Practice Solving Session 1

MGMT331 – Behavioral Economics for Management

Chapters Covered: 2, 3, 4, 5

Practice Problems

1. Relations: Assuming the universe is the set of all people – past, present, and future –
are the following relations transitive? Are they complete?

Relation Transitive Complete

a. “is the mother of” X X

b. “is an ancestor of” ✓ X

c. “is the sister of” * ✓ X

d. “detests” X X

e. “weighs more than” ✓ X

f. “has the same first name as” ✓ X

g. “is taller than” ✓ X

* excluding half siblings

2. Indifference curves: Represent the following sets of indifference curves graphically.

a. Suppose that an apple for you is always as good as two bananas.
 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management
b. Suppose that one apple is always as good, as far as you are concerned, as a
banana.

c. Suppose that you do not care for tea without milk or for milk without tea.
However, every time you have two units of tea and one unit of milk, you can
make yourself a cup of tea with milk. You love tea with milk, and the more the
better, as far as you are concerned.
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MGMT331 – Behavioral Economics for Management
3. Budget sets: Suppose that your budget is $12. Use a graph to answer the following
questions:
a. What is the budget set when apples cost $3 and bananas cost $4?

Budget line: 3𝑎 + 4𝑏 = 12

b. What is the budget set when apples cost $6 and bananas cost $2?

Budget line: 6𝑎 + 2𝑏 = 12
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MGMT331 – Behavioral Economics for Management
c. What is the budget set when apples always cost $2, the first banana costs $4,
and every subsequent banana costs $2?

Budget line:

● 2𝑎 + 4𝑏 = 12 𝑓𝑜𝑟 𝑏 ≤ 1
● 2𝑎 + 2𝑏 = 12 𝑓𝑜𝑟 𝑏 > 1

4. Opportunity cost: The figure below represents a decision problem in which utilities and
opportunity costs of four acts have been identified. The number on the left is the utility;
the number in parentheses is the opportunity cost.

Suppose that a fifth act (call it a5 ) becomes available. Assume that a5 has a utility of 9.

a. What would the tree look like now? - See the graph below
b. What would happen to the opportunity costs of the different alternatives? - New
opportunity costs shown in brackets on the graph
 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management

5. Value functions: An ill-fated investment of yours in the junk bond market just decreased
from $1 to $0. Your value function is v(x) = x/2 for gains and v(x) = 2x for losses.

a. Suppose, first, that your reference point is $0. In value terms, how large is the
loss you just experienced?
1
𝑣(+ 1) = 2

𝑣(0) = 0

1 1
𝑙𝑜𝑠𝑠 = 0 − 2
= − 2

b. Suppose, instead, that your reference point is $1. In value terms, how large is the
loss you just experienced?

𝑣(0) = 0

𝑣(− 1) =− 2

𝑙𝑜𝑠𝑠 =− 2 − 0 = −2

c. Which framing makes you feel worse?

A reference point of $1 makes you feel worse

 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management
6. Value functions: Alicia, Benice, and Charlie own stock in the same company. When they
bought the stock, it was worth $10. It later rose to $17, but then dropped to $12 before
they sold it. The three are loss averse and have the same value function: v(x) = x/2 for
gains and v(x) = 2x for losses.

a. Alicia uses the selling price ($12) as her reference point. If you ask her, how
much would she say that she lost in terms of value when the price dropped from
$17 to $12?

𝑣(+ 5) = 2. 5

𝑣(0) = 0

𝑙𝑜𝑠𝑠 = 0 − 2. 5 = − 2. 5

b. Benice uses the peak price ($17) as her reference point. If you ask her, how
much would she say that she lost in terms of value when the price dropped from
$17 to $12?

𝑣(0) = 0

𝑣(− 5) =− 10

𝑙𝑜𝑠𝑠 =− 10 − 0 = − 10

c. Charlie uses the buying price ($10) as her reference point. If you ask her, how
much would she say that she lost in terms of value when the price dropped from
$17 to $12?

