Fall 2015 USC

ECON 415 Behavioral Economics Professor Yilmaz Kocer

SAMPLE MIDTERM I PROBLEMS

1. (Rationalizable Choice, based on Kalai, Rubinstein, Spiegler (2002)) An agent is choosing a car, x X.
Each car has a price and a quality (assume no two cars have the exact same quality or price). She has a
"target" quality q and a target price p. For any choice set (i.e, a set of cars A C X),
a) If there is any car (in her choice set) with quality q or better, then she buys the highest quality car in the
choice set. If not, she goes for the cheapest car. Is her choice rationalizable?
Answer: yes
b) If the highest quality car (in her choice set) is cheaper than p, she buys that car. If not, she buys the
cheapest car. Is her choice rationalizable?
Answer: no !

2. (Fixed Costs and Rational Firm behavior) Firm A and Firm B produce a good called x and both firms have a
production function given by

. It costs each firm $0.25 to produce each unit of x and both firms sell a

unit of x for $2. However, to purchase the equipment needed to produce x, Firm A spent $2500 and Firm B spent
$1500. The equipment each firm purchased is identical. How many units of x should each firm produce?

Answer: Both firms should produce 16 units of x. Each firm solves its maximization problem: Firm A solves
and Firm B solves
result in

. Both maximization problems

3. (Two Part Tariffs) A consumer has a budget constraint given by

if positive amounts of
has a utility function given by

where

are purchased and 0 otherwise. If the consumer

, then how much of

does the consumer purchase?

Answer: 13. This utility function has a bliss point at 13. If the consumer consumes more or less than 13 he loses
utility.

4. (Endowment Effect under Rationality - Income Effect) Suzie has $50 of income and a utility function
given by
a.

. The price of good 2,

First suppose

Answer:
b.

How much is Suzie willing to pay to acquire one unit of

Now suppose
Answer:

d.

does Suzie have?

Answer:
c.

How much of

is $2.

How much is Suzie willing to sell her one unit of

George faces the same prices and has the same income as Suzie, but his utility function is given by
.

e.

Repeat part a.

Answer:
f.

Repeat part b.
Answer:

g.

Repeat part c.
Answer:

h.

What feature of the utility function results in

Answer: Concavity.

5. (Prospect Theory / Loss Aversion ) Consider a Prospect Theory expected-value maximizer with value

function defined over gains and losses relative to a reference point 0, defined as no gains or losses:





v(x) = { x for x 0




2x for x < 0 }
He has some money invested, and each day the value of his investments goes up by $3000 with probability
or down by $1000 with probability , and the probability of up or down on the second day is
independent of what happened on the first day. Suppose first that he has the choice of checking his portfolios
performance either at the end of each day, or only at the end of the second day. However, even if he chooses
to check at the end of each day, he still cannot change his portfolio after the first day. His expected value is
additive across days, so that if he checks at the end of each day, his total expected value equals his expected
value from the first day plus his expected value from the second day. But if he checks only at the end of the
second day, his total expected value is just his expected value from the sum of both days outcomes. (That is,
he experiences his gains or losses whenever he checks, whether it is at the end of each day or only at the end
of both days.)

(a) Which will he prefer, to check his portfolios performance at the end of each day or to check only at the end of the
second day? Explain, both algebraically and intuitively.

If he checks at the end of each day, his expected value for each day is:
3000 21000 = 750 - 1500 = -750, for a total expected value of -1500 over the two days.
If he checks only at the end of the second day, his total expected value is:
(1/16)(3000+3000) + 2(3/16)(3000-1000) (9/16)2(1000+1000) = -18000/16 = -1125.
So its better to check only at the end of the second day. Intuitively, checking only at the end of the second day
gives him a chance of offsetting some losses against possible gains. With loss aversion, this increases his total
expected value.


Now suppose that he faces the same choice, but that if he decides to check at the end of each day, he can pull all of his
money out of the stock market (the only option) at the end of the first day is he wishes. Further suppose that even if he
decides to check at the end of each day, his value is still determined by his total gains or losses over both days, with
reference point 0.

(b) What would his investment decision be at the end of the first day, if he finds that his stocks have gone up by $3000?
Explain, both algebraically and intuitively.

Given that his stocks have gone up by $3000, if he leaves his money in for the second day he has a chance of
ending up with a total gain of $6000 and a chance of ending up with a total gain of $2000. This yields him
total expected value 6000 + 2000 = 3000, so he is indifferent between leaving his money in for the second
day and pulling it out. Intuitively, if his stocks go up in the first day, he is assured of a gain. He is then
effectively risk-neutral, and the investment has zero expected return, so he is indifferent between leaving his
money in and taking it out.
(c) What would his investment decision be at the end of the first day, if he finds that his stocks have gone down by
$1000?

