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 default
However 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 numbers
Because 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 Independence
Defining Alternatives;
We will define each alternative so that it integrates the immediate
objects of choice with DMs 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 DMs
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, its 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 DMs choice.
*Related vs Unrelated Sunk Costs
A 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 x
As a general rule, there is a violation of path-independence if DMs
choices are affected by whether sunk costs are related or unrelated
to an alternative.
Example:
Treatment 1
DM 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 2
DM 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: pollutionclean air
Usually 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,