Behavioural Economics

• A. That markets always clear
• B. That people act as fully rational decision-makers who consistently maximise utility ✓
• C. That prices are determined by supply and demand
• D. That governments should regulate monopolies

Why: Standard economics assumes agents have stable preferences and process information rationally to maximise utility. Behavioural economics challenges this by showing systematic deviations from rational choice, such as biases and heuristics.

• A. Algorithms
• B. Heuristics ✓
• C. Equilibria
• D. Externalities

Why: Heuristics are simple rules of thumb that reduce cognitive effort. They are often useful but can produce predictable biases, which is why they are central to behavioural economics.

• A. Loss aversion ✓
• B. Diminishing marginal utility
• C. Sunk cost fallacy
• D. Herd behaviour

Why: Loss aversion, a core concept from prospect theory (Kahneman and Tversky), shows that losses loom larger than equivalent gains, so a loss of 100 typically hurts more than a gain of 100 feels good.

• A. Adam Smith and David Ricardo
• B. John Maynard Keynes and Milton Friedman
• C. Daniel Kahneman and Amos Tversky ✓
• D. Paul Samuelson and Kenneth Arrow

Why: Kahneman and Tversky's work on judgement under uncertainty and prospect theory laid much of the psychological groundwork for behavioural economics, and Kahneman later received the Nobel Memorial Prize in Economic Sciences.

• A. The idea that people are always perfectly rational
• B. The idea that rationality is limited by available information, cognitive capacity, and time ✓
• C. The idea that markets are inherently irrational
• D. The idea that governments should limit individual choice

Why: Herbert Simon proposed that human decision-making is constrained by limited information, computational ability, and time, so people often satisfice (seek a good-enough option) rather than optimise.

• A. Anchoring
• B. Availability heuristic ✓
• C. Representativeness heuristic
• D. Loss aversion

Why: The availability heuristic leads people to estimate how probable or frequent something is based on how easily instances can be recalled. Vivid or recent events, such as plane crashes, often seem more likely than they really are.

• A. Sunk cost fallacy
• B. Confirmation bias
• C. Anchoring effect ✓
• D. Bandwagon effect

Why: The original $500 price serves as a reference point, or anchor, that makes $300 seem like a bargain even if the jacket's true value is lower. Anchoring causes people to rely heavily on the first number they encounter.

• A. Loss aversion ✓
• B. Status quo bias
• C. Hyperbolic discounting
• D. Framing effect

Why: Loss aversion, a central idea in prospect theory, means people weigh losses roughly twice as heavily as equal-sized gains. This is why many people hold onto losing investments rather than accept a realized loss.

• A. Representativeness heuristic ✓
• B. Availability heuristic
• C. Affect heuristic
• D. Recency bias

Why: The representativeness heuristic leads people to judge probability by how well something matches a stereotype or prototype. This causes neglect of base rates, the actual proportions of librarians versus salespeople in the population.

• A. Confirmation bias ✓
• B. Overconfidence effect
• C. Ostrich effect
• D. Endowment effect

Why: Confirmation bias is the tendency to seek out, interpret, and remember information that supports existing beliefs or decisions while disregarding contrary evidence. It helps people feel comfortable with choices they have already made.

• A. They feel losses and gains with roughly equal intensity
• B. They feel losses more intensely than equivalent gains ✓
• C. They feel gains more intensely than equivalent losses
• D. They ignore losses entirely when a gain is also possible

Why: Loss aversion, a core idea of prospect theory, holds that losses loom larger than equivalent gains. Losing $100 typically hurts more than gaining $100 feels good, which is why people often weight losses roughly twice as heavily as gains.

• A. The objective wealth level a person holds in total
• B. The benchmark, often the current status quo, against which gains and losses are evaluated ✓
• C. The average return of the stock market over time
• D. The minimum amount a person needs to survive

Why: Prospect theory argues that people evaluate outcomes as gains or losses relative to a reference point, usually their current situation or expectations, rather than in terms of final absolute wealth.

• A. Choose the gamble because its expected value is higher
• B. Choose the sure $50 because they are risk averse for gains ✓
• C. Be indifferent, since both options have the same expected value
• D. Choose the gamble because they are risk seeking for gains

Why: In the domain of gains, prospect theory predicts risk aversion: people prefer a certain outcome over a gamble with the same or slightly higher expected value. The value function is concave for gains, so the sure $50 is preferred.

