Behavioural W5

Question 1

If what 3 things hold, then preferences can be represented by expected utility function

Answer 1

1. Completeness: q greater or equal than r, r greater or equal to q, or both.
2. Transitivity: if q is greater than r, and r is greater than s, then q is greater than s.
3. Continuity: s: if q is greater than r and r is greater then s, there must be a probability p such that (p : q ; 1-p : s) ∼ r.

Question 2

show independence

Answer 2

For all q, r, s and all probabilities p, we have that if q is greater than r, then (p : q ; 1-p : s) is greater than
(p : r ; 1-p : s).

Question 3

what are the violations of the independence axiom

Answer 3

1. Allais Paradox - Common Ratio Effect. Common Consequence Effect. Both aren’t compatible with EUT.
2. Ellsberg Paradox - Ambiguity aversion and source dependence.

Question 4

describe the unusual disease

Answer 4

violation of the principal of description invariance.

Question 6

what is the reflection effect

Answer 6

people’s attitudes towards risk changes depending on if they are working with gains or losses.

Question 7

what is the endowment effect

Answer 7

people place higher value on goods they already own compared to identical items they don’t own.

Question 8

what are preference reversals

Answer 8

when individuals’ preferences change depending on the way options have been framed or presented.

Question 9

what is the original prospect theory and what are the 5 key points

Answer 9

A framework for understanding decision-making under uncertainty.
1. Editing
2. Evaluation
3. Value Function
4. Reference Dependence
5. Probability Weighting Function.

Question 10

describe editing

Answer 10

individuals transform choice options through six operations: coding, combination, segregation, cancellation, simplification, and detection of dominance. These operations help individuals simplify and compare different prospects.

Question 11

describe evaluation

Answer 11

Prospects are then evaluated based on whether they are strictly positive, strictly negative, or regular. This evaluation involves subjective probability weighting and a value function that captures how individuals perceive gains and losses.

Question 12

describe value function

Answer 12

The value function reflects how individuals evaluate gains and losses relative to a reference point. It exhibits loss aversion, meaning losses are felt more strongly than equivalent gains, and diminishing sensitivity, where the impact of gains and losses decreases as their magnitude increases.

Question 13

describe reference dependence

Answer 13

Prospect theory emphasizes that individuals perceive changes from a reference point rather than absolute levels. This leads to a focus on gains and losses rather than final outcomes.

Question 14

describe probability weighting function

Answer 14

Unlike traditional expected utility theory, which uses additive probabilities, prospect theory introduces a probability weighting function that transforms probabilities into decision weights. This function tends to overweight small probabilities and underweight large probabilities, with discontinuity at extreme probabilities.

Question 15

what are the criticisms of the original prospect theory

Answer 15

Criticism of the original Prospect Theory includes concerns about the ad-hoc nature of the editing phase, its limitations in handling prospects with more than two non-zero outcomes, and the potential for violations of stochastic dominance, which can lead to inconsistencies in decision-making.

Question 16

what is the cumulative prospect theory

Answer 16

1. Removal of editing phase
   2.

Question 17

describe removal of editing phase

Answer 17

CPT eliminates the ad-hoc editing phase present in the original Prospect Theory. This simplifies the evaluation process and allows for the assessment of prospects with any number of non-zero outcomes.

Question 18

describe Updated Probability Weighting Function

Answer 18

CPT introduces a specific probability weighting function with a specified functional form. Instead of transforming each probability separately, CPT transforms cumulative probabilities, ensuring that the sum of transformed decision weights is 1. This eliminates potential violations of stochastic dominance.

Question 19

describe evaluation of prospects

Answer 19

In CPT, the overall evaluation of a prospect involves computing the positive and negative parts separately. These parts are determined by ranking gains and losses from lowest to highest in absolute value and applying the probability weighting function relevant to the sign of the outcome.

Question 20

describe computation of weights

Answer 20

The weights for gains and losses are computed as the difference between the probability weight of events that are at least as large as the event being considered and the probability weight of events that are strictly larger. This computation ensures that larger outcomes are given higher weights.

Question 21

describe functional form and curvature

Answer 21

CPT assumes a specific functional form for the value function, which governs its curvature. Empirically, the value function for gains is more curved than for losses.

Question 22

what are the criticisms of the cumulative prospect theory

Answer 22

Criticisms of Cumulative Prospect Theory include its lack of a normative basis, as it is not grounded in axioms with normative status like Expected Utility Theory (EUT). Additionally, questions arise regarding the choice of reference point and how it should be determined in decision-making contexts.