4.3

Question 1

Expected utility theory

Answer 1

Rational. What we should be doing.

• U = expectation overall prospect
• Asset integration = u accept prospect when integration assets > assets alone. Final states instead of losses and gain
• Concavity of utility function = risk aversion

Question 2

Which phenomenon violate the EUT?

Answer 2

100% - red reflection - dark alone

1. certainty = overweight certain prospects
2. Reflection Effect = we are risk-seeking when it comes to losses

*probabilistic insurance
When winning is probable -> we take higher probability. When its possible -> higher gain

3. Isolation effect = to simplify choice ppl disregard components that the alternatives share.

EUT is not realistic => Prospect theory

Question 3

Explain how Certainty violates EUT

Answer 3

1. certainty = overweight certain prospects vs probable outcomes. As soon as a certain outcome is mentioned people choose that and underweights the probable option

EUT is not realistic => Prospect theory

Question 4

Explain why reflection effect violates EUT

Answer 4

1. certainty = overweight certain prospects
2. Reflection Effect = we are risk-seeking when it comes to losses

• probabilistic insurance, reduces risk -> EUT
• regular, eliminate risk -> PT

When winning is probable -> we take higher probability. When its possible -> higher gain

Question 5

Explain why the Isolation effect violates the EUT

EUT is not realistic => Prospect theory

Answer 5

3. Isolation effect = to simplify choice ppl disregard components that the alternatives share, and focus on components that distinguish them. Leads to inconsistent preferences!!!!

EUT is not realistic => Prospect theory

Question 6

What are the 2 phases people use in PT

Answer 6

1. editing phase = to simplify choice
   Coding/ combination/ segregation/ cancellation/ simplification/ detection of dominance
2. Evaluation phase = look at vie of each prospect and choose. Split in V= subjective value of outcome, deviation from reference point. and ~= decision weights ( perceived stated probability)

Question 7

Coding phase (6)

Answer 7

Coding/ combination/ segregation/ cancellation/ simplification/ detection of dominance

Question 8

(3) Value Function

Answer 8

V= subjective value of outcome, deviation from reference point.

1. Reference point depends on framing
2. Concave / convex: diminishing marginal value over time
3. Steeper for losses than for gains. Losses hurt more. And faster.

Question 9

(4) weighting function

Answer 9

and ~= decision weights ( perceived stated probability)

1. Overweighting: when p=small, we put extra weight on it because its hard for us to understand how small it is. We therefore overestimate.
   * beginning graph
2. Subaddivity: the tendency to judge the probability as a whole to be LESS than prob of its parts. E.g. Deceases
3. Subcertainty: doesn’t happen for impossible or certain events. Weight of event A+B < 1. *End graph
4. Subproportionality: for small p (lottery ticket) the sum is closer to unity (=rational line) due to convex curve. *highlight in graph