Behavioral Finance

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Behavioral Finance

• Economics 437

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Imagine that the US is preparing for the
outbreak of an unusual disease, which is expected
to kill 600 people. Two alternative programs
have been proposed.

1. Program A 200 people will be saved
2. Program B, there is 1/3 probability that 600
   people will be saved and 2/3 probability that no
   one will be saved

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Richard Thaler and the wine-loving economist

• Purchased some nice bottles of Bordeaux wine
  years ago at 10 per bottle
• Current price 200 per bottle
• The economist now drinks his wine occasionally
  but is unwilling to buy any more at 200 nor is
  he willing to sell any wine at 200.

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Knetsch and Sinden (1984)

• Lab experiment
• Some given a lottery ticket
• Some given 2.00
• Then each person given an opportunity to trade
  one for another
• Very few subjects chose to switch

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Sellers, Chooser, Buyers

• First group given mugs
• Second group given nothing
• Third group given a choice of receiving money or
  receiving the mug
• Then prices were announced from .25 up to
  9.25
• Median reservation prices wer 7.12, 3.12, and
  2.87 (note that first and third group are in
  identical choice situations)

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Samuelson and Zeckhauser

• You inherit an estate worth 10 million how
  should you invest it
• You inherit an estate worth 10 million that has
  a 3 million invested in Apple stock. How
  should you invest it?
• Participants frequently left the Apple investment
  alone

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Choose between the following

• A
• 100 chance of winning 1million
• Or
• B
• 89 chance of winning 1 million
• 1 chance of winning nothing
• 10 chance of winning 5 million

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Imagine that the US is preparing for the
outbreak of an unusual disease, which is expected
to kill 600 people. Two alternative programs
have been proposed.

1. Program A 200 people will be saved
2. Program B, there is 1/3 probability that 600
   people will be saved and 2/3 probability that no
   one will be saved

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These are examples of

• Endowment effect
• Status Quo effect
• Framing
• All involve preference reversals

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Two stage game First stageyou have a 75 chance
of winning nothing and the game is over 25
chance to move to second stage of the game, which
presents you with the following options. You
must first decide which of the two choices below
you would pick.

• A. A certain win of 30
• B. 80 chance of winning 45 and 20 chance
  of winning zero

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1. 25 chance to win 30 and 75 chance to win
   zero
2. 20 chance to win 45 and 80 chance to win zero

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1. 25 chance to win 30 and 75 chance to win
   zero
2. 20 chance to win 45 and 80 chance to win zero

1. A certain win of 30
2. 80 chance of winning 45 and 20 chance of
   winning zero

Must choose A or B before stage one
25
Game ends, you win zero
75
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• A. 80 chance of imminent death and 20 chance
  of normal life with an expected longevity of 30
  years
• B. 75 chance of imminent death and 25 chance
  of normal life with an expected longevity of 18
  years

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Consider new case where there is a 25 chance
that the tumor is treatable and a 75 chance
that it is not. If not, death is imminent.
Otherwise, the potential outcomes are as follows

• C. 20 chance of imminent death and 80 chance
  of normal life with an expected longevity of 30
  years
• D. Certainty of a normal life with an expected
  longevity of 18 years

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Imagine that the US is preparing for the
outbreak of an unusual disease, which is expected
to kill 600 people. Two alternative programs
have been proposed.

• Program A 200 people will be saved
• Program B, there is 1/3 probability that 600
  people will be saved and 2/3 probability that no
  one will be saved

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If Program C is Adpted, 400 people will de. If
Program D is adopted, there is a 1/3 chance that
nobody will die and 2/3 chance that 600 people
will die. Which do you favor?

• Program C
• Program D

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Mental Accounting

• Sale of two items
• 150 Jacket
• 5 calculator
• Will you go to the store two blocks away to buy
  145 jacket?
• To get the calculator for free
• Get a free ticket to go to the play. Lose the
  ticket that morning, will you go?
• Find 1,000 on the street. Get a 1,000
  unexpected dividend on your stock.

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The End