Questions and Answers by topic
Introduction and Brief History
1. ‘Behavioural economics should enhance, not replace, traditional economics’. Comment on this statement.
A good answer will begin by explaining what behavioural economics is and give a brief history (how it gained
momentum around 1950s as it was easier to target standard economics theory. Why there was a need for
behavioural economics and finally give an overview of how it works.
Behavioural Economics is the method of economic analysis that applies psychological insights into human behaviour
in order to explain economic decision making. Neoclassical economics take a normative approach and adopts basic
axioms of rationality which can be described by a standard utility function that is only observable from choices and is
therefore ordinal in nature.
Behavioural Economics does not abandon the neoclassical (traditional) method but enhances it by adding new, non-
traditional assumptions. We note a number of areas where empirical evidence has underlined the failure of
traditional Economic assumptions and these anomalies provide basis for Behavioural Economics. Some empirical
examples outlining the failure of standard theory include the Allais Paradox, Ellsberg Paradox and Framing Effect.
Despite this, standard assumptions are still appropriate however can be expanded on by Behavioural Economics,
through additional insights from psychology, to introduce and build on concepts such as altruism and envy.
Behavioural Economics therefore has its place in enhancing traditional economic methods. The most common
method used in Behavioural Economics is that of experimental economics, which are completed in labs or in the
field, although observational, survey-based data studies and alternative Neuroeconomic methods are also as
important. The concept involves identifying anomalies from standard economic theory and constructing new,
behaviour-based models using behavioural assumptions from alternative theories that generalise existing models.
identify normative assumptions or models that are universally used by economists, such as Bayesian
updating, expected utility, and discounted utility
identify anomalies—i.e., demonstrate clear violations of the assumption or model, and painstakingly rule
out alternative explanations, such as subjects’ confusion or transactions costs
use the anomalies as inspiration to create alternative theories that generalize existing models
construct economic models of behaviour using the behavioural assumptions from the third step, derive
fresh implications, and test them
Decision Under Uncertainty
What are the main assumptions of the Expected Utility Theory (EUT)? Give two examples (of puzzles or deviations)
where the standard theory is not empirically robust. (18 marks)
The four assumptions of the EUT are:
1. Transitivity
2. Completeness
3. Independence
4. Continuity
Transitivity means that if ApB and BpC, then ApC. Completeness means that for any prospects A and B, either ApB,
BpA or an agent is indifferent between the two. Independence means that the preference over two lotteries is not
affected by mixing in a third. Continuity means that given a good, medium and bad lottery, there is some weighted
average of the good and bad ones that is exactly as good as the medium one. The Allais paradox and Ellsberg
paradox are both examples of deviations from the assumption of independence.
EUT Function
,2. What is the Allais paradox and how should standard expected utility theory be modified to explain the
paradox? (18 Marks)
Given the choice between A and B, most people will choose A, yet given the choice between C and D, most
people will choose D. This is a violation of the independence axiom as the transition of gambles A and B to C and
D are simply characterized by the removal of the 89% chance of winning 5 million, this change being identical for
both gambles, yet results in preference reversal. This means that the addition of a further prospect creates a
contradiction in preferences between A and B, which violates the independence axiom of standard utility theory.
This finding can be explained by the intuition that removing the 89% chance of winning 5 million matters more
for gamble A than gamble B, because changing a sure thing to a risk is more of a deal than changing a risk to a
risk. This evidence is known as the certainty effect. This deviation from the EUT could be explained by
incorporating a weighting function, as is done in prospect theory.
In prospect theory, probabilities are replaced by decision weights, meaning that the impact of events are
measured by the desirability of prospects rather than merely the perceived likelihood of these events.
How does the Prospect Theory differ from the EUT? Explain with reference to the Allais Paradox (14 marks)
Main difference between EUT and PT in terms of Value Function and Weighting Function. Can show the two
functions to differentiate and explain related concepts (Value Function, Weighting Function)
Demonstrate the difference in reference to the paradox.
For example, no assumption of Independence axiom made under PT.
PT can explain the choice of A (certain outcome) and D [compared to Gamble C, the difference in probability is
minor, but large difference in amount of win] in the gamble.
