What is the revealed preference approach?
Making an assumption based on observation
Assumption: choices reveal latent preferences
If Anna chooses an apple over an orange, Anna prefers the apple
How is economic psychology relevant for social policy?
Questions asked:
How to spend money
How to allocate effort
How to plan for the future
Answered by decision theory, which is used by
Economics: How to make “optimal” choice
Psychology: How people actually make choices
Which leads to consequences for social policies
What is the rational choice theory?
Theory on how people SHOULD make decisions (rationally)
Which three assumptions does rational choice theory follow?
WARP: Weak axiom of revealed preferece/Completeness assumption
When given the choice between A and B, we assume that the consumer prefers
A
B
Neiter/No preference
Violation of WARP: Consumer prefers both A and B
Independence of irrelevant alternatives assumption (IIA):
Assumption: If someone prefers A over B, this preference will hold up consistently in every circumstance
Violation: If someone prefers A over B, but will choose B if they have to choose between A and a grape or B and a grape
Transitivity Assumption
Assumption: Concluding that if A > B, and B > C, then A > C
Violation: the money pump thought experiment
If object ranking is not rational, a person would want to trade B for A, A for C and C for B -> this is how people can be exploited
Being rational is in ones own best interest, since being irrational opens the gates for being exploited
What is rationality in rational choice theory?
Choice patterns which satisfy simple, logical assumptions of choice
What can be assumed about decisions when consumers decide rationally?
Decisions reveal preferences
Preferences can be ranked/ordered from low to high
Decisions can be characterized as if the decision maker would maximize their “utility”
What is utility (according to Jeremy Bentham)?
Property in any object that
produces benefit, good, wellbeing, happiness, advatage
and/or
Prevents the happening of mischief, pain, evil, unhappiness
to the party whose interest is considered
What is utilitarianism?
If we can quantify the pain and pleasuer of decisions, we should choose those decisions which maximize the total expected utility of everyone if affects (maximize pleasure, minimize pain)
What is an example for a violation of utilitarianism?
The trolley problem
According to utilitarianism, we should always choose the option which saves most lives (even by sacrificing one)
People struggle to act accordingly when they have to actively push someone to their death
How is the trolley dilemma related to self-driving cars and which challenges does this bring about?
Trolley-dilemma is being used for self-driving cars to decide who should die in case of an accident
Problems:
There are preferences based on age, occupation, animal vs. humans etc.
Those preferences are further influenced by culture, i.e. they differ between west/south/east
-> should cars decide depending on the location where they drive?
What is the expected value and how is it calculated?
Calculated by multiplying each possible outcome by its likelihood and then summing it together to make a rational decision under risk
Example:
Option A: 50% chance of winning 100.-, 50% chance of winning nothing
Option B: Getting 40.- for sure
0.5 x 100 + 0.5 x 0 = 50.- -> 50.- > 40.- -> Rational choice would be choosing option A (expected value optimiser)
What is the St. Perersburg Paradox (Bernoulli)? How can it be explained?
Paradox in relation to expected value
Choice: a fair coin is tossed
If head appears, you win 2 Euros and the game goes on
If head appears, you win 4 Euros and the game goes on
If head appears, you win 8 Euros and the game goes on
etc.
The game ends when tails appears
How much are you willing to pay?
Calculating with expected value, it would look like this:
.05 x 2 + 0.25 x 4 + 0.125 x 8 etc. -> infinite
Accordingly you should be willing to pay an infinite amount of money to play (according to expected value maximizer)
Yet, almost no human being is willing to do that
Possible explanation
The value of an item is not based on the price, but rather the utility it yields (i.e. winning 1000.- is more relevant to a poor person than to a rich person, even though it is the same amount of money objectively)
-> Money chages its value depending on who has it
How are utility and value different and how can the relationship between the two be characterized?
Utility: depends on psychology/perception (contrary to value)
Relationship between utility and value is NOT (necessarily) linear
-> Chages things around decision making under risk
What is the expected utility theory?
Alterantive to the expected value theory/calculation
Instead of including the actual value, the individual utility is inserted
I.e. if the utility of earning 40.- is 30, we can then calculate the utility of winning 100 and 0 CHF -> can change the result of the best “rational” decision
The difference in utility between 40.- and 100.- might be smaller than the actual difference in value
-> Maximizing utility (rather than value) is also rational, since rationality = sticking to your preferences, being consistent
What do the different Value-utility functions/curves look like depending on how risk-averse a person is?
Risk aversion: Concave utility function (value > utility)
Risk neutrality: Linear utility function (value = utility)
Risk-seeking: Convex utility function (value < utility)
What can be said about risk preferences (in the context of decision making and utility)?
Risk preferences are not considered irrational (as long as chooser consistently maximises utility)
There is a context depencence to risk preferences (otherwise risk adverse people would never go to a casino)
Individual risk preferences can be assessed by presenting different decision problems and always adapting option A (the risky decision) -> depending on the decision pattern you can tell the risk preference of that person
On average across groups people are rather risk-averse (concave curve)
however, not to an extreme, they are around 0.5 risk averse
What is the exponential time discounting model?
People discount value over time by a certain factor
Can be calculated with the following equation:
U(X) = X x e^-kD
U(X) = utility of X
X = actual value of X (i.e. 20.-)
k = discount factor
D = delay (i.e 5 days)
Value of X changes/diminished depending on the Delay and the k factor
Time preferences are also rational, as long as they are dynamically consistent
Through choice patterns, the latent time variable k can be made visible
Which possible reasons for exponential time discounting exist?
Inflation (money might lose it’s worth)
Interest rate over money
Uncertainity about future wellbeing
How should policies be made if humans were perfectly rational choosers?
Policies should be aimed at making decision consequences transparent (perfect information)
No need to help decision makers make decisions
People would know best what they want
Libertarian principle of governance
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