CEA Behavioral Economics and Decision Theory 2 — Questions and Answers
Question 1: The 'ultimatum game' in experimental economics primarily demonstrates which behavioral finding?
- People reject unfair offers even at personal cost (Correct answer)
- People always maximize their own monetary payoff
- Rational actors never deviate from Nash equilibrium
- Cooperation collapses without repeated interaction
Correct answer: People reject unfair offers even at personal cost
In the ultimatum game, responders frequently reject low offers to punish perceived unfairness, contradicting the standard rational-agent prediction that any positive offer should be accepted.
Question 2: What does 'bounded rationality' mean in the context of economic decision-making?
- Decision-makers use simplified strategies due to cognitive and information constraints (Correct answer)
- Rationality is strictly bounded by income constraints
- Agents always reach optimal decisions given enough time
- Preferences are fixed and transitive across all choices
Correct answer: Decision-makers use simplified strategies due to cognitive and information constraints
Bounded rationality, coined by Herbert Simon, recognizes that cognitive limitations, incomplete information, and time constraints cause people to use heuristics rather than full optimization.
Question 3: Which behavioral concept explains why people continue investing in a failing project because of prior irrecoverable costs?
- Sunk cost fallacy (Correct answer)
- Moral hazard
- Adverse selection
- Status quo bias
Correct answer: Sunk cost fallacy
The sunk cost fallacy causes individuals to factor in already-spent, irrecoverable costs when making forward-looking decisions, leading to economically irrational continuation of bad investments.
Question 4: In behavioral economics, 'mental accounting' refers to which tendency?
- Treating money differently depending on its source or intended use (Correct answer)
- Calculating opportunity costs mentally before every purchase
- Discounting future income relative to current income
- Overestimating the value of windfall gains
Correct answer: Treating money differently depending on its source or intended use
Mental accounting, described by Thaler, is the tendency to categorize and evaluate economic outcomes by grouping them into separate mental 'accounts' rather than treating all money as fungible.
Question 5: What is 'present bias' in behavioral economics?
- Overweighting immediate utility relative to future utility (Correct answer)
- Preferring current prices over projected future prices
- Discounting past losses relative to present gains
- Anchoring forecasts to present economic conditions
Correct answer: Overweighting immediate utility relative to future utility
Present bias describes the tendency to give stronger weight to present payoffs than to future ones, even when the future benefits are much larger, leading to self-control problems.
Question 6: Which behavioral finance concept describes investors mimicking the actions of a larger group, often inflating asset bubbles?
- Herding behavior (Correct answer)
- Overconfidence bias
- Gambler's fallacy
- Disposition effect
Correct answer: Herding behavior
Herding behavior occurs when investors follow the crowd rather than their own independent analysis, which can amplify market trends and contribute to speculative bubbles.
CEA Behavioral Economics and Decision Theory 2
The 'ultimatum game' in experimental economics primarily demonstrates which behavioral finding?