known -People more likely to give more in the dictator game when they know something about the other person |
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How people think about the future & wealth |
-People think that acquiring wealth will make them permanently happy -People adapt quickly to new situations, so they overestimate the duration of happy and sad feelings |
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Naive Realism |
tendency for people to think that their own tastes and beliefs are more legitimate and more widely shared than they really are |
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Reasons behavioral phenomena should matter |
1) feedback is infrequent 2) experience can exacerbate a bias 3) debiasing by experienced agents can be a substitute for direct experience 4) not all nonstandard features should be mitigated by experience |
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Aggregate Demand |
Individuals respond rationally: -spend more when they expect future output to increase -spend less when the real interest rate increases |
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Aggregate Supply |
Firms act rationally: Profit maximization |
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Efficient Market Hypothesis |
-asset values reflect all information about that -asset Assets *can’t* be over- or under-valued |
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Permanent Income Hypothesis |
-A person’s consumption is a function of “permanent income” -Consumption smoothing: transitory changes in income are “spread out” over the lifetime |
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Ricardian Equivalence |
more government spending, less public savings offsetting private savings |
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System 1 vs. System 2 |
System 1: Fast, automatic, intuitive System 2: Slow, analytical, reasoning |
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“Bounded rationality |
-rationality limited by information and cognition limits, tractability of a problem, and time -“Biases” arise when system 1 heuristics cause us to make errors |
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“Decision utility |
weight of an outcome in a decision |
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“Experienced utility” |
Instant utility or Remembered utility |
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“Peak End Rule” |
-Duration neglect -Violations of temporal monotonicity -people use a representative moment as a proxy and last event lingers in memory more (salience) |
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remembered utility |
people choose to repeat episode with highest remembered utility |
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Duration neglect |
duration has hardly any effect on remembered utility |
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Expected Utility Theory |
-Utility a function of absolute wealth -Utility increases in wealth -Diminishing marginal utility -Risk aversion, usually -Use true probabilities when weighing decisions -sumi(iPiu(Xi)) |
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Rabin Critique |
-Too much curvature for it to continue out and make sense -risk aversion comes solely from the concavity of a person’s utility defined over wealth levels -Risk aversion over small bet means that his marginal utility for wealth must diminish incredibly rapidly |
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Framing |
The context in which a decision is presented matters |
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Loss Aversion |
People dislike losses more than they like equivalent gains |
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Prospect Theory |
-Value function + probability weighting function -Utility = pi(p)v(x) + pi(q)v(y) -Reference dependent -Loss aversion -Reflection effect: risk averse in gains, risk seeking in losses -Diminishing sensitivity -Probability weighting: overweight low probabilities and underweight high probabilities -People seek risk when gambles involve only losses such that the best they can do is break even. They avoid risk when gambles all yield gains |
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Tiger Woods & Loss Aversion |
-More likely to make it if it’s for par or over par as opposed to for birdie -players invest more focus when putting for par to avoid encoding a loss -golfers hit birdie putts less hard than they hit par putts and are more likely to leave birdie putts short of the hole than par putts |
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Home Sales |
-Boom: houses sell for close to asking price, quickly (Selling house for a gain less incentive to ask for more) -Bust: fewer houses sell, but asking prices are above expected selling prices, and it takes a long time (Selling house at a loss ask for more to minimize losses) |
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Tax Refunds |
-Underpay & write check -> Feels like a loss -Overpay & get refund -> Feels like a gain -Peak at 0- People find a way to owe $0 |
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Two factors contribute to investor being unwilling to bear risk |
Loss aversion Short evaluation period |
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Stocks vs Bonds |
Stocks do better than bonds, but over time Stocks fluctuate more |
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NYC Cab Drivers |
On busy days where you can make a lot of money, work less hours Especially true for less experienced cab drivers |
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Endowment Effect |
-The individual is more sensitive to declines in consumption relative to the reference point than to increases -People who have acquired an item tend to raise their valuation of the item beyond how much they valued it at purchase |
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Sports memorabilia study |
Randomly assigns sports memorabilia (A or B) to sports cards traders at a sports cards fair -Low experience card traders want to swap 6.8% of the time -High experience traders swap 46.7% of the time |
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IKEA effect |
When you build something, you may overvalue it |
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Wheel of Fortune & Anchoring |
Randomly assigned to land on either 65 or 10 Subjects asked for exact percentage of African countries in the UN Wheel on 65: median = 45% Wheel on 10: median = 25% |
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When asked to estimate product, |
8*7*...*1 average guess was 2250 1*2*...*8 average guess was 512 |
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“Coherent Arbitrariness” |
1) cannot be interpreted as a rational response to information 2) does not decrease as a result of experience with a good 3) is not necessarily reduced by market forces 4) is not unique to cash prices |
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Recital Study |
Group 1 -Attend recital for $2: 59% yes -Attend recital for free: 8% yes Group 2 -Pay $2 to attend recital? 3% yes -Attend recital for free: 35% yes |
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Recital & Duration |
WTP/WTA increased/decreased with increasing duration |
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Status Quo Bias |
-a preference for the current state of affairs -Sticking with the status quo feels much better even if we know it’s costing us money. |
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Risk & Loss |
-“People are willing to run huge risks to avert or recover losses.” -In the real world, this is why people hold falling stocks, hoping for a rebound rather than cutting their losses, and it’s why they double down after losing a bet |
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Retirement Plans |
