behavioral economics

Sample Solution

Theoretical Assumptions of the Standard/Neoclassical Model of Choice Under Certainty:

The standard/neoclassical model of choice under certainty, also known as rational choice theory, rests on several key assumptions:

1. Rationality: Individuals are assumed to be rational actors who make choices that maximize their expected utility. They possess complete information about all available options and their associated consequences. 2. Transitivity: If an individual prefers A over B and B over C, then they will logically prefer A over C. Preferences are consistent and do not exhibit cyclical patterns. 3. Independence from Irrelevant Alternatives: The presence or absence of other irrelevant options does not influence the individual's preference between two available choices. 4. Continuity: Preferences are continuous, meaning individuals can distinguish between small changes in outcomes and adjust their choices accordingly. 5. Stationarity: Preferences are stable and do not change over time due to factors like learning, adaptation, or changes in context.

These assumptions create a framework where individuals make optimal choices based on a logical analysis of available options and their expected consequences. However, several empirical experiments have challenged these assumptions, highlighting the limitations of the standard model in capturing the complexities of real-world decision-making.

Full Answer Section

Empirical Experiments Violating Standard Model Assumptions:

1. The Endowment Effect: Kahneman, Knetsch, and Thaler (1990) demonstrated that individuals value objects they own more than identical objects they do not own, even if they are willing to sell them for the same price. This violates the assumption of independence from irrelevant alternatives, as the mere act of owning influences the perceived value.

2. Framing Effects: Tversky and Kahneman (1981) showed that how choices are presented can significantly influence decisions. For example, people were more likely to accept a risky surgery framed as "saving 20 lives" than one framed as "a 1 in 5 chance of death." This challenges the assumption of stable and context-independent preferences.

3. The Loss Aversion Effect: Kahneman and Tversky (1979) found that individuals are more sensitive to losses than gains, often assigning a higher weight to avoiding losses than achieving equivalent gains. This violates the assumption of continuous and rational assessments of outcomes, as the emotional response to losses distorts decision-making.

These are just a few examples, and countless other experiments have revealed deviations from the standard model's assumptions. These findings suggest that human decision-making is often influenced by cognitive biases, emotions, social context, and other factors not captured by the rational actor framework.

It is important to remember that the standard model remains a valuable tool for understanding some aspects of choice, but it should not be viewed as a universally applicable and fully accurate representation of human decision-making. By acknowledging its limitations and incorporating findings from behavioral economics and other fields, we can gain a more nuanced understanding of how individuals make choices in the real world.