𝑣(+ 7) = 3. 5

𝑣(+ 2) = 1

𝑙𝑜𝑠𝑠 = 1 − 3. 5 = − 2. 5

d. Who was more disappointed when the price dropped?

Benice was the most disappointed because she had the highest reference point

7. Value functions: A thief steals $100 from a victim. Let us suppose that the thief and
victim have the same value function over money: v(x) = x/2 for gains and v(x) = 2x for
losses.

a. How much, in value terms, does the thief gain as a result of his robbery?

As the thief had no money initially, his reference point is $0

 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management
𝑣(0) = 0

𝑣(+ 100) = 50

𝑔𝑎𝑖𝑛 = 50 − 0 = 50

b. How much, in value terms, does the victim lose as a result of the robbery?

As the victim had $100 initially, this will be his reference point

𝑣(0) = 0

𝑣(− 100) =− 200

𝑙𝑜𝑠𝑠 =− 200 − 0 = − 200

c. Assuming that it makes sense to compare the thief’s gain and the victim’s loss,
and ignoring any other consequences of the crime, what is the total effect of the
robbery in value terms?

𝑔𝑎𝑖𝑛𝑡ℎ𝑖𝑒𝑓 + 𝑙𝑜𝑠𝑠 = 50 − 200 = − 150

𝑣𝑖𝑐𝑡𝑖𝑚

d. Does this suggest that crime is a force for good or bad?

As the total impact of the robbery is negative in value terms, it is safe to say that
crime is BAD.

8. Probability: Your neighbor, Mr Peters, has three children. Having just moved to the
neighborhood, you do not know whether the children are boys or girls. Let us assume that
every time Mr Peters had a child, he was equally likely to have a boy and a girl (and that
there are no other possibilities).

a. What is the relevant outcome space?

{BBB, GGG, BBG, GGB, BGB, GBG, BGG, GBB}

b. Imagine that you learn that at least one of the children is a girl. What is the new
outcome space?

{GGG, BBG, GGB, BGB, GBG, BGG, GBB}

c. Given that you know that at least one of the children is a girl, what is the
probability that Mr Peters has three girls?

1/7 (there is 1 successful outcome, and 7 possible outcomes in the outcome

space)

d. Imagine that you learn that at least two of the children are girls. What is the new
outcome space?
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MGMT331 – Behavioral Economics for Management
{GGG, GGB, GBG, BGG}

e. Given that you know that at least two of the children are girls, what is the
probability that Mr Peters has three girls?

1/4 (there is 1 successful outcome, and 4 possible outcomes in the outcome

space)

9. Unconditional probability: Suppose you draw two cards from a well-shuffled deck of
cards with replacement, meaning that you put the first card back into the deck (and
shuffle the deck once more) before drawing the second card.

a. What is the probability that you draw the ace of spades twice?

As these are two independent events, the probability of both of them happening
1 2
is ( 52 )

b. What is the probability that you draw two aces?

4 2
( 52 ) (same as above)

10. Unconditional probability: For the following questions, assume that you are rolling two
fair dice:

a. What is the probability of getting two sixes?

1 1 1
6
* 6
= 36

b. What is the probability of getting no sixes?

5 5 25
6
* 6
= 36

c. What is the probability of getting exactly one six?

There are two possible ways to get 1 six only: a) the first dice lands on 6, the
second one on NOT 6; b) the first dice doesn’t land on 6, the second one does.
The total probability is:
1 5 5 1 10
6
* 6
+ 6
* 6
= 36

d. What is the probability of getting at least one six?

