ECON2013

due 5:00pm Friday, 26 August, 2022.

1.(30 points) Explain each of the following findings/curiosities briefly using
concepts from the “Departures from Rational Choice” lectures.
(a) (10 Points) In an experiment half of the participants were randomly
given mugs, while the other half were given pens. After the partici-
pants looked at both items, the experimenter offered to exchange each
mug for a pen plus 5 cents, and each pen for a mug plus 5 cents. If
the characteristics of both groups are essentially the same and each
individual has fixed (that is, stable) given preference between mugs
and pens, then if, say, 60% of subjects on average preferred mugs to
pens, we should see approximately 60% of those given pens to switch
to mugs, and approximately 40% of those given mugs to switch to
pens. In general, we should see a situation where approximately x%
switch from mugs to pens, and approximately (100-x)% switch from
pens to mugs. However, it was observed that only 12% of those who
originally received a mug, and 10% of those who originally received a
pen, chose to exchange it for the other item plus 5 cents.
(b) (10 points) Dan Ariely in his 2008 book Predictably Irrational: The
Hidden Forces that Shape our Decisions, opens his first chapter with
an example relating to subscriptions to The Economist magazine.
(i) 1-year online subscription for USD 59
(ii) 1-year print subscription for USD 125
(iii) 1-year online and print subscription for USD 125
Why does The Economist magazine bother to offer an option that is
clearly dominated by one of the other two options?
(c) (10 points) In a study, students agreed to fill out a short online survey
for $2. At the end of the survey, respondents were offered a chance to
exchange their $2 for a gift. Some students could exchange the money
for a metal zebra pen, and some students could exchange the money
for their choice of a metal zebra pen or two plastic pilot pens. Among
the students who had two options for exchange, 53 percent chose to
keep the money. Of the students who had only one option, 25 percent
chose to keep the money. Explain these differences in the observed
(average) willingness to exchange.

2.(20 points) Explain the following phenomena using the idea that the
carrier of value for an individual is a function of the change in his or her
situation from a reference point by answering the following three questions:
(i) what outcome is being evaluated in a reference-dependent way? (ii) what
is the reference point?; and (iii) what feature of the value function explains
the phenomenon, and how?
(a) (5 points) On the residential housing market, each seller sets an initial
“asking price” for her house that can be substantially different from
the final sale price. Controlling for the current market value of their
house, sellers set a higher asking price, and eventually receive a higher
sale price, if the housing market has gone down since they bought their
house. (Houses of such sellers sit on the market for a longer time.)
(b) (5 points) Online sport betting platforms offer to pay out on bets
even before the conclusion of the sporting event. For example, if the
football team you back to win goes 2 goals ahead at any stage during
normal time, bet365 will settle your bet early as a winner regardless
of the final result.
(c) (5 points) Half of the subjects in an experiment were asked to imagine
that they were at the Apple Store to buy a keyboard case for their
iPad for $125, and then learned that they could buy the same caser
$5 cheaper at JB HiFi. However, the nearest JB HiFi store was a 20
minutes drive away. 30% said they would drive to the JB HiFi store.
The other half of the subjects were asked the same question, except
they were told the keyboard case cost $15. This time, 70% reported
that they would drive to the other store to save $5.
(d) (5 points) Small investors tend to hold on to losing stocks (stocks that
have gone down in value relative to the purchase price) and sell winning
stocks (stocks that have gone up in value relative to the purchase price)

3.(50 points) When the Australian Government introduced the ‘carbon
tax’ on 1 July 2012, it was accompanied by a package of tax reforms and
other compensation measures designed to make the average household at
least as well off despite the rise in electricity prices resulting from the im-
position of the carbon tax. Suppose we model the average household’s con-
sumption of electricity as a utility maximization problem in which the house-
hold is choosing between consumption of electricity (measured in units of
gigawatt hours along the horizontal axis) and its consumption of “all other
goods” (hereafter referred to as “aog”, and measured in units of dollars)
along the vertical axis. If we normalize the price of aog to be 1, and let p
denote the price of electricity, then the slope of the household’s budget line
will be −p.
(a) [20 marks] Using the standard model of rational choice, analyze
the effect of an increase in the price of electricity accompanied by a
compensation package that increases the household’s income by the
amount that its expenditure on electricity would need to rise in order
to purchase the same quantity of electricity that it was demanding
before the price rise. In particular argue why the Government was
expecting such a household to reduce the quantity of electricity it
demanded and for that household to be made better off as a result
of these changes. [Hint: you may assume that the average household
exhibits the property of “moderation in all things” or equivalently, that
“variety is the spice of life” and thus draw indifference curves that are
bowed-in toward the origin.]
(b) [20 marks] Repeat your analysis but this time for a household that
exhibits loss aversion.
(c) [10 marks] For a household that exhibits loss aversion, how else might
the Government encourage it to reduce those activities (such as its
demand for electricity) that contribute to green-house gas emssions?