Behavioral Economics Assignment 2

Course on
BEHAVIOURAL ECONOMICS (S1 2019)
Ralph-Christopher Bayer
Assignment 2
Deadline: End of Week 13 (Sunday June 16th, midnight)
Multiple Choice Questions
1. A person that chooses the alternative that has the highest Expected Value, when risk is
involved, violates the assumptions of expected utility maximization.
True. An individual chooses the outcome with the highest expected utility according to
expected utility maximization. So, on the basis of expected value, the assumption of
expected utility maximization is violated
2. An expected utility maximizer with u(x) = log(x) rejects all fair gambles (i.e. those
with an expected value of zero).
False. Because a common utility model suggested by Bernoulli, himself is logarithmic
function of the gamblers total wealth (x) and the concept of diminishing marginal utility
of money is built into it.
3. Prospect Theory can explain the Ellsberg Paradox.
False. The combining behavioral economic theory known as the prospect theory and it
can explain in Allais paradox not Ellsberg paradox.
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4. Sophisticated Quasi-Hyperbolic Discounters behave time consistently, as they know
that they will have a present bias in future decisions and therefore act to eliminate the
bias.
True. Hyperbolic discounters behave time inconsistent model of delay discounting.
5. The outcome resulting from a Nash Equilibirum is socially efficient, since in a Nash
Equilibrium all players play best responses to each other.
False. Nash Equilibrium is an outcome in which every player is doing the best possible
can be given other player’s choices. So, no player can benefit from unilaterally
changing his choice.
6. Rational preferences should only depend on the person’s own outcomes (such as their
own consumption, wealth, etc.)
True.
7. Jack, who has the utility function u(x,y) = x − γy, where x is his own material payoff,
while y is the material payoff of his neighbour, can be described as envious.
False
8. Somebody who plays the lottery cannot be an expected utility maximizer.
False
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9. If somebody is taking drugs, then that does not necessarily mean that she/he cannot be
an exponential discounter.
False
10. The Allais Paradox demonstrates that many humans evaluate the same lotteries
differently if they are combined with the same other lottery.
True. The lotteries are evaluated differently because the earlier ones are nested within
others and the new ones are of compound nature.
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Problems
1. Lucy has current wealth of $100,000. She has just been sent a notice to pay $500 for
speeding. Lucy decides not to pay and to go to court. There she will either get off
(because of insufficient evidence)and pay nothing or will have to pay the fine plus the
court cost which together amount to $1,000. Lucy sees her chances of getting off at
50%.
(a) Suppose Lucy is an expected utility maximizer. Draw a graph with a utility function
that can explain Lucy’s choice. Clearly label the wealth axis. Mark the expected
utility of going to court and the utility of paying the fine.
Part a )
Current wealth of Lucy w=$ 100,000
Now, in scenario 1 Lucy can go to court and decide not to pay anything and get
which has a probability pr (Q)= 50 % or 0.5
In scenario 2 , she will have to pay the fine and the court expenses amounting to a
total of $ 1000. The probability of paying all the expenses, Pr(E)=50% or 0.5 as
well know
, the Expected utility (EV) =Pr (event 1).Gain from event 1+Pr(event 2). Gain from
event 2 + Pr (event 3). Gain from event +Pr (event n). Gain from event n.
In scenario 1 Lucy’s gain= $ 100,000as she pays nothing in scenario 2 her gain = ($
100,000-$ 1000)=$ 99,000
Lucy’s expected utility from scenario 1(getting off)= Pr(G)Gain from getting off
scenario 1.
=0.5 ($ 100,000)
=$ 50,000
= Ev (G)
Lucy’s expected utility from scenario 2 paying a total of $
1000
Pr (E) Gain from scenario 2
=0.5 ($ 99,00)
=$ 49,500=EV(E)
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