Microeconomics Lecture 2: Individual Choice Theory

Framing

Definition: Given a feasible set F, framing (or a framing effect) occurs if different ways of describing or presenting the alternatives in F, which are equivalent in terms of the information they provide about the alternatives in F, lead to different choices.In order for something to be classed as framing, it must:

- Be of the same informational set- And it must be informationally equivalent

No-Framing Assumption: One assumption made is that the feasible set F, there is no-framing.

Types of Framing:

*Different Wording: for example. Studies by Khaneman and Tversky (1981) found that different wording affects the choices that individuals made despite there being no difference in information in each text. For example if there was an operation that had a 30% chance of failure, there would be less people willing to undertake it, where as if there is a 70% chance of success, more people would take the treatment despite the fact both statements mean exactly the same thing.

*Different Complexity: for example if one company offered interest rates of 2% and 2.1%, more people would go towards the 2.1%, however, if I were to say; (210+976)/1000 pounds and (37-87)/1000 pounds, there would be a more even split, despite the fact both are exactly the same. This is noticed in phone plans, insurance policies and mortgage plans.

*Different Defaults: this is when an individual opts to do nothing, thereby the individual is automatically, assumed to be enrolled in the scheme. An example of this is organ donations. In countries such as France, an individual who has a driving licence has automatically opted in by getting a driving licence, however, in order to opt out, he/she must inform the agency they do not want to opt in. Caveat: when different choices leads to different decisions, only occurs if;

i. Default cannot be viewed as recommendation that provides relevant information

ii. No cost to switching from defaultHowever in organ donation, there is the cost of the individual going to the agency and opting out whereas the cost of the individual choosing to opt in is nothing.

*Narrow vs Broad Bracketing: lets assume that DM faces choices. DM knows she will be making all these choices. We can distinguish between; Narrow Bracketing- where DM reviews all choices individually or Broad Bracketing- where DM views all choices at once.Framing occurs when Narrow vs Broad Bracketing causes different choices.

Law of large numbersBecause there is a larger set of options there is a more attractive gambles (under broad bracketing) as opposed to any single gamble (under narrow bracketing), thus there may be framing as it alters behaviour despite the fact the odds are exact.

Path IndependenceDefining Alternatives;We will define each alternative so that it integrates the immediate objects of choice with DM’s existing assets.Assume DM has an Apple and she has the choice between getting a banana or orange. Thus it will be X={Apple & Orange, Apple & Banana}.Assumptions of Path Independence*Let us say there are different paths leading DM to face the same feasible set F. Let us also say the different paths do not convey different information about the alternatives in F. Then choice from F is the same after each path.In lemans terms it means that there is no factor that affects DM’s choice other than the two paths.When checking whether there is a violation, important to make sure that:-The feasible set is the same after the different paths-The different paths are informationally equivalent For example if DM is deciding on how to invest 100k;-Path 1: DM saves 100k from salary-Path 2: DM inherits 100k from aunt.If DM paths differ, it’s a violation of path independence.

Paths independence is not always good for normative or descriptive statement; Example 1:DM chooses from {tennis racket, violin}.Path 1: DM learns to play tennis.Path 2: DM learns to play the violin.Example 2:DM chooses from {have whole pie for myself, share pie with Tom}.Path 1: Tom is my former classmate.Path 2: Tom is a stranger.

*Important violations:– Endowment effect– Related vs. unrelated sunk costs– Disposition effect (not quite a violation)– Nonneutrality of composition of lifetime wealth (optional)– Imperfect crowding out of private charity by public charity

(optional)• In these cases, path-independence is often normatively more appealing

*Endowment Effect: choice depends on item F that DM previously owned. For example in a study by Kahneman, Knetsch and Thaler (1990), they gave the DM either a mug, a chocolate bar or a choice of the two. Then they were asked to trade it for the opposite item. When asked, they found that DM was less likely to give up their current item, whereas in the option where there was a choice, there was a 50/50 split, thus showing how owning something previously had an effect on DM’s choice.

*Related vs Unrelated Sunk CostsA sunk cost can be defined as a past cost that has already been incurred upon the individual.Given an alternative x in F, distinguish between:-Sunk costs related to x-Sunk costs unrelated to xAs a general rule, there is a violation of path-independence if DM’s choices are affected by whether sunk costs are related or unrelated to an alternative.

Example: Treatment 1DM buys house for 70k, then roses to100k but looses 30k in following year on the value of the house. DM is considering moving cities. Should she sell the house or keep it?Treatment 2DM buys house for 70k, increases to 100k, but then DM looses 30k on an unrelated business venture. DM is considering moving to another city, should she sell her house or keep it?

Both scenarios are equivalent in terms of information, DM has an equal amount of wealth and she looses 30k in some form, however her choices seem to differ due to related and unrelated sunk costs.

*Disposition Effect:

Microeconomics Lecture 3: INDIVIDUAL CHOICE: CHOICE OF CONSUMPTION BUNDLE

Consumption Bundle

Assume that there are two goods (apples & oranges). A consumption bundle x=(x1,x2) consists of x1 units of good 1 and x2 units of good 2. Objects of choice are consumption bundles. {insert picture}

More than 2 goods is straightforward conceptually (but more difficult to visualize)• Goods can be nontangible (museum visits, French lessons)

Goods are continuous:

- Small discrete units are fine (apples)- Cars, houses, etc. are not.(But living space area is ok.)

Main assumptions of C

Unless otherwise stated, we assume throughout C satisfies:- WARP- [continuity (a technical condition)]- monotonicity (see below)[Can be relaxed a bit to so-called local nonsatiation.]We also discuss another important assumption, called convexity

Monotonicity*Assumptions of Monotonicity:For any two consumption bundles x and y: if x lies northeast of y, then xSPy [if x lies exactly north or exactly east of y, then xPy]{insert picture}

I.e., more is better- If good is undesirable (pollution, stinky garbage, etc.), it can be redefined: pollutionàclean airUsually plausible as descriptive assumption, esp., if free disposal (i.e., if DM can throw away goods)Is it a good normative assumption if having more means:- Others have less- Resources are depleted- Environment is degraded- One becomes spoilt?

Convexity*Assumptions of Convexity:For any three consumption bundles, x, y, and, z, such that z lies on the line segment connecting x and y, we cannot have both xSPz and ySPz.. {insert Picture} Example:Assume we have two goods, a glass of orange juice and a glass of milk,