2 Decision Making under certainty

• Explicit cost:

  What you have to pay (e.g., in EUR) to obtain or do something.

• Opportunity (Implicit) Cost:

  The value of the best option forgone.

Example: If you watch a movie with friends, the explicit cost is the price of the movie ticket; the opportunity cost includes the time lost that could perhaps have spent studying.

• Economic profit:

  Benefit of your choice minus the opportunity cost.

Example: Suppose watching a movie gives you a (net) benefit of 10 [pleasure (12) – cost of ticket (2)] while studying gives you a benefit of 4. —>When going to the movies, your economic profit is 10 – 4 = 6.

When making rational choices, opportunity costs never exceed (net) benefits, i.e. the economic profit is non-negative.

a) Draw a decision tree illustrating this decision problem.

b) What is the opportunitiy cost of buying real estate.

1000

c) Waht is the opportunitiy cost of buying bonds?

1000

a) What would the tree look like now?

b) keine Lösung —>opp. costs sind in Klammer

Rational choice ⇔ 𝒖(𝒂𝒌) ≥ 𝒄(𝒂𝒌)

—>Nutzen muss größer als Kosten sein

In other words:

− Select the best available alternative from your set of alternatives.

Depends on preferences but they could be

a) the most fulfilling relationship you could have instead

b) the course of study that excites you most

c) the most satisfying activity you could engage in instead of sleeping in the morning

For them the opp c for mowing lawns etc is greater.

You may be ignoring that there are better things you could spend 60€ on.

The Opportunity-Cost Fallacy:

Individuals do not always consider opportunity costs (that include “hidden costs”) even though it is irrational not to do so.

(Individuen berücksichtigen nicht immer die Opportunitätskosten

(einschließlich "versteckter Kosten"), auch wenn es irrational ist

ist, dies nicht zu tun.)

Example:

Bastiat‘s “Broken Window” In a pamphlet published in July 1850, Frederic Bastiat defined a bad economist as one who sees only the immediate or visible effects produced by some cause. A good economist, by contrast, analyzes also the effects arising from the same cause that are not evident immediately.

“What Is Seen and What Is Not Seen”, tells the tale of Jacques Bonhomme, whose son is caught breaking a shop window. Seeing the boy surrounded by shattered glass on the sidewalk, passersby are in unanimous agreement: “It’s an ill wind that blows no good. But such accidents keep industry going. What would become of glaziers if no one ever broke a window?”

Why is this economically a bad statement?

Suppose that replacing the window costs $100. A glazier is called to do his job, is paid $100, and goes home offering a silent prayer for juvenile delinquents. That is what the passersby see, and that is what leads them erroneously to conclude that, because a job has been “created”, breaking the window was not such a bad thing after all. What the passersby (and the bad economists) fail to see is that $100 has been deducted from the baker’s bank account. Because he has been forced to spend $100 to replace his broken window, he will not be able to spend that sum on anything else. And since he did not plan to replace his old window by a new one, replacing the window was obviously not what he perceived to be his best option or alternative (decision)

The Correct Answer: When you go to the Clapton concert, you forgo the $50 of benefits you would have received from going to the Dylan concert. You also forgo the $40 of costs that you would have incurred by going to the Dylan concert. An avoided benefit is a cost, and an avoided cost is a benefit. Thus, the opportunity cost of seeing Clapton, the value you forgo by not going to the Dylan concert, is $10, i.e. the net benefit forgone.

Failure to correctly take opportunity cost into account is equivalent to … − …ignore alternatives or − …take alternative into account that do not exist. Thinking about opportunity costs helps to correctly think about alternatives.

A cost is sunk, if it cannot be recovered at the time when the decision is made

If you honor sunk costs, you are committing the sunk-cost fallacy:

• Irrelevant costs are taken into account.

• Opportunity cost fallacy: relevant costs are not taken into account.

Example:

You expect that the LAGO shops offer sales. You go to the LAGO and realize there are no sales. You still buy something because if you do not, you feel as if you had wasted time going to the mall.

A company has to decide which of two projects to continue, A or B. Project A has somewhat better prospects but the company already invested a lot into Project B. The company could decide for B – not to lose the investment into B.

