HW: Individual Choice General Theory

1. Consider the following two paths.

Path 1: Out of her total wealth of £1000, DM bought a ticket to a concert, which cost her £50.
When she arrives at the concert hall, DM finds she has lost the ticket.
Path 2: DM, whose total wealth is £1000 is going to a concert. When she arrives at the
concert she discovers she has lost a £50 bill along the way.

a) If DM decides differently after Path 1 and Path 2 whether to buy a ticket or not, does this
constitute path-dependence? Explain. You can assume DM has enough cash to buy a ticket
after each path. (Hint: Figure out the available effective alternatives after each path. Each
effective alternative needs to specify DM’s remaining wealth and whether she sees the
concert.)

b) How about if DM had not lost the £50 bill on path 2? Explain.

2. (Stretch) Consider the following thought experiment about the effect of sunk costs.

Treatment 1: Your initial wealth is £1000. You pay £100 for a ticket to a basketball game.
The game is 60 miles away and you need to drive to get there. On the day of the game, there
is a snowstorm. Do you try to drive to the game through the snowstorm? (You cannot sell the
ticket if you miss the game.)

Treatment 2: Your initial wealth is £1000. You get a free ticket to the same basketball game.
(If you had to buy the ticket, the price is £100.) The game is 60 miles away and you need to
drive to get there. On the day of the game, there is a snowstorm. Do you try to drive to the
game through the snowstorm? (You cannot sell the ticket if you miss the game.)

Suppose you would drive to the game in Treatment 1 (when there’s a sunk cost), but not in
Treatment 2 (when there’s no sunk cost). If the sunk costs affect your behaviour in this way,
does this constitute path-dependence? Explain. (Hint: Figure out the available effective
alternatives in each treatment. Each effective alternative needs to specify your remaining
wealth and whether you drive to the game.)

3. Consider the following two paths:

Path 1: DM receives favourable news about Google.
Path 2: DM receives favourable news about Facebook.

After each path DM choose from {buy 1 share of Google stock for $50, buy 1 share of
Facebook stock for $30}. Suppose that after path 1 DM buys the Google stock while after
path 2 she buys the Facebook stock. Is there path-dependence?

4. (Stretch) Consider the following choices from various feasible sets:

Feasible set DM’s choice

{a,b} b

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 {a,c} a
{b,c} b
{a,b,c} a

Does DM satisfy WARP? If yes, why? If no, why not?

5. (Stretch) Consider the following restaurant dishes: A (which is cheap), B (which is more
expensive), and C (which is even more expensive). Suppose that DM chooses A from {A,B}
and B from{A,B,C}.

a) Does DM violate WARP? (Assume the only way in which the two decision situations
differ is in the feasible set.)

b) Suppose that, when a dish is the cheapest of three dishes, this provides less favourable info
about the quality of the dish than when it’s the cheapest of two dishes. Does DM violate
WARP?

c) This choice pattern is known as the compromise effect. Why do you think it’s called that?

6. (Stretch) Consider the following based on an experiment from Ariely (2008). There are
pictures of two people, A & B. Suppose -A/-B is a photo-shop-edited version of A/B with a
foible (say, a crooked eyebrow). A subject looks at the pictures and chooses with whom she’d
rather go out on a date. Suppose the subject is more likely to choose A from {A,-A,B} and B
from {A,B,-B}.

a) Does this violate WARP?

b) This choice pattern is known as the asymmetric dominance effect. (Ariely’s study and
other studies provide evidence for this effect.) Why do you think it’s called that?

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c) The company Williams-Sonoma was having trouble selling their bread-making machine.
I.e., most customers were choosing “not buy” from {buy machine, not buy}. How do you
think the company exploited the asymmetric dominance effect to boost the sales of this
machine?

7. The government is auctioning the rights to drill oil from a given oil field in Texas.
Company X is one of the bidders. Before it makes its bid, company X is given the
opportunity to conduct a test on the oil field in order to assess whether it is rich in oil or poor
in oil. Before looking at the field, company X believes that there is a .6 probability that the
field is rich in oil and a .4 probability that it’s poor in oil. It also believes that the test
procedure works in the following way:
- if the field is rich in oil the test comes out positive with probability .8 and negative
with probability .2;
- if the field is poor in oil the test comes out positive with probability .3 and negative
with probability .7.

a) If company X gets a positive test result, what is the probability that the field is rich in oil?
b) If company X gets a negative test result, what is the probability that the field is rich in oil?