7 - Prospect theory

Question 1

what is an alternative decision making under risk model

Answer 1

prospect theory - maximisation of something else

• different explanations of allais paradoxes

Question 2

what is expected utility

Answer 2

the probability weighted sum of utilities of its possible consequences

Question 3

what are the 2 modifications of EUT

Answer 3

1. to the conception of consequences
2. to the weights on the utilities - weight in a different way

Question 4

what is prospect theory

Answer 4

• It suggests that individuals do not always make rational decisions based on expected utility theory, as traditional economics assumes.
• Instead, they tend to make decisions based on perceived gains and losses relative to a reference point.

Question 5

what is reference dependence

Answer 5

• people evaluate outcomes relative to reference point rather than the absolute level of outcome
• different attitudes to risk in gains and loss domain

Question 6

what is loss aversion

Answer 6

losses are evaluated more strongly than equivalent gains

Question 7

what are the implications of prospect theory for attitudes of risk

Answer 7

allows attitudes towards risk in domains for gains and losses to be different

• risk seeking in choices that only involve riksy losses
• risk averse in choices that only involves risky gains

Question 8

how does prospect theory apply to us

Answer 8

take lottery prizes to be deviations from reference point

Question 9

what is the modification made

Answer 9

no longer weight utility by probability, instead weight by decision weights

Question 10

what are the 3 decision weight models

Answer 10

1. expected utility theory
2. simple probability weights
3. rank dependent decision weights

Question 11

what is simple non-linear probability weighting

what is the point of using it = captures psychological tendencies that EUT doesnt

Answer 11

weight is a non-linear function of p
- inverse S form

• overweighting low probabilities
• underweighting high probabilities
• mid range insensitivity

Question 12

how does simple non-linear weighting capture something different to EUT

Answer 12

• allows you to explain a persons tendency of under and over weighting at the same time
• the person can be risk seeking and risk averse at the same time - unlike EUT

Question 13

can simple probability weighting account for CCE and CRE
- that EUT cant account for

Answer 13

yes it can

Question 14

how does simple probability weights account for CCE

Answer 14

is choice 1
- overweights the bad outcome and underweights the good outcome of the risky choice –> chooses safe

choice 2
- the probabilities of both options are evaluated the same
- so chooses risky choice because the relative outcome 2500 is higher

Question 15

how does simple probability weighting account for CRE

Answer 15

choice 1
* underweights good choice in risky, and overweights bad - favour safer

choice 2
* probabilities of the good outcome are similar so treated the same
* favour risky outcome because is higher

Question 16

what is the limitation of simple probability weighting that led to the use of rank dependent decision weighting

Answer 16

• problem with ruling out dominated choices
• could underweight/overweight both outcomes, even though one is certain to occur

Question 17

how is rank dependent decision weighting different

Answer 17

• forces decision weights on a lottery’s outcome to sum to 1
• uses non-linear probability weighting function but different to simple
• makes decision weight on given outcome depend on its position in ordering of outcomes
• decision weight depends on the best option

Question 18

how does rank dependent decision weighting work

Answer 18

• if good outcome has high probability then is underweighted, and bad outcome is thus overweighted
  and vice versa
• depends on point of inflection if p is above or below
• doesnt face same problem as simple - that would allow both to be underweighted and prevents dominance violations

Question 19

how does rank dependent decision weighting account for CCE

Answer 19

problem 1:
- underweight the best outcome 2500 - but the decision weight is in the middle so doesnt overweight or underweight
- so overweights the 0 - making A more favourable

problem 2:
- overweighting and underweighting doesnt strongly influence this decision because the probabilities are similar - so relative outcomes you choose D

Question 20

how does rank dependent decision weighting account for CRE

Answer 20

problem 1:
- best outcome is underweighted and worse is overweighted - safer option is preferred

problem 2:
- probabilities are treated the same 0.2 and 0.25 so decision turns to relative outcomes - favours the risky choice

Question 21

why does CRE get proven with rank independence

Answer 21

• because when probabilities are scaled down from problem 1 to problem 2
• agent becomes less sensitive to relative probability
• and chooses based on relative outcome

Question 22

how does prospect theory embed psychological tendencies

Answer 22

overweighting low probabilities
underweighting high probabilities

Question 23

how is prospect theory an alternative model

Answer 23

this model explains allais paradoxes unlike EUT
is a ‘maximise something else’ alternative to EUT