-Higher rate of participation with opt-out program -participants hired under automatic enrollment retain both the default contribution rate and fund allocation even though few employees hired before automatic enrollment picked this particular outcome -Without this, the rate of participation goes up over time and eventually matches the rate for the opt-out group |
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Active Decisions & Retirement Plans |
Higher rate of retirement plan enrollment when forced to make a decision |
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EITC Study |
People don’t fill out complex form to get their refund, but when resent a simple form, roughly 25% people will it out |
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Movie Ticket Example |
-When they “lost the ticket,” 46% say they would buy a ticket! -When they “lost the $10,” 88% say they would buy a ticket! |
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Mental Accounting |
People tend to code, categorize and evaluate economic outcomes and decisions based on mental frames or “accounts” in ways that lead to objectively “non-rational” behavior |
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Components of Mental Accounting |
1) How outcomes are perceived/experienced; how decisions are made/evaluated 2) Assignment of activities to accounts 3) Frequency of evaluation and “choice bracketing” |
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Acquisition Utility |
Consumers economic gain or loss associated with purchase Related to utility of product and purchase price |
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Transaction Utility |
-Pleasure or displeasure from the financial part of the purchase – how much of a “deal” it was -Related to difference between internal reference price and purchase price |
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Flypaper Effect |
Money “sticks” where it “hits” Why? Loss aversion and lack of fungibility |
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Jam Study |
More people approach stand if more jamsPeople taste more jams on average if more jamsLess people buy a jam if more jams |
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Why having many jams to sample is bad |
-A large array of options may discourage consumers because it forces an increase in the effort that goes into making a decision. So consumers choose not to decide -Also, a large array of options may diminish the attractiveness of what people actually choose, |
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Paradox of Choice |
-More choice is not always a good thing -Choice overload can lead to violations of regularity -We should be learning to make good choices about the things that matter, while at the same time unburdening ourselves from too much concern about the things that don’t. |
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Relativity |
Many decisions and choices dictated by how one thing appears in relation to another |
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Asymmetric Dominance |
The P is there as a decoy to make P + Coffee look better |
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Compromise Effect |
People pick the middle option |
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Defaults & Doctors |
more physicians chose the default option (referring to an orthopedist) when two untried medication options were available (72%) than when only one was (53%). |
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Menu Engineering |
-Put box around item, people more likely to order -Put price at end of menu item line and people are forced to read descriptions -Prices lined up on right cause you to pick based on price |
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Branding & Neurons |
Neurons light up differently when you believe you are drinking expensive wine |
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Allais Paradox |
Misunderstandings of probability call into question the validity of EUT |
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Bayes Rule |
P(A|B) = ( P(B|A)P(A) ) / P(B) |
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Risk vs. Uncertainty |
-Risk generally refers to a scenario where the probabilities of various outcomes are known -Uncertainty is a scenario where probabilities are themselves unknown |
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Ellsburg Paradox |
People prefer taking risks in scenarios where they know the specific odds, rather than in alternate scenarios where the odds are ambiguous… but mathematically identical! |
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Betting & Competence |
they found that people prefer to bet on their vague beliefs in situations where they feel especially competent or knowledgeable, although they prefer to bet on chance when they do not |
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Comparative Ignorance Hypothesis |
Ambiguity aversion present when people's confidence is undermined when they contrast their limited knowledge about an event with their superior knowledge about another event |
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Ambiguity Aversion |
person evaluates both clear and vague prospects, seems to disappear in a noncomparative context in which a person evaluates only one of these prospects in isolation |
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Betrayal Aversion |
People take less risk when agent of uncertainty is a person, and not “nature” Why? 1) Decision situation usually involves payoffs to the other player 2) Elements beyond outcome-based preferences may enter the utility function |
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Oxytocin study |
Subjects given oxytocin took the social risk involved in trusting more readily, but not the natural risk involved in a risky-choice task |
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Gambler’s Fallacy |
People ignore the independence of events & think that an outcome is “due” if it hasn’t happened in a long timeJudges, loan officers, and umpires all do this |
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Clustering Illusion |
Clustering Illusion |
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Hot Hand Fallacy |
People believe if you made previous shots you are more likely to make the next one |
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Ludic Fallacy |
“Basing studies of chance on the narrow world of games and dice” when sometimes not actually relevant |
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Representativeness Heuristic |
Degree to which event is similar to essential characteristics to its parent population & reflects salient features of process by which it is generated |
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Availability Heuristic |
estimates frequency or probability by the ease with which instances or associations could be brought to mind. Famous people list- more male or female More words with r in first position or third position |
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Conjunction Fallacy |
Assuming specific conditions more probable than a single general one. |
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Base-Rate Fallacy |
People fail to properly account for the prior probabilities (in this case, 2%) when coming to conclusions based on new information. |
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Misconceptions of regression |
people do not expect regression where it is likely to occur When they recognize regression, they invent spurious causal explanations for it |
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Misconceptions of chance |
people expect sequence of random events generated by random process to represent randomness even if sequence is short |
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Insensitivity to prior probability of outcomes |
one factor that should have no effect on representativeness but should have major effect on probability is the prior probability |
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Insensitivity to sample size |
the similarity of a sample statistic to a population parameter does not depend on the size of the sample |