• A. An investor sells winning stocks quickly to lock in profits
• B. An investor holds losing stocks for too long, hoping to avoid realising a loss ✓
• C. An investor diversifies a portfolio across many asset classes
• D. An investor rebalances their portfolio every year according to a plan

Why: The disposition effect, driven by loss aversion, leads investors to hold onto losing assets to avoid making the loss feel real, while often selling winners too early. Holding losers to avoid a realised loss is the classic example.

• A. Because people are generally pessimistic about the future
• B. Because the value function is steeper for losses than for gains around the reference point ✓
• C. Because gains are always taxed while losses are not
• D. Because people cannot calculate gains accurately

Why: Prospect theory's value function is steeper in the loss domain than in the gain domain, meaning each additional unit of loss reduces value more than the same unit of gain increases it. This asymmetry is the mathematical expression of loss aversion.

• A. Nearly zero, keeping almost the entire sum
• B. Around 40-50% of the total amount ✓
• C. Around 10% of the total amount
• D. Exactly 100% of the total amount

Why: Experiments consistently show proposers typically offer about 40-50% of the pie. Standard self-interested models predict minimal offers, so this reveals a preference for fairness.

• A. They do not understand the rules of the game
• B. They are willing to pay a cost to punish unfair behaviour ✓
• C. They expect the proposer to make a better offer later
• D. They are required by the experimenter to reject

Why: Responders are willing to sacrifice their own payoff to punish offers they perceive as unfair. This is evidence of negative reciprocity and inequity aversion.

• A. Hyperbolic discounting
• B. Prospect theory
• C. Inequity aversion (Fehr and Schmidt model) ✓
• D. Mental accounting

Why: Fehr and Schmidt's inequity aversion model assumes people experience disutility from both advantageous and disadvantageous inequality, explaining rejections of unfair offers and generosity toward others.

• A. Repaying kind actions with kindness and unkind actions with unkindness ✓
• B. Always cooperating regardless of how others behave
• C. Splitting resources equally with everyone
• D. Maximising one's own monetary payoff in every interaction

Why: Reciprocity is the tendency to respond to kindness with kindness and to hostility with hostility, even at a personal cost. It is a central driver of cooperation and fairness in experiments.

• A. That people fear punishment from the recipient
• B. That people have some intrinsic concern for others' welfare beyond strategic motives ✓
• C. That people are confused about the rules
• D. That people always seek to maximise their own payoff

Why: Since the recipient cannot punish or reward, transfers in the dictator game cannot be strategic. Positive transfers therefore suggest genuine other-regarding (altruistic or fairness) preferences, though they are typically smaller than in the ultimatum game.

• A. A tendency to overvalue future rewards relative to immediate ones
• B. A tendency to disproportionately prefer immediate rewards over later rewards, even when the later reward is larger ✓
• C. A preference for risky investments over safe ones
• D. A belief that current prices will always rise

Why: Present bias describes the tendency to give extra weight to immediate rewards compared with rewards further in the future, leading people to choose smaller-sooner rewards over larger-later ones when the choice is immediate, even though they would prefer the larger-later reward when both options are far off.

• A. Expected utility theory
• B. Quasi-hyperbolic (beta-delta) discounting ✓
• C. Prospect theory with loss aversion
• D. Constant exponential discounting

Why: The quasi-hyperbolic (beta-delta) model, proposed by Laibson and others, adds a present-bias parameter beta to standard exponential discounting delta. This generates preference reversals over time, which constant exponential discounting cannot produce.

• A. Hyperbolic discounting combined with self-control problems ✓
• B. Risk neutrality
• C. The endowment effect
• D. Anchoring

Why: Repeatedly postponing a costly but beneficial action in favour of immediate comfort reflects hyperbolic (present-biased) discounting. The person's current self wants to exercise later, but when the time comes, the immediate cost dominates, which is a self-control problem.

• A. A legally binding contract with a bank to lend money
• B. A tool that restricts future choices to help a person follow through on long-term goals ✓
• C. A mental technique for estimating probabilities
• D. A pricing strategy used by firms to lock in customers

Why: Commitment devices, such as savings accounts with withdrawal penalties or pre-paying for a gym membership, limit a person's future options so that their present self can help bind their future self to decisions they would otherwise abandon.

