BITS, PILANI- Hyderabad Campus

Second Semester, 2023-24

BEHAVIORAL ECONOMICS: ECON F345
Assignment 2

Due Date: 23rd April, 2024 (4 PM) Max. Marks: 12+2

Weightage:- (Total Assignment Weight: 10 %)

Write your answers very clearly and neatly.

Arguments and steps should be precise and complete.

For all the questions, you need to provide the complete derivation.

You need to write your answers neatly, with proper margins. It can be either handwritten or
typed. The entire assignment should be written on homogenous sheets in a legible manner!
2 marks are for these!

1. Suppose you have an option of either spending Rs. 62,500/- now or spending it after one
period. Lets assume per period interest rate to be 7 percent. Further suppose your value
function is given by u(m) = m0.5, where m is money spent. For what value of the discount
factor (δ), you will be indifferent between spending today or (investing and) spending to-
morrow? Assume that you follow the exponential discounting. What if you are a hyperbolic
discounter. Explain. 1 marks

2. Consider a lottery (−5000, 0.35, ; 4000, 0.65). Assume the prospect theory setup with
the reference point equals to 2000 per period for the analysis. Assume the value function
to be v = x in the domain of gain and v = 2x in the domain of loss.
Further take the probability weight function as simply w(p) = p. Suppose the individual is
facing this lottery at t = 0 as well as t = 1, the returns are independently and identically
distributed (i.i.d) across time periods. If you are myopic decision maker with a decision time
frame of 1 period, are you going to accept or reject this lottery? What if you are a farsighted
decision maker, what will be you decision? 1 marks
1
3. Consider1
an individual who has the following value function: v(x) = x 2 for gains and v(x) =
−2(|x|) 2 for losses. This individual is facing a lottery which consist of winning Rs. 25000
with a 25 % chance, Rs. 15000 with a 50 % chance, and winning nothing with a 25 % chance.
The individual counts all outcomes as gain; that is, he takes as his reference point the worst
0.50
possible outcome under consideration. Suppose the weight function is 0.50 p 0.50
.
p +(1−p)

(a) What will be the value of this lottery as per the prospect theory approach? What will
be the value of this lottery as per the RDU approach? 1 marks
(b) What will be the certainty equivalent of this lottery as per the prospect theory approach?
1 marks

4. According to Paul Samuelson, the mathematician Stanislaw Ulam defined a coward as some-
one who will not bet even when you offer him two-to-one odds and let him choose his side.
(A gamble with two-to-one odds is one in which the individual wins 2x if an event A occurs
and

ECON F213 Assignment-2 Page 1 of 2

 loses x if A does not occur. Letting the individual choose his side means letting him
choose between winning 2x if A occurs and losing x if A does not occur, or winning 2x if A
does not occur and x if A occurs.)

Show by example that it is possible for an expected-utility maximizer who likes money to be
a coward according to Ulam’s definition. Use a suitable graph for illustration. 1 marks

5. Consider a game where with probability half, you win $1000 and with probability half you lose
$550. assume a non-decreasing probability weighting function w(p) and with the following
prospect theory value function: 2 marks
(
x if x ≥ 0
V (x) = 2.5x if x < 0

(a) What will this agent choose among-

(i) do not participate,

(ii) play G one time,

(iii) play G two times with a single payment done at the end by adding up the two results.

(b) What will he do if he has also the extra option-

(iv) play G one time, see the result and have the option of playing it a second time. A single
payment is done at the end.

6. Consider the following table in the regret theory framework. A number is randomly drawn
between 1 to 100, the payoff in different options are as follows-

Suppose the regret function is Q(x) = x2 in case of rejoice and −x3 in case of regret.
Verify the preference order among A, B, and C in pairwise manner. 1 marks

7. A student must do a problem set, but can do it in any one of the three periods t = 0, 1, 2.
The immediate utility cost of doing it in period t = 0 is 4; in period t = 1 it is 6; and in
period t = 2 it is 9. The student is a quasi-hyperbolic discounter with β = 0.60 and δ = 0.90.

(a) First assume that the student is naive. When will the student do the problem set?
Assume that not doing the problem set is not an option! 1 marks
(b) Now assume that the student is sophisticated. When will the student do the problem
set? Assume that not doing the problem set is again not an option! 1 marks

ECON F213 Assignment-2 Page 2 of 2

 8. Suppose you are a quasi-hyperbolic discounter with β = 0.70 and δ = 0.85. What is going
to be the effective discount factor, between t = 3 and t = 9? What is going to be the
effective discount factor, between t = 0 and t = 4? 1 marks

9. Suppose there are three movies lined up in next three weeks (periods)- A, B and C consecu-
tively. Instantaneous utilities from A, B and C are 12, 18 and 27 respectively. Suppose you
are a quasi-hyperbolic discounter with β = 0.70 and δ = 0.90. Further suppose you have 2
coupons i.e. you can watch maximum two movies. Which one(s) are you going to watch if
you are a naive decision maker? Which one(s) are you going to watch if you are a
sophisticated decision maker? Do we have the issue of procrastination here? Explain
briefly. 1 marks

ECON F213 Assignment-2 Page 3 of 2