EC3450

Summer Examinations 2022/23

Behavioural Economics: Theory and Applications

Section A: Answer ALL FOUR questions

1.

(a) Tanaka, T., Camerer, C. F., & Nguyen, Q. (2010) estimate the coefficient of β to be 0.644 in their paper titled Risk and Time Preferences Linking Experimental and Household Data from Vietnam. How would you interpret this β term and the coefficient? (8 marks)

(b) Discuss the main result of this paper with regards to time preference and income. (10 marks)

2.

(a) What is the Law of Small Numbers? (5 marks)

(b) Suppose the return to a mutual fund is drawn from an urn with 10 balls, 5 Up and 5 Down, with replacement. After 2 draws of Up, a rational investor expects the probability of another Up to be 0.5. Gambler’s fallacy would dictate that individuals compute such probability as 0.375 < 0.5. Explain this with the help of belief in Law of Small Numbers. (8 marks)

(c) How is the gambler’s fallacy different than overinference (hot hand fallacy)? (5 marks)

3.

(a) Are experimental results for the ultimatum game and dictator game consistent with the predictions of subgame perfect Nash equilibrium with money maximising agents? Explain why the assumption of subgame perfection is important. (10 marks)

(b) One of the main results of Charness and Rabin (2004) is a dictator game finding that around half of experimental subjects choose 375 for themselves and 750 for the other player, rather than 400 each. What do they suggest this may imply for different competing explanations of social preferences in experimental settings like these? (8 marks)

4.

(a) Explain what Frank (1997, 2005) means by ‘positional externalities’. Include reference to an explicit example. (9 marks)

(b) What do Di Tella et al (2001) find regarding the relative magnitude of the relationships between subjective well-being and inflation, and subjective well-being and the unemployment rate, and why might this kind of evidence be useful? (9 marks)

Section B: Answer ONE question

5.

(a) Explain the statement: time is discounted at constant rate. Is this claim empirically consistent? (8 marks)

(b) Briefly describe how the hyperbolic model of inter-temporal choice explains this empirical inconsistency. (6 marks)

(c) Explain the concept of ‘self-awareness of changing time preference’. Based on the example in the paper by O’Donoghue and Rabin (1999), consider the case when rewards are immediate and explain the choices made by Naïfs and Sophisticates. (14 marks)

6.

(a) What is the disposition effect? (6 marks)

(b) Describe how the disposition effect is measured in the paper by Odean (1998). What are the main results found in the study? (14 marks)

(c) Apply your understanding of the value function in Prospect Theory to explain the results found in Odean (1998). You may use a diagram to explain your answer. (8 marks)

7.

(a) Consider the sequential game below. Why might Player 1’s beliefs about others be important here? (6 marks)

(b) Why might label salience increase payoffs in coordination games, and what do Crawford et al (2008) find is the effect of label salience on coordination under asymmetric payoffs? Your answer should include the pattern of miscoordination as the size of the asymmetry varies. (12 marks)

(c) How do Crawford et al (2008) explain this pattern of miscoordination? (10 marks)

8.

(a) Explain how Chetty et al (2009) examine the potential importance of tax salience through a grocery store experiment. How are their experimental conclusions strengthened by observational data regarding alcohol consumption? (14 marks)

(b) Discuss the key implications of modern psychology for public economics and the evaluation of economic policy according to Layard (2006). Include explicit reference to both positional externalities and projection bias. (14 marks)