Micro-Economics AP Chapter 8 Vocabulary & Review – Flashcards

The dominant and conventional branch of economic theory that attempts to predict human behavior by building economic models based on simplifying assumptions about people's motives and capabilities. These include that people are fundamentally rational; motivated almost entirely by self-interest; good at math; and unaffected by heuristics, time inconsistency, and self-control problems.

The branch of economic theory that combines insights from economics, psychology, and biology to make more accurate predictions about human behavior than conventional economics, which is hampered by its core assumptions that people are fundamentally rational and almost entirely self-interested. Behavioral economics can explain framing effects, anchoring, mental accounting, the endowment effect, status quo bias, time inconsistency, and loss aversion.

Behaviors and decisions that maximize a person's chances of achieving his or her goals.

Suboptimal choices that (1) are not rational because they do not maximize a person's chances of achieving his or her goals and (2) occur routinely, repeatedly, and predictably.

People are fundamentally rational and will adjust their choices and behaviors to best achieve their goals. Consequently, they will not make systematic errors.

People are irrational and make many errors that reduce their chances of achieving their goals. Some errors are regularly repeated systematic errors.

People's preferences are completely stable and unaffected by context.

People's preferences are unstable and often inconsistent because they depend on context (framing effects).

People are eager and accurate calculators.

People are bad at math and avoid difficult computations if possible.

People are just as good at assessing future options as current options.

People place insufficient weight on future events and outcomes.

People have no trouble resisting temptation.

People lack sufficient willpower and often fall prey to temptation.

People are almost entirely self-interested and self-centered.

People are often selfless and generous.

People do not care about fairness and only treat others well if doing so will get them something they want.

Many people care deeply about fairness and will often give to others even when doing so will yield no personal benefits.

The brain's low-energy mental shortcuts for making decisions. They are "fast and frugal" and work well in most situations but in other situations result in systematic errors.

Misperceptions or misunderstandings that cause systematic errors. Most result either (1) from heuristics that are prone to systematic errors or (2) because the brain is attempting to solve a type of problem (such as a calculus problem) for which it was not evolutionarily evolved and for which it has little innate capability.

In prospect theory, changes in people's decision making caused by new information that alters the context, or "frame of reference," that they use to judge whether options are viewed as gains or losses relative to the status quo.

- Behavioral economics differs from neoclassical economics because its models of decision-making take into account the fact that heuristics and cognitive biases cause people to make systematic errors. - To conserve energy, the brain relies on low-energy mental shortcuts, or heuristics, that will usually produce the correct decision or answer. - Cognitive biases are systematic misperceptions or bad decisions that arise because (1) heuristics are error-prone in certain situations or (2) evolution did not prepare our brains to handle many modern tasks such as solving calculus problems.

The existing state of affairs; in prospect theory, the current situation from which gains and losses are calculated.

In prospect theory, the property of most people's preferences that the pain generated by losses feels substantially more intense than the pleasure generated by gains.

A behavioral economics theory of preferences having three main features: (1) people evaluate options on the basis of whether they generate gains or losses relative to the status quo; (2) gains are subject to diminishing marginal utility, while losses are subject to diminishing marginal disutility; and (3) people are prone to loss aversion.

The tendency people have to unconsciously base, or "anchor," the valuation of an item they are currently thinking about on recently considered but logically irrelevant information.

The tendency people have to create separate "mental boxes" (or "accounts") in which they deal with particular financial transactions in isolation rather than dealing with them as part of an overall decision-making process that would consider how to best allocate their limited budgets across all possible options by using the utility-maximizing rule.

The tendency people have to place higher valuations on items they possess (are endowed with) than on identical items that they do not possess; perhaps caused by loss aversion.

The tendency most people have when making choices to select any option that is presented as the default (status quo) option.

Refers to the difficulty human beings have with conceptualizing the more distant future. Leads to decisions that overly favor present and near-term options at the expense of more distant future possibilities.

The human tendency to systematically misjudge at the present time what will actually end up being desired at a future time.