The opposite of getting at least one six is getting no sixes at all. Considering this,
the probability of getting at least one six is:
25 11
1− 36
= 36
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MGMT331 – Behavioral Economics for Management
11. Total probability: Use the rule of total probability to solve the following problem. You are
a physician meeting with a patient who has just been diagnosed with cancer. You know
there are two mutually exclusive types of cancer that the patient could have: type A and
type B. The probability that he or she has A is 1/3 and the probability that he or she has B
is 2/3. Type A is deadly: four patients out of five diagnosed with type A cancer die (D)
within one year. Type B is less dangerous: only one patient out of five diagnosed with
type B cancer dies (D) within one year.

a. Draw a tree representing the four possible outcomes.

b. Compute the probability that your patient dies within a year.

The patient either had Type A and Died (D|A) or Type B and Died (D|B). The
combined probability of these events is:

4 1 1 2 2
𝑃(𝐷) = 𝑃(𝐷|𝐴 𝑜𝑟 𝐷|𝐵) = 𝑃(𝐷|𝐴) * 𝑃(𝐴) + 𝑃(𝐷|𝐵) * 𝑃(𝐵) = 5
* 3
+ 5
* 3
= 5

c. Suppose that your patient dies in less than one year, before you learn whether he
or she has type A or type B cancer. Given that the patient died in less than a
year, what is the probability he or she had type A cancer?
𝑃(𝐷|𝐴)*𝑃(𝐴) 4/15 2
𝑃(𝐴|𝐷) = 𝑃(𝐷)
= 2/5
= 3

12. Conditional probability: You are considering asking L out for a date, but you are a little
worried that L may already have started dating somebody else. The probability that L is
dating somebody else, you would say, is 1/4. If L is dating somebody else, he/she is
unlikely to accept your offer to go on a date: in fact, you think the probability is only 1/6. If
 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management
L is not dating somebody else, though, you think the probability is much better: about
2/3.

a. What is the probability that L is dating somebody else but will accept your offer to
go on a date anyway?

Notations: Accept (A), Dating (D), Reject (R), Not dating (ㄱD)
1 1 1
𝑃(𝐷 & 𝐴) = 𝑃(𝐷) * 𝑃(𝐴|𝐷) = 4
* 6
= 24

b. What is the probability that L is not dating somebody else and will accept your
offer to go on a date?
3 2 1
𝑃(ㄱ𝐷 & 𝐴) = 𝑃(ㄱ𝐷) * 𝑃(𝐴|ㄱ𝐷) = 4
* 3
= 2

c. What is the probability that L will accept your offer to go on a date?

1 1 13
𝑃(𝐴) = 𝑃(𝐷 & 𝐴) + 𝑃(ㄱ𝐷 & 𝐴) = 24
+ 2
= 24

d. Suppose L accepts your offer to go on a date. What is the probability that L is

dating somebody else, given that L agreed to go on a date?
𝑃(𝐴|𝐷)*𝑃(𝐷) 1/24 1
𝑃(𝐷|𝐴) = 𝑃(𝐴)
= 13/24
= 13

13. Gambler’s fallacy: Carefully note the difference between the following two questions:

a. You intend to flip a fair coin eight times. What is the probability that you end up
with eight heads?

1 8
(2)

b. You have just flipped a fair coin seven times and ended up with seven heads.
What is the probability that when you flip the coin one last time you will get
another heads, meaning that you would have flipped eight heads in a row?
1
2

14. Disjunction fallacy: Imagine that you live in an area where floods occur on average
every ten years. The probability of a flood in your area is constant from year to year. You
are considering whether to live in your house for a few more years and save up some
money, or whether to move before you lose everything you own in the next flood.
 Practice Solving Session 1
MGMT331 – Behavioral Economics for Management
a. What is the probability that there will be no floods in your area over the course of
the next two years?

1 2
(1 − 10
) = 0. 81

b. What is the probability that there will be exactly one flood in your area over the
course of the next two years?
1 9 9 1
10
* 10
+ 10
* 10
= 0. 18

c. What is the probability that there will be at least one flood over the course of the
next two years?

1 − 0. 81 = 0. 19

d. What is the probability that there will be at least one flood over the course of the
next ten years?

9 10
1 − ( 10 ) = 0. 65