Evans Love February 15, 2011 Behavioral Economics

Problem Set #1
1. Summarize the anomalies described by Fehr/Gacheter and Fredrick/Loewenstein/ODonoghue in their respective papers. What adjustments to the standard models would help us better predict behavior? Fehr/Gacheter Fariness and Retaliation in general are anomalies to being a self-interested individual. 1. Ultimatum Game: P1 gives P2 an offer. P2 either accepts or rejects the offer. If P2 rejects the offer then both P1 and P2 get nothing. Generally: P2 rejects if the sum is less than 30%. 2. Gift Exchange Game: P1 sends P2 any amount (which gets multiplied x3). P2 sends back any amount. Generally: P1 sends some money and P2 sends enough back to make it fair. 3. Public Goods Game (Part I): Each player gives a certain number of tokens to the pot. At the end of the giving round everyone gets a certain % back from each token (ie. 10%). Generally: If everyone gives, everyone wins. However, selfish people tend to freeride, which causes fair people to give less and less. Public Goods Game (Part II): Introduce Punishment. Players can punish others, but it costs 1/3 of a token to punish 1 token. Generally: A minority of fair people can induce a majority of selfish people to cooperate. 4. Labor Contracts: Two types of contracts: Explicit Gives exact level of effort, wage, and bonuses (1-10 scale). Implicit Gives wage and suggested effort. Generally: Reciprocity contributes to the enforcement of contracts (essentially bosses who trust their employees (implicit contract) get employees to work harder. Adjustments: Accommodate situations by taking into consideration fairness and reciprocity, while simultaneously accounting for selfish and fair people in the system. Fredrick/Loewenstein/ODonoghue Hyperbolic Discounting: - The discount-utililty model requires time consistency (that time preferences must remain constant over a period of time) but not that time preferences for different length periods must be the same. Therefore, hyperbolic discounting allows for peoples time preferences

to fluctuate for different length time periods (often decreasing as period length increases). Discount Rates Vary Across Different Types of Intertemporal Choices: - Get It Done With!Gains are discounted more than losses (Example: Parking Tickets). - Dont Be Greedy.Large amounts are discounted at a lower rate than small amounts (Example: $15 to $60 versus $3,000 to $4,000). - A Sense of Entitlement Greater discounting is shown to avoid delay of a good than to expedite its receipt (Example: VCR $54 to receive it, $126 to delay it). - It Only Gets Better With Time People prefer improving sequences to declining sequences even though positive time preference dictates the opposite Adjustments: Accommodate situations by taking into consideration the fact that the discount-utility model has anomalies such as hyperbolic discounting and differing discount rates across different types of intertemporal choices. 2. Based on Adam Smiths quotes featured in the Ashraf/Camerer/Loewenstein paper, explain the connections between the following: a. Smiths view of the impartial spectator and the discount-utility model. According to Adam Smiths first book, The Theory of Moral Sentiments, everyones carnal instincts are kept in check by an impartial spectator, or a moral hector who, looking over the shoulder of the economic man, scrutinizes every move he makes. This imaginary being, unlike humans, has no intertemporal choice preferences and therefore does not discount the value and utility of pleasure postponed into the future. b. Smiths view of human nature and the alternatives to the discount-utility model. According to Adam Smiths Duel Process Model, it is human nature to value the present to a greater extent than the future. In his words, The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day, the passion which the first excites, is naturally so weak in comparison with that violent emotion which the second is apt to give occasion to, that the one could never be any balance to the other, unless it was supported by the sense of propriety. Although alternatives to the discount-utility model, such as hyperbolic discounting were not around during Smiths lifetime, I am fairly certain he would have adapted his theory to accommodate the more recent findings! 3. Uncover a potential causal chain behind each of the following hypothetical relationships and explain your logic. Keep the links hypothetical and feel free to be creative your links dont need to be

supported by any real evidence (though they should be governed by some logic). a. A glass of wine a night improves life expectancy. - A glass of wine each night may provides the body with additional antioxidants. - Antioxidants may prevent oxidative cellular damage and the subsequent release of the glucocorticoid steroid hormone, cortisol. - Reduced levels of circulating cortisol may lower heart rate and blood pressure. - Over time, lower heart rate and blood pressure may help prevent heart disease which is the leading cause of death in the United States. b. Introducing the white iPhone increase Apples profits substantially. - The new white iPhone may prove to be more aesthetically pleasing to some consumers. - People who like white (who may not have otherwise bought an iPhone) may buy one. - This purchase may lead to additional shopping trips to the Apple store, which may lead to increased sales for other Apple products in the long run. - Increased sales means increased production and increased efficiency which ultimately leads to increased profits. c. Best actress winners have shorter marriages than nominees. - Best actress winners may get offered more prestigious roles in the future. - Over time, the increased number of roles available may cause the actress to take on a greater workload and she may end up working longer hours. - By working longer hours, the actress will have less time to spend with her family. - Less family time means that she will not be able to provide the support her husband needs to have a functional family. - Unhappy husbands often divorce their wives. 4. Studies that look at social preferences examine the extent to which people are difference-averse. Someone who is differenceaverse prefers equal outcomes to unequal outcomes. Considering the following experiment: Game 1 B chooses (400, 400) or (750, 400) Game 2 B chooses (400, 400) or (750, 375) Game 3 B chooses (200, 700) or (600, 600) Game 4 B chooses (0, 800) or (400, 400) Result: Left 31%, Right 69% Result: Left 50%, Right 50% Result: Left 27%, Right 73% Result: Left 78%, Right 22%

In this experiment, B gets the second payoff in each parenthetical pair and the counterpart (A) gets the first payoff in the pair. Left denotes the percentage of Bs who took the first option and Right denotes the percentage of Bs who took the second option. Does the behavior across these games seem to support the claim that people are difference averse? Based on these results, what other factors seem to be important to people. Not necessarily. In the end, people weigh a number of factors when playing a game like the one described above. The main factors that I see at play in this example are Altruism, Fairness, and Self-Interest. Altruism: As can be seen by Game 1, when given the opportunity to help Player A at no cost, Player B choose a majority of the time to give Player A an increased payoff. The same is true in Game 2, except in addition to simply giving Player A more, Player B was willing to sacrifice a portion of payoff to provide Player A with the increase. This, however, does not necessarily show differenceaversion. Fairness: As can be seen by Game 3, when given the opportunity to increase their own payoff by 100 at the expense of a reduction of 400 to Player A, Player B instead chooses to take a reduction in payoff of 100 a majority of the time in order to provide Player A with an increased payoff of 400. This demonstrates difference-aversion. Self-Interest: As can be seen by Game 4, Player Bs sense of Altruism and Fairness only goes so far. When provided with an opportunity to increase payoff by a large amount, Player B chooses 78% of the time to reduce Player As payoff to 0 for a gain of 400. This shows a self-interested motivation, and the tendency to favor personal gain after a certain point.