Refers to the difficulty people have in sticking with earlier plans and avoiding suboptimal decisions when finally confronted with a particular decision-making situation. A manifestation of time inconsistency and potentially avoidable by using precommitments.

Actions taken ahead of time that make it difficult for the future self to avoid doing what the present self desires. See time inconsistency and self-control problems.

- Prospect theory models decision-making by accounting for the fact that people's choices are affected by whether a possible outcome is perceived as a prospective gain or a prospective loss relative to the current status quo situation. - Because our ancestors were focused on short-term survival, our brains suffer from myopia and are not good at dealing with decisions that involve the future. - Precommitments can be used to compensate for time inconsistency and the self-control problems that arise when the future self doesn't want to do what the present self prefers.

A person's opinion as to whether a price, wage, or allocation is considered morally or ethically acceptable.

A mutually anonymous behavioral economics game in which one person ("the dictator") unilaterally determines how to split an amount of money with the second player.

A behavioral economics game in which a mutually anonymous pair of players interact to determine how an amount of money is to be split. The first player suggests a division. The second player either accepts that proposal (in which case the split is made accordingly) or rejects it (in which case neither player gets anything).

Neoclassical economics bases its predictions about human behavior on the assumption that people are fully rational decision-makers who have no trouble making mental calculations and no problems dealing with temptation. While some of its predictions are accurate, many are not. The key difficulty facing neoclassical economics is that people make systematic errors, meaning that they regularly and repeatedly engage in behaviors that reduce their likelihood of achieving what they want. Behavioral economics attempts to explain systematic errors by combining insights from economics, psychology, and biology. Its goal is to make more accurate predictions about human choice behavior by taking into account the mental mistakes that lead to systematic errors.

Behavioral economists have found extensive evidence that people are not purely self-interested. Rather, they care substantially about fairness and are often willing to give up money and other possessions in order to benefit other people. The field evidence for fairness includes donations to charity, law-abiding behavior, the reluctance of retailers to raise prices during natural disasters, and the willingness of many consumers to pay premium prices for Fair Trade products. The dictator and ultimatum games provide experimental evidence on fairness by showing how pairs of people interact to split a pot of money that is provided by the researcher. In the dictator game, one person has total control over the split. In the ultimatum game, both players must agree to the split. The dictator game shows that many people will share with others even when anonymity would allow them to be perfectly selfish and keep all the money for themselves. The ultimatum game shows that people put a very high value on being treated fairly. They would rather reject an unfair offer and get nothing than accept it and get something.

Our brains make systematic errors for two reasons. First, our brains were not prepared by evolution for dealing with many modern problems, especially those having to do with math, physics, and statistics. Second, our brains also make mistakes when dealing with long-standing challenges (like interpreting visual information) because caloric limitations forced our brains to adopt low-energy heuristics (shortcuts) for completing mental tasks. Heuristics sacrifice accuracy for speed and low energy usage. In most cases, the lack of accuracy is not important because the errors that result are relatively minor. However, in some cases, those errors can generate cognitive biases that substantially impede rational decision-making. Examples include confirmation bias, the overconfidence effect, the availability heuristic, and framing effects.

Prospect theory is the behavioral economics theory that attempts to accurately describe how people deal with risk and uncertainty. Its key feature is that it models a person's preferences about uncertain outcomes as being based on whether those outcomes will cause gains or losses relative to the current status quo situation to which the person has become accustomed. Prospect theory also accounts for loss aversion and the fact that most people perceive the pain of losing a given amount of money as being about 2.5 times more intense than the pleasure they would receive from an equal-sized gain.

Myopia refers to the difficulty that most people have in conceptualizing the future. It causes people to put insufficient weight on future outcomes when making decisions. Time inconsistency refers to the difficulty that most people have in correctly predicting what their future selves will want. It causes self-control problems because people are not able to correctly anticipate the degree to which their future selves may fall prey to various sorts of temptation. People sometimes utilize precommitments to help them overcome self-control problems. Precommitments are courses of action that would be very difficult for the future self to alter. They consequently force the future self to do what the present self desires.