(i) Mr. A was given tickets to lotteries involving the World Series. He won $50
ID: 1145511 • Letter: #
Question
(i) Mr. A was given tickets to lotteries involving the World Series. He won $50 in one and $25 in the other. (ii) Mr. B was given a ticket to a single, larger, World Series lottery. He won $75. (iii) Mr. C received a letter from the IRS saying he made a minor arithmetical error on his tax return and owes $100. He received a similar letter the same day from his sate income tax authority saying he owed $50. There are no other repercussions from either mistake. (iv) Mr. D received a letter from the IRS saying he made a minor arithmetical error on his tax return and owes $150. There are no other repercussions from either mistake. a) Using Prospect Theory and/or Mental Accounting, why might there be a difference in what people feel in situation (i) vs situation (ii), and between situations (iii) and (iv)? b) What assumptions of economics are violated in the above examples? c) Using similar reasoning, why are people unwilling to sell stocks that are declining in value. [The best answers will include discussion from appropriate readings).
Explanation / Answer
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Answer a) The theory of mental accounting states the humans habit to evaluate the loss or profit from a transaction in his/her mind based on the circumstances and then prepare himself for a decision.
In this case we have to compare Situation i to ii, in the first situation Mr A will feel to be better position as he will think that he has won 2 times though the amount that he would win in situation ii is equal to i but the chance of occurring of winning is greater. In situation ii the amount is one in one shot whereas in situation i he would win the same amount in two instances giving a mental satisfaction.
Comparing situation iii to iv, in both these cases Mr A is at loss as he has to pay out instead of earning and therefore would like to bear the burden in one shot. Hence for him situation iv would be more better for him as in this case he would bear the loss in one go and pay the complete tax.
Answer to b) The assumption of economic that is breached over here is that the economic gain will be leftover of the amount after all the losses have been taken away irrespective of the number of transactions. Here we see that the person is more concerned about the number of transaction instead of the amount in $
Answer C. The people are not willing to let go off the loss making stocks because they are not able to believe that they can commit mistakes and are hopeful that the stock will make profits in the end. The hope and inspiration to hold on to the stock even though it is making loss comes out from the fact that it will make profit sooner or later, makes the people to hold on to the stock. They always presume that the stock will make money from them.
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