• A. Children who wait longer for a larger reward always become wealthier adults
• B. The ability to delay gratification is linked to self-control and later outcomes, though the strength of the link is debated ✓
• C. Children cannot delay gratification before age ten
• D. Immediate rewards have no effect on childhood behaviour

Why: Walter Mischel's studies found that the ability to delay gratification was associated with later academic and life outcomes. Subsequent replications have found smaller effects than originally reported and suggest that family background and environment strongly influence the results, so the link is real but its size and causal interpretation are debated.

• A. A legally binding regulation that forces people to make a specific choice
• B. A change in how choices are presented that predictably alters behaviour without removing any options or significantly changing economic incentives ✓
• C. A financial penalty imposed to discourage undesirable behaviour
• D. A rational calculation of costs and benefits made by consumers before purchasing

Why: A nudge, as defined by Thaler and Sunstein, alters the way choices are presented so people are more likely to choose a particular option, while keeping all options available and without major changes to economic incentives.

• A. Market equilibrium
• B. Choice architecture ✓
• C. Opportunity cost
• D. Loss aversion

Why: Choice architecture refers to the design of the environment in which people make decisions, including how options are arranged, framed, and presented, which can systematically influence the choices made.

• A. A mandate that requires students to eat fruit
• B. A default option
• C. A change in product position that makes healthier choices more salient and convenient ✓
• D. A price subsidy on fruit

Why: Placing healthier foods at eye level is a classic example of a nudge through product positioning. It makes the healthier option easier to choose without removing the dessert or changing its price.

• A. The most expensive option available to consumers
• B. The option that takes effect automatically if the individual does not actively choose otherwise ✓
• C. An option that is legally required by government regulation
• D. The option that the majority of people select when given a free choice

Why: A default is the pre-selected outcome that applies if a person takes no action. Because inertia is strong, defaults often have a powerful effect, such as high enrolment rates in pension plans with automatic enrolment.

• A. Because they remove all freedom of choice from individuals
• B. Because they preserve freedom of choice while steering people toward choices that may improve their welfare ✓
• C. Because they are always more expensive than mandates, discouraging government use
• D. Because they rely on people making fully rational decisions

Why: Supporters argue nudges are libertarian paternalist: they keep all options open so individuals remain free to choose otherwise, while still using behavioural insights to guide people toward decisions that serve their own long-term interests.

• A. Loss aversion
• B. Status quo bias ✓
• C. Anchoring
• D. Availability heuristic

Why: Status quo bias is the tendency for people to stick with the existing or pre-selected option. Automatic enrolment exploits this by making saving the default, so many people remain enrolled even though opting out is easy.

• A. To ban choices that people make irrationally
• B. To alter the way choices are presented without restricting options or significantly changing incentives ✓
• C. To increase taxes on goods that cause harm
• D. To require citizens to complete compulsory education on decision-making

Why: Nudges, as defined by Thaler and Sunstein, change the choice architecture to steer behaviour in a predictable direction while preserving freedom of choice and avoiding large financial incentives or mandates.

• A. Social norms ✓
• B. Sunk cost fallacy
• C. Hyperbolic discounting
• D. Framing effect through gains

Why: Telling people what most others do leverages social norms, since individuals tend to conform to perceived group behaviour. This approach has been shown in trials to increase tax compliance.

• A. They increase the monetary penalty for missing appointments
• B. They counteract present bias and forgetfulness by prompting people at the moment of need ✓
• C. They make patients feel more anxious, which motivates attendance
• D. They shift the cost of the appointment onto the provider

Why: People often underweight future tasks due to present bias and simply forget. Timely reminders bring the commitment back to attention at the right moment, reducing missed appointments without changing incentives.

• A. Requiring citizens to submit lengthy forms with many optional sections
• B. Reducing the number of steps and the complexity of language in application forms to increase take-up of benefits ✓
• C. Adding more options to a menu so people have greater choice
• D. Delaying benefit information until after applications are submitted

Why: Complexity and administrative burden are major barriers to take-up. Simplifying forms and language reduces cognitive load, helping eligible people access benefits they are entitled to.