Given that his stocks have gone down by $1000, if he leaves his money in for the
second day he has a chance of ending up with a total gain of $2000 and a chance of ending up with a total
loss of $2000. This yields him total expected value 2000 -22000 = -2500. If he pulls his money out after
the first day, his total expected value is -2000, so its better to pull it out after the first day.

(d) Given the investment decisions in (b) and (c), and assuming that he breaks any ties in his optimal decisions by
leaving his money in the investment, which will he prefer, to check at the end of each day or to check only at the end of
the second day?

If he checks at the end of each day, under the tie-breaking assumption he will leave his money in if he has a
gain, realizing total expected value 3000; and pull it out if he has a loss on the first day,realizing total expected
value -2000. Thus if he checks at the end of each day, his total expected value is 3000 - 2000 = -750. If he
checks only at the end of the second day, his total expected value is -1125 from part (a). So he will prefer to
check at the end of each day.

6. (Ambiguity Aversion )Suppose there are two jars. In Jar 1 I know that there are 10 white balls and either 5
or 20 black balls. In Jar 2 I know that there are 10 red balls and either 10 or 30 black balls. I receive $5 if a
white ball is drawn from jar 1 and $10 if a red ball is drawn from jar 2 and 0 otherwise.
a. Suppose that I am risk-neutral. Using maxmin expected utility theory, do I draw from jar 1 or jar 2 and
what is the value of my maxmin expected utility?
Answer: I use the lowest possible values for probabilities of white or red balls being drawn from jar 1 and jar
2, respectively. This means that I perceive the probability of drawing a white ball from jar 1 as 1=1020 and
the probability of drawing a red ball from jar 2 as 2=1030. The expected utility of drawing from Jar 1 is then
1=1020(5) and from jar 2 2=103010. max125,1310=max{2.5,103}=103 I choose jar 2.
b. Now suppose I am risk-averse, with a utility function given by =ln. Do I choose Jar 1 or Jar 2?
Answer: The problem reduces to choose max125,1310=12ln5 I choose jar 1.

7. (Loss Aversion and Aggregating/Segregating Gains/Losses) A consumers indirect utility function is given

The individual wins $500 dollars at the casino, but gets a speeding ticket that requires him to pay $75 on his
drive home. Is he better off by integrating or segregating these two transactions?

Answer: He is better off segregating. If he segregates the two transactions then he receives
If he integrates then he receives

8. (Bracketing Decisions) I live for two time periods: today and tomorrow. At the beginning of today, I must
choose to smoke cigarettes or not smoke cigarettes. On the first day that I smoke cigarettes, I receive a utility
of and pay a cost of c. I only receive a utility from smoking on the second day and still pay cost . But,
I also receive a fraction
of utility from yesterdays smoking. If I choose not to smoke on a given
day, then my utility is 0. Let
, and
. I am risk neutral and I care about the sum of today's and
tomorrow's utility.

a. If I do not choose to start smoking today, will I choose to smoke tomorrow?
No. My utility from today is 0 and my utility tomorrow will be
choose not to smoke.

if I choose to smoke and 0 if I

b. Suppose
that is, I carry no utility from smoking today into tomorrow. If I choose to smoke today,
will I quit tomorrow?
Answer:No.

. In fact, if

, Im better off not smoking today either.

c. Suppose
that is, I carry all of the utility from smoking today into tomorrow. If I choose to smoke
today, will I quit tomorrow?
Answer:

No.

d. What is the minimum level of that I will smoke today and tomorrow.
Answer:

This is always true if

9. (Bracketing Decisions) Raul is trying to plan what to do on Saturday. He will do one leisure activity in
the afternoon and one chore in the morning. His two leisure activity choices are a movie and hiking and his
two chore choices are paying bills and mowing the law. He prefers hiking to going to the movies only if its
sunny. And prefers mowing the lawn over paying the bills only if its sunny. However, whats most
important to Raul is to not over-exert himself: mowing the lawn and hiking on the same day is too much
activity for Raul.

a. Raul wakes up on Saturday and sees that its sunny. If the decision for the Saturdays activities is taken
simultaneously, how does Raul rank the activities: U(morning activity, afternoon activity)? (Hint: there
may be more than one correct answer).
Answer: U(bills, hike)>U(mow, movie)>U(bills, movie)>U(mow, hike).
b. Raul wakes up on Saturday and makes his choices sequentially. In the morning it is sunny. Write down
Rauls decision problem in the morning and his choice.
Answer:

Choice of morning activity is to mow.

c. It is still sunny in the afternoon when Raul must decide which leisure activity to do. Write down Rauls
decision problem in the afternoon and his choice.
Answer:

Choice of afternoon

activity is to go to the movies.

d. Is Raul better off making decisions sequentially or simultaneously?
Answer: Simultaneously. If he had known that it would be sunny all day he would have preferred to do
the bills in the morning and then go hiking in the afternoon. However, he wasnt sure whether the sun
would stay out and so he made his choice in the morning only based off his preference for mowing and
paying the bills.