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Optional Problem Set | ECON 202

Neoclassical economics and expected utility theory assume that people are rational to
make economic problems more tractable. However, researchers observed that, on average,
people are consistently non-rational under certain situations. These findings form a vital part of
the heretical field of behavioral economics.
Under the framework of neoclassical economics, preferences are stable and well-defined,
and people make rational decisions that clear the market in the long run. (Kahneman, Knetsch,
& Thaler, 1991). In line with this, standard theory does not necessarily expect people to 1) derive
utility from gains and losses rather than absolute amounts of goods, 2) be more sensitive to
losses than gains, 3) become less sensitive to both gains and losses as they pile up, and 4)
underweight high probabilities and overweight low probabilities. But items 1 to 4 are observed in
experimental studies and are actually the main elements of prospect theory under behavioral
economics: reference dependence, loss aversion, diminishing sensitivity, and probability
weighting. (Barberis, 2013)
One of the pieces of experimental evidence that illustrates prospect theory, particularly
loss aversion, is the endowment effect. An experiment involving a market for mugs showed that
the number of resulting trades fell short of 50%what standard theory expects under a
competitive setting. This was because the average seller endowed with the mug was only willing
to part with it if she was paid a considerably higher amount than what the average buyer was
willing to give.i (Kahneman, Knetsch, & Thaler, 1990)
People also exhibit non-rational behavior in making choices under uncertainty. Expected
utility (EU) theory supposes that people act rationally based on the expected values of gambles.
EU theory, however, is unable to explain some paradoxes, one of which is the Allais Paradox
or the Certainty Effect. This is because people use decision weights (which misbehave when
considering highly probable or improbable outcomes) instead of the rational probability weights
of homo economicus. (Tversky & Kahneman, 1981)
In general, behavioral economics implies that preferences are endogenous in the sense
that indifference curves are not fixed and that budget constraints that recurred today may not
generate the same consumption pattern as they did before, owing to the first three elements of
prospect theory. In addition, people facing uncertain alternatives use something more than just
probabilities, and the use of decision weights help explain paradoxes that are beyond the scope of
EU theory. These ideas, among others, show how some findings of behavioral economics run
counter to traditional economic theory. Perhaps they have also convinced some traditional
economists that economics as a whole doesnt need to be dogmatic, and that heretical ideas
enrich rather than threaten the field.
References:
Barberis, N. C. (2013). Thirty years of prospect theory in economics: a review and assessment.
Journal of Economic Perspectives, 27(1), 173-196.
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment
effect and the Coase theorem. Journal of Political Economy, 98(6), 1325-1348.

Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). Anomalies: the endowment effect, loss
aversion, and status quo bias. The Journal of Economic Perspectives, 5(1), 193-206.
Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice.
Science, 211(4481), 453-458.
Discussion class notes and class lecture slides

i In other words, there was a gap between the willingness-to-accept (minimum reservation price) of sellers and the
willingness-to-pay (maximum reservation price) of buyers. The number of trades become more in line with standard theory
when the goods are perceived as for trade rather than for personal use. Experiments have also ruled out the role of the
income effect on the sellers and have found that reluctance to sell outweighs reluctance to buy.

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