Econ 6723: Industrial Organization

Problem Set 2
Salar Jahedi
Due: March 9, 2011

1. Evidence suggests that people believe that the probability of an unlikely event (such
as obtaining more than 80% boys in a hospital) does not depend on sample size.

(a) Calculate the probability that 80% or more of 5 flips of a fair baby will be boys.
(b) Calculate the probability that 80% or more of 20 flips of a fair baby will be boys.
(c) What is wrong with people?

2. Hazel is a Bayesian who believes that her i.i.d coin is biased towards heads, but doesn’t
know the degree of the bias. She believes that with probability π1 , the coin is biased
towards heads with probability θ1 , and with probability π2 = 1 − π1 , the coin is biased
towards heads with probability θ2 . If the coin has come up heads h times and come up
tails t times, what does Hazel believe is the probability P (θ = θ1 |h, t). Your answer
should be a dunction of θ1 , θ2 , π1 , π2 , h, t.

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3. Kyle is a mutual fund manager, who is of one of the following types: Skilled (he
outperforms the market index 75% of all years), Average (he outperforms the market
50% of all years), or Unskilled (he outperforms the market 25% of all years).

(a) If Kyle is Skilled, what is the probability that he outperforms the market three
years in a row? What if Kyle is Average? What if Kyle is Unskilled ?
(b) Suppose that it was equally likely that Kyle is Skilled, Average, or Unskilled, that
is, you believe that (Pr(Skilled )=Pr(Average)=Pr(Unskilled )= 13 ). If observe Kyle
beat the market three years in a row, what would you believe is the likelihood
that he is Skilled ? [Calculate Pr(Skilled |outperform market 3 in a row).]

Now Consider Freddy, whom we discussed in class. Freddy believes there is an urn
containing N =4 balls, each ball is labeled either “Outperform” or “Underperform.”
When Kyle is Skilled, 3 of the balls say “Outperform,” and only 1 says “Underperform.”
If Kyle is Average, 2 of the balls say “Outperform” and 2 say “Underperform.” If Kyle
is Unskilled, 1 of the balls say “Outperform,” and 3 of the balls say “Underperform.”
Every year Kyle makes investments, one of these balls is randomly drawn from the urn
without replacement.

(c) If Kyle is Skilled, what does Freddy believe is the probability that he will outper-
form the market in his first year? If Kyle beats the market in the first year, what
does Freddy believe is the probability that he will beat the market again in the
next year? What phenomenon does this reflect?
(d) If Kyle beats the market three years in a row, what does Freddy believe about the
probability that he will beat the market in the fourth year? What is the actual
probability that he will beat the market in the fourth year?
(e) Suppose that, in reality, there is no such thing as being Skilled or Unskilled. Kyle
is always Average. Calculate the frequency with which Kyle beats the market
0,1,2, and 3 times in a row in his first three years.
(f) What does Freddy believe is the probability that Kyle is Skilled given that he
beat the market 2 years in a row? What does Freddy believe is the probability
that Kyle is Skilled given that he beat the market 3 years in a row?
(g) How might this error explain why technology stocks often earn higher returns
than value stocks.

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4. In his book Predictably Irrational, Dan Ariely describes an actual ad which he saw
on the website of The Economist. He thought the ad was trying to manipulate his
behavior, so he conducted an experiment using the MBA students at M.I.T.’s Sloan
School of Management. He gave half the students in the class the actual ad. Of those
students, 16% of them chose the to buy the online subscription, 0% chose to buy the
print subscription, and 84% of them chose to buy the print and web subscription. He
gave the other half of the students a tailored ad, which removed the print subscription
(the option that nobody chose).

(Actual Ad) (Tailored Ad)

(a) Consider the tailored ad. What would classical economics predict is the percentage
of people that choose the online subscription and the percentage of people that
choose the print and web subscription. What did Ariely find, was the fraction of
people who chose the print and web subscription higher or lower than 84%?
(b) Provide an explanation using a behavioral effect that we discussed in class to
explain Ariely’s findings.
(c) Provide an explanation using classical economics that can also explain Ariely’s
findings.
(d) Provide an example where adding a dominated object into a menu will not change
people’s behavior at all. Try and comment about the ‘type’ of goods that will
most likely produce the above effect.

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5. Suppose one in ten women have breast cancer. A mammogram (a breast X-ray) is
a test used to detect breast cancer, but is only 90% accurate. This means that if
the woman has breast cancer, the test returns a positive result with 90% probability,
and if the woman does not have breast cancer, it returns a negative result with 90%
probability.

(a) Before going in for testing, Barbara completes a self-examination. She feels a
bump, which she automatically attributes to breast cancer. In reality, there are
many reasons why she may have felt a bump, but Barbara can only think of one
possible reason. What heuristic or bias is this likely a result of? Explain.
(b) If Barbara’s mammogram returns a positive result (that is, suggests she has breast
cancer), Barbara will undergo a more thorough test for breast cancer. These
second test sometimes reveal that the mammogram was a false positive, and cancer
is actually not present. It is known that when patients take this second test and
are told that the first result was a fluke and that they are completely healthy,
they tend to continue to worry about having breast cancer. What heuristic or
bias is this likely a result of? Explain.
(c) Barbara’s doctor is convinced that Barbara does not have cancer and yet continues
to perform expensive tests on her. The doctor is afraid that, on the off chance
that Barbara actually develops cancer, the doctor’s supervising attendant will
blame the doctor for not spotting it. What heuristic or bias is this likely a result
of? Explain.

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In reality, the results from multiple mammogram results are independent from each
other. Hence, mammogram results can be correctly modeled as draws with replacement
from an urn that has 10 balls: 9 balls correspond to the true diagnosis and 1 ball
corresponds to a false diagnosis. Barbara’s doctor, Frederika, however believes in
the law of small numbers – she incorrectly thinks that the balls are being without
replacement from an urn with 10 balls (N = 10).

(d) In reality, Barbara does not have cancer. What is the true probability that,
if she gets tested twice, she tests positive for cancer each time? If Frederika
knows Barbara to be cancer-free, what does Frederika believe is the likelihood
that Barbara gets two positive results?
(e) Explain in one or two sentences the error that Frederika is making.
(f) In reality, what is the total proportion of people that will get two positive results?
What does Frederika believe is the total proportion of people that will get two
positive results? Explain in one or two sentences the error that Frederika is
making.
(g) If Barbara’s first mammogram screening came back positive, what is the true prob-
ability that she has breast cancer? (Recall Bayes’ Rule: P r(A|B) = P r(B|A)·P
P r(B)
r(A)
).