7 - Prospect theory Flashcards
what is an alternative decision making under risk model
prospect theory - maximisation of something else
- different explanations of allais paradoxes
what is expected utility
the probability weighted sum of utilities of its possible consequences
what are the 2 modifications of EUT
- to the conception of consequences
- to the weights on the utilities - weight in a different way
what is prospect theory
- 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.
what is reference dependence
- people evaluate outcomes relative to reference point rather than the absolute level of outcome
- different attitudes to risk in gains and loss domain
what is loss aversion
losses are evaluated more strongly than equivalent gains
what are the implications of prospect theory for attitudes of risk
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
how does prospect theory apply to us
take lottery prizes to be deviations from reference point
what is the modification made
no longer weight utility by probability, instead weight by decision weights
what are the 3 decision weight models
- expected utility theory
- simple probability weights
- rank dependent decision weights
what is simple non-linear probability weighting
what is the point of using it = captures psychological tendencies that EUT doesnt
weight is a non-linear function of p
- inverse S form
- overweighting low probabilities
- underweighting high probabilities
- mid range insensitivity
how does simple non-linear weighting capture something different to EUT
- 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
can simple probability weighting account for CCE and CRE
- that EUT cant account for
yes it can
how does simple probability weights account for CCE
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
how does simple probability weighting account for CRE
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
what is the limitation of simple probability weighting that led to the use of rank dependent decision weighting
- problem with ruling out dominated choices
- could underweight/overweight both outcomes, even though one is certain to occur
how is rank dependent decision weighting different
- 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
how does rank dependent decision weighting work
- 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
how does rank dependent decision weighting account for CCE
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
how does rank dependent decision weighting account for CRE
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
why does CRE get proven with rank independence
- 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
how does prospect theory embed psychological tendencies
overweighting low probabilities
underweighting high probabilities
how is prospect theory an alternative model
this model explains allais paradoxes unlike EUT
is a ‘maximise something else’ alternative to EUT