3. The following is a quote from Adam Smith’s ‘The theory of Moral Sentiments’: “we suffer more . . . when we
fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better.” Can you
link this to any concept in behavioural theory that you have learned in the course? Explain this concept with
an example. (18 marks)
- Loss aversion
- Prospect theory
1. Explain how prospect theory differs from the EUT standard model.
Key inconsistencies of utility theory:
- people underweight outcomes that are probable compared to outcomes obtained with certainty = certainty
effect
- certainty effect contributes to risk aversion in choices involving certain gains, and risk seeking in choices
involving certain losses WEIGHTING FUNCTION
, - people generally discard components shared by all prospects under consideration = isolation effect
results in inconsistent preferences when the same choice is presented in different forms VALUE
FUNCTION
Key components of prospect theory:
- VALUE FUNCTION = value assigned to gains and
losses rather than assets concave for gains,
convex for losses and steeper for losses than for
gains
- WEIGHTING FUNCTION= probabilities are replaced by
decision weights decision weights are generally
lower than corresponding probabilities, except in the
low probability range, in which probabilities may be
overweighted- this overweighting of low
probabilities may contribute to the attractiveness of
both insurance and gambling
- S-shaped value function similar to standard utility
function except defined on gains and losses instead of
levels of wealth. It is concave in gains domain and
convex in losses domain, and steeper for losses than
for gains implies people are generally risk averse
(risk averse in gains and loss averse altogether
(although risk seeking in high losses))
2. Explain the Ellsberg paradox. What assumption is violated here? Is ambiguity aversion a good explanation
for this paradox?
30 balls 60 balls
Gamble Red Black Yellow
A $100 $0 $0
B $0 $100 $0
C $100 $0 $100
D $0 $100 $100
In most cases people will choose A over B and D over C. This is in violation of independence axiom as we would
anticipate that those who choose gamble A over gamble B would also choose gamble C over D. Ambiguity
aversion can explain the paradox since it is thought that betting for or against the known information (red ball) is
safer than betting for or against the unknown (black ball). Here, A≻B because the proportion of red balls is
known and D≻C because the proportion of black and yellow balls is known.
2. Explain the Ellsberg paradox. What assumption is violated here? Is ambiguity aversion a
good explanation for this paradox?
The Ellsberg paradox where given two choices, it has been shown that people tend to choose an option where there
is known information rather than betting for/against missing information, even if this means violating the
independence axiom of EUT example with balls - independence assumption violated as preference between red
and blue should remain the same (red preferred in A but then blue preferred in second scenario if D chosen, by the
Introduction and Brief History
1. ‘Behavioural economics should enhance, not replace, traditional economics’. Comment on this statement.
A good answer will begin by explaining what behavioural economics is and give a brief history (how it gained
momentum around 1950s as it was easier to target standard economics theory. Why there was a need for
behavioural economics and finally give an overview of how it works.
Behavioural Economics is the method of economic analysis that applies psychological insights into human behaviour
in order to explain economic decision making. Neoclassical economics take a normative approach and adopts basic
axioms of rationality which can be described by a standard utility function that is only observable from choices and is
therefore ordinal in nature.
Behavioural Economics does not abandon the neoclassical (traditional) method but enhances it by adding new, non-
traditional assumptions. We note a number of areas where empirical evidence has underlined the failure of
traditional Economic assumptions and these anomalies provide basis for Behavioural Economics. Some empirical
examples outlining the failure of standard theory include the Allais Paradox, Ellsberg Paradox and Framing Effect.
Despite this, standard assumptions are still appropriate however can be expanded on by Behavioural Economics,
through additional insights from psychology, to introduce and build on concepts such as altruism and envy.
Behavioural Economics therefore has its place in enhancing traditional economic methods. The most common
method used in Behavioural Economics is that of experimental economics, which are completed in labs or in the
field, although observational, survey-based data studies and alternative Neuroeconomic methods are also as
important. The concept involves identifying anomalies from standard economic theory and constructing new,
behaviour-based models using behavioural assumptions from alternative theories that generalise existing models.
identify normative assumptions or models that are universally used by economists, such as Bayesian
updating, expected utility, and discounted utility
identify anomalies—i.e., demonstrate clear violations of the assumption or model, and painstakingly rule
out alternative explanations, such as subjects’ confusion or transactions costs
use the anomalies as inspiration to create alternative theories that generalize existing models
construct economic models of behaviour using the behavioural assumptions from the third step, derive
fresh implications, and test them
Decision Under Uncertainty
What are the main assumptions of the Expected Utility Theory (EUT)? Give two examples (of puzzles or deviations)
where the standard theory is not empirically robust. (18 marks)
The four assumptions of the EUT are:
1. Transitivity
2. Completeness
3. Independence
4. Continuity
Transitivity means that if ApB and BpC, then ApC. Completeness means that for any prospects A and B, either ApB,
BpA or an agent is indifferent between the two. Independence means that the preference over two lotteries is not
affected by mixing in a third. Continuity means that given a good, medium and bad lottery, there is some weighted
average of the good and bad ones that is exactly as good as the medium one. The Allais paradox and Ellsberg
paradox are both examples of deviations from the assumption of independence.
