2 - Lecture Unit

Question 1

What is decision making?

Answer 1

Decision Making can be defined as selecting one option from a
set of possible options.

The choice made has consequences for the individual that makes the decision.

Question 2

Both x and y factors influence people’s decision making abilities. x and y?

Answer 2

cognitive and social factors

Question 3

What is the difference between risky and risk-free decision making?

Answer 3

Risky decision making involves uncertainty about outcomes, while risk-free decision making has known outcomes.

Question 4

What is the formula for expected utility?

Answer 4

Expected utility = probability of outcome × utility of outcome

Question 5

According to the expected utility theory, what do people choose in decision making?

Answer 5

The expected utility theory holds that, in decision making, people choose the option that maximises the expected utility for them.

Question 6

When is an individual can be called risk-averse?

Answer 6

If an individual strictly prefers a sure thing to a gamble with the same expected utility, we call this individual risk averse.

Question 7

How does risk aversion relate to expected utility?

Answer 7

A risk-averse person prefers a sure thing over a gamble with the same expected utility.

Question 8

Who developed Prospect Theory?

Answer 8

Daniel Kahneman and Amos Tversky - based on the idea of utility-focused decision making.

Question 9

Expected utility theory assumes that…

Answer 9

• expected utility is linear in probabilities
• preferences are related to wealth rather than gains and losses

Question 10

Initial step of Prospect Theory?

Answer 10

replace the notion of utility (usually defined only in terms of net wealth) by value (defined in terms of gains and losses as deviations from a reference point)

Question 11

What are the two phases of decision making in Prospect Theory?

Answer 11

Editing phase and Evaluation phase

Question 12

Explain editing phase

Answer 12

• the decision problem is represented. Information perceived as unimportant is discarded.
• A reference point is established and the outcomes of the possible options are represented as possible gains and losses.

Question 13

Explain evaluation phase

Answer 13

The potential choices are evaluated, using preconceived attitudes towards risk, gains and losses.

Question 14

Name key features of Prospect Theory.

Answer 14

1. Certainty
2. Small probabilities
3. Relative positioning
4. Loss aversion
5. Diminishing sensitivity
6. Reference point
7. Framing effect

Question 15

Features of the Prospect Theory: Certainty?

Answer 15

People underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty.

Question 16

Features of the Prospect Theory: Small probabilities?

Answer 16

They tend to give unjustified weight to things very unlikely to occur, regardless of whether they represent a gain or a loss (e.g. lottery, insurance).

Question 17

Features of the Prospect Theory: Relative positioning?

Answer 17

They respond differently to a risk depending on whether the outcome is a gain or a loss.

Question 18

Features of the Prospect Theory: Loss aversion?

Answer 18

People are far more sensitive to possible losses than to possible gains. They have a natural loss aversion!

Question 19

Features of the Prospect Theory: Diminishing sensitivity?

Answer 19

Diminishing sensitivity as losses or gains mount

Question 20

Features of the Prospect Theory: Reference point?

Answer 20

People think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes.

Question 21

Features of the Prospect Theory: Framing effect?

Answer 21

risk aversion in the positive frame vs. risk seeking in the negative frame

When it comes to gains, people do not want to take any risk. However, when it comes to losses people suddenly become risk takers.

Question 22

What does Framing Effect refer to?

Answer 22

The framing effect refers to the fact that people’s decision making is often influenced by irrelevant details given in a scenario.

People make different decisions based on how identical outcomes are framed—as gains or losses.

demonstrate the asymmetry between gain and loss
scenarios that is assumed by prospect theory.

Question 23

What was the result of the disease scenario experiment?

Answer 23

Positive framing led to risk-averse choices; negative framing led to risk-seeking choices.

Question 24

What does the value function in Prospect Theory show?

Answer 24

Concave for gains (risk-averse), convex for losses (risk-seeking), with losses felt more strongly than equivalent gains.

Question 25

What is mental accounting?

Answer 25

Mental Accounting describes the process how individuals code, categorize and evaluate economic outcomes. ## Footnote Mental Account Theory is an extension of the Prospect Theory.

Question 26

Who introduced mental accounting?

Answer 26

Richard Thaler

Question 27

How does Richard Thaler defines mental accounting?

