Practice More Quizzes:
Q:
One example that we saw in Utility of Money was labeled “Example 1: Two Decisions with Gains and Losses.” You were invited
to make two decisions, to which many people select outcomes A & D. The Example is replicated below.
Which axiom does the A-D error violate?
Q:
Choosing vs. Pricing: preferring one option, but being willing to pay more for the other, violates which axiom?
Q:
Here is the Allais Paradox, which we looked at this week.
Which of the following axioms does the Allais Paradox violate?
Q:
For many years—for so long, in fact, that he practically forgot that he had them—Mr. Duke has owned $20,000 worth of shares in a certain company. One day he remembers them and considers whether he should sell them. He notes that they have exactly maintained their value over the years, so he decides to hold onto them.
A few months later, the company unexpectedly fails, and his shares are no longer worth anything. Mr. Duke realizes that he has lost $20,000.
His friend Mr. Brown has also owned shares worth $20,000 in a company; and he, too, has almost forgotten that he possessed them. One day, he remembers the shares and considers whether to keep or sell them. He notes that they have maintained their value throughout the years, so he decides to convert them to cash. A few months later, the company whose shares he had sold unexpectedly markets a new product, and the value of its shares doubles. Mr. Brown realizes that he has $20,000 less than he might have had if he had just held onto the shares he had owned for so many years.
Both men started in the same position, and both came to the same conclusion (ending up $20,000 poorer), but they feel different levels of regret. Most people would argue that Mr. Brown feels a stronger sense of regret than Mr. Duke.
If so, which of the following best explain his greater disappointment?
Q:
Suppose that Mr. K buys 1,000 shares in a software company at $25 / share. The company is currently attracting considerable media attention for its new accounting software, a highly touted product that is expected to become the industry standard, with considerable improvements in both efficiency and ease of use.
Mr. K is an accountant who also has considerable expertise in evaluating accounting software options. He read all of the software company’s advance information on the new package and carried out his own extensive research prior to buying the shares. Within two weeks of his purchase, the shares are up to $30, and Mr. K is tempted to sell them. He decides to hold on, however, as the industry excitement about the new software is increasing as the release date approaches. The shares continue to appreciate until there begin to be whispers about a serious bug in the software. In the weeks coming up to the release date, the company’s share price becomes increasingly volatile, as rumors and counter-rumors abound. The company’s share price falls below $30, and then below $25. Occasionally some positive stories on social media cause brief bounces in the price, but Mr. K is becoming increasingly pessimistic about the product. The shares are currently trading at $20. Although Mr. K now believes that the product will fail, he decides to hold onto the shares in the hope that a new rumor will bounce the price up to $25 so that he can sell.
Which Prospect Theory feature best explains Mr. K’s behavior during the time that he has owned these shares?
Q:
Think about the visual illusion in which three triangles somehow became four triangles, even though the changes on the page were not triangular. Suppose we compare this visual distortion to the way in which we sometimes “distort” rational decision-making by violating the Axioms.
This visual illusion could serve as a metaphor for the violation of which Axiom?
Q:
Let’s assume we all have preferences that are consistent with Prospect Theory. Suppose also that we could select whether our salaries are paid on a weekly basis or a monthly basis. Which alternative would we pick, assuming that the total monthly salary is the same as the sum of the weekly payments? Ignore the impact of extra interest that
Q:
Now suppose you have the option to pay your utility bills on an annual rather than a monthly basis. Assume that you have enough money in the bank that you could pay the annual bill (which is simply the sum of all of your monthly bills) without running an overdraft or taking out a loan.
If your choices are consistent with Prospect Theory preferences, would you choose to do so? Once again, ignore the impact of any interest that you would earn (or forego).
Q:
This week, you were introduced to the Disposition Effect, which highlights the way in which many people’s preferences “flip” from Decision A to Decision D—even though A & C are identical, as are B & D. [Note: There is more than one correct answer]
Which of the following aspects of Prospect Theory help(s) to explain this violation of the Invariance Axiom (select all that apply).
Q:
Suppose there are two investors: Michael and Steve. Both have pension funds, into which they deposit money each month from their paychecks. Both are in their early 30s, and anticipate retiring at around age 65. Neither anticipates withdrawing any money from his pension fund prior to retirement.
Michael watches his pension fund closely, looking each week at whether has gone up or down in value. On a week to week basis, the US equity markets are down almost as often as they are up. Steve, on the other hand, only checks the value of his pension fund once every five years or so. On a five-year basis, the US equity markets are down less than 10% of the time.
Michael’s pension fund money is all in bonds, while Steve’s is all in equities.
Which single feature of Prospect Theory provides the best explanation for the two men’s different portfolio allocations?
Q:
Assume an investor recently purchased shares in Dynamo Products (a hypothetical company) at $60 per share. Shares are now at $40. See the three attached Prospect Theory value functions. Which of the value functions below correctly reflects the investor’s value function assuming:
(1) The investor has updated his reference point for the price of the Dynamo shares?
(2) The investor has not updated his reference point?
Q:
Which bias helps to explain why people like to go to all-inclusive resorts, where the entire cost of the vacation is paid upfront, and guests don’t have to pay for individual meals, drinks, activities etc., even though they know they will probably end up paying more for the all-inclusive than if they went to a regular resort?
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