EUT Function
,2. What is the Allais paradox and how should standard expected utility theory be modified to explain the
paradox? (18 Marks)
Given the choice between A and B, most people will choose A, yet given the choice between C and D, most
people will choose D. This is a violation of the independence axiom as the transition of gambles A and B to C and
D are simply characterized by the removal of the 89% chance of winning 5 million, this change being identical for
both gambles, yet results in preference reversal. This means that the addition of a further prospect creates a
contradiction in preferences between A and B, which violates the independence axiom of standard utility theory.
This finding can be explained by the intuition that removing the 89% chance of winning 5 million matters more
for gamble A than gamble B, because changing a sure thing to a risk is more of a deal than changing a risk to a
risk. This evidence is known as the certainty effect. This deviation from the EUT could be explained by
incorporating a weighting function, as is done in prospect theory.
In prospect theory, probabilities are replaced by decision weights, meaning that the impact of events are
measured by the desirability of prospects rather than merely the perceived likelihood of these events.
How does the Prospect Theory differ from the EUT? Explain with reference to the Allais Paradox (14 marks)
Main difference between EUT and PT in terms of Value Function and Weighting Function. Can show the two
functions to differentiate and explain related concepts (Value Function, Weighting Function)
Demonstrate the difference in reference to the paradox.
For example, no assumption of Independence axiom made under PT.
PT can explain the choice of A (certain outcome) and D [compared to Gamble C, the difference in probability is
minor, but large difference in amount of win] in the gamble.
3. The following is a quote from Adam Smith’s ‘The theory of Moral Sentiments’: “we suffer more . . . when we
fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better.” Can you
link this to any concept in behavioural theory that you have learned in the course? Explain this concept with
an example. (18 marks)
- Loss aversion
- Prospect theory
1. Explain how prospect theory differs from the EUT standard model.
Key inconsistencies of utility theory:
- people underweight outcomes that are probable compared to outcomes obtained with certainty = certainty
effect
- certainty effect contributes to risk aversion in choices involving certain gains, and risk seeking in choices
involving certain losses WEIGHTING FUNCTION
, - people generally discard components shared by all prospects under consideration = isolation effect
results in inconsistent preferences when the same choice is presented in different forms VALUE
FUNCTION
Key components of prospect theory:
- VALUE FUNCTION = value assigned to gains and
losses rather than assets concave for gains,
convex for losses and steeper for losses than for
gains
- WEIGHTING FUNCTION= probabilities are replaced by
decision weights decision weights are generally
lower than corresponding probabilities, except in the
low probability range, in which probabilities may be
overweighted- this overweighting of low
probabilities may contribute to the attractiveness of
both insurance and gambling
- S-shaped value function similar to standard utility
function except defined on gains and losses instead of
levels of wealth. It is concave in gains domain and
convex in losses domain, and steeper for losses than
for gains implies people are generally risk averse
(risk averse in gains and loss averse altogether
(although risk seeking in high losses))
2. Explain the Ellsberg paradox. What assumption is violated here? Is ambiguity aversion a good explanation
for this paradox?
30 balls 60 balls
Gamble Red Black Yellow
A $100 $0 $0
B $0 $100 $0
C $100 $0 $100
D $0 $100 $100
In most cases people will choose A over B and D over C. This is in violation of independence axiom as we would
anticipate that those who choose gamble A over gamble B would also choose gamble C over D. Ambiguity
aversion can explain the paradox since it is thought that betting for or against the known information (red ball) is
safer than betting for or against the unknown (black ball). Here, A≻B because the proportion of red balls is
known and D≻C because the proportion of black and yellow balls is known.
2. Explain the Ellsberg paradox. What assumption is violated here? Is ambiguity aversion a
good explanation for this paradox?
The Ellsberg paradox where given two choices, it has been shown that people tend to choose an option where there
is known information rather than betting for/against missing information, even if this means violating the
independence axiom of EUT example with balls - independence assumption violated as preference between red
and blue should remain the same (red preferred in A but then blue preferred in second scenario if D chosen, by the