Answer 27

Richard Thaler coined the term, defining it as “the inclination to categorize and treat money differently depending on where it comes from, where it is kept and how it is spent”. According to Mental Accounting Theory developed by Thaler (1985), individuals hark back to “mental” accounts, on which they save and retain “gains” and “losses”.

Question 28

Explain the theatre ticket example.

Answer 28

People treat losing a ticket differently than losing money, even though the financial outcome is the same.

Question 29

What’s the pricing takeaway from mental accounting?

Answer 29

Integrate losses, segregate gains—present discounts separately but bundle prices. - multiple losses are unpleasant - multiple gains lead to a higher gratification > The presentation of the overall price should be integrated but discounts segregated

Question 30

What is the main idea behind Expected Utility Theory?

Answer 30

People choose the option that maximizes expected utility based on outcomes and their probabilities.

Question 31

What does it mean if EU(A) < EU(B)?

Answer 31

An expected utility maximizer will prefer option B over option A.

Question 32

How does a square root utility function affect expected utility?

Answer 32

It reflects diminishing marginal utility; people value each additional unit less.

Question 33

Why might someone choose a lower monetary outcome in a gamble?

Answer 33

Because they are risk-averse and perceive higher utility from the certainty.

Question 34

What assumption of Expected Utility Theory does Prospect Theory challenge?

Answer 34

That people evaluate options purely based on final wealth and linear probability weighting.

Question 35

What does Prospect Theory use instead of utility?

Answer 35

Value, based on gains and losses from a reference point.

Question 36

How do people treat small probabilities, according to Prospect Theory?

Answer 36

They overweight them—e.g., lottery tickets or insurance.

Question 37

What are mental accounts?

Answer 37

Cognitive categories individuals use to track financial activities separately.

Question 38

Why do people behave differently in the ticket vs. lost money theatre scenarios?

Answer 38

They mentally account the ticket as part of the 'entertainment' budget.

Question 39

Give an example of mental accounting in action.

Answer 39

Treating a tax rebate differently than regular income.

Question 40

What pricing strategy is supported by Mental Accounting Theory?

Answer 40

Segregate gains (e.g., separate discounts) and integrate losses (e.g., bundled pricing).

Question 41

What does the Prospect Theory value function look like?

Answer 41

Concave for gains (risk-averse), convex for losses (risk-seeking), and steeper for losses.

Question 42

Why are multiple gains better when separated?

Answer 42

Due to diminishing marginal utility, each separate gain feels more rewarding.

Question 43

Why are multiple losses better when combined?

Answer 43

Combining them minimizes perceived pain due to diminishing marginal losses.

Question 44

What is hedonic editing?

Answer 44

Combining smaller losses with larger gains, or separating small gains from larger losses, to feel better about outcomes.

Question 45

What is mixed gain strategy in hedonic editing?

Answer 45

Integrate small losses with larger gains to soften the impact. Integration is preferred to segregation.

Question 46

What is mixed loss strategy in hedonic editing?

Answer 46

Segregate small gains from larger losses to highlight the gain.

Question 47

What pricing presentation increases perceived value?

Answer 47

Showing itemized discounts rather than a single lump sum reduction.

Question 48

What does the phrase 'a euro is a euro is a euro' refer to?

Answer 48

The irrational way people treat identical amounts of money differently depending on context.

Question 49

What is the sunk cost effect?

Answer 49

Throwing good money after bad People irrationally continue investments due to past losses.

Question 50

What is the breakeven effect?

Answer 50

People taking on risks they otherwise wouldn’t Tendency to take risks after a loss in an attempt to return to the original reference point.

Question 51

What is the house money effect?

Answer 51

Increased risk taking People take more risks after prior gains.

Question 52

How can previous losses affect future behavior?

Answer 52

Can lead to sunk cost fallacy or risky behavior (breakeven effect) to recover losses.

Question 53

How can previous gains affect future behavior?

Answer 53

Makes people more prone to risk-taking (house money effect) or spending freely (windfalls, funny money).

Question 54

What is an example of the framing effect?

Answer 54

People prefer '200 lives saved' over '400 will die,' even though outcomes are identical.