The concept of consequentialism:

• Only the consequences, or the rest of the tree, matter.

• Decision trees help you to ignore sunk costs if you so wish.

• But do we always wish to do so?

Four Caveats

• Neglecting sunk costs might induce us to switch too often, never completing our projects? (permanently zapping from one TV program to another one)

• Taking sunk cost into account improves self-control? (next time you think harder about which movie to watch)

• Switching too often may have negative signaling effects? (this guy cannot be trusted, he is too impatient and unreliable)

• Actions may count independently of their consequences

• Do nothing and allow the trolley to kill the five people on the main track.

• Pull the lever, diverting the trolley onto the side track where it will kill one person.

Most people switch.

Fat man variant

As before, a trolley is hurtling down a track towards five people. You are on a bridge under which it will pass, and you can stop it by putting something very heavy in front of it. As it happens, there is a very fat man next to you – your only way to stop the trolley is to push him over the bridge and onto the track, killing him to save five. Should you proceed?

Most people do not push.

• Representations matter.

• Framing is implicitly assumed away in traditional economic theory.

• Representation also matters when probabilities (risk) are not involved.

  
  

• Cash discount vs. credit card surcharge

• Charge people who have a record of buying luxury goods higher prices for these goods than people who usually do not buy luxury goods’ vs. ‘giving people who usually do not buy luxury goods a rebate’

• Making health cost tax deductible vs. subsidizing health cost by giving the rich a higher percentage subsidy.

Since Frames matter, they are used in marketing and for nudging.

The concept of anchoring and adjustment:

• A process used when forming judgments: first pick an initial estimate (an anchor), then adjust up or down as necessary.

• The estimate need not be related to the issue at hand. Nor does the anchor have to be consciously chosen by the consumer.

• If adjustments are insufficient, final judgments will reflect the (possibly arbitrary) anchors.

Example: The manufacturer’s suggested retail price is an attempt to make consumers use a high price as their anchor.

Anchoring heuristic:

• In the absence of solid data, any number can be used as an “anchor”.

• Can be used strategically.

• Is it rational?

• If you do not have any information at all, you need to proceed from somewhere, the starting point should depend, of course, on your assessment of the quality of the source…

A Special Anchoring Effect – The Decoy Effect:

• Choice between Competitor and Target.

• A decoy for the target is an additional option that is dominated by the target.

• —> People are more likely to choose the target.

Decoy = Köder/Lockvogel

Characteristics of decoy:

• The decoy must be asymmetrically dominated by the target, meaning dominated by the target but not by the competitor.

• The decoy effect might be due to reason-based choice: consumers looking for a reason to choose one of the options rather than the other.

The endowment effect occurs when a person’s preferences depend upon what they already own.

Example: You might not be willing to pay more than $20 for a concert ticket, but will only accept $30 or more if someone wants to buy that ticket from you.

This implies that a person’s preferences depend on a certain reference point, perhaps determined by the person’s possessions (endowment).

Results:

• How much would you pay to buy it? p=$2.87

• What gift would be equivalent? g = $3.12

• How much would you demand to sell it? d = $7.12

Generalization:

• We tend to value what we have more than what we still don’t have.

• A special case of “status quo bias”.

• Often due to “loss aversion”.

  
  

Rationalization of the Endowment Effect:

• Information (used car).

• Stabilization of choice.

• Habits and efficiency (word processor).

Definition: Loss aversion is the phenomenon that people dislike losses more than they like gains.

Example: If you found $5 and then lost it, you might feel sad even though you were no worse off than when you started (assume you were not sad then). This would suggest that the loss hurt more than the gain made you happy.

Mathematical Representation:

• Utility depends on reference points.

• Steeper for losses than for gains.

Generalization: Different expenses come from “different” accounts even though money is fungible

Other examples

• Your friend buys you the gift you did not want to buy for yourself (birthday account).

• You spend more on special occasions (vacation account, week-end account).

Is mental accounting rational?

Mental accounting can be useful:

• Helps solve a complicated budget problem top-down.

• Helps cope with self-control problems.

• Uses external events as memory aids.

… but it can sometimes lead to decisions that are clearly unreasonable