Decision Under Risk 2 Flashcards
Who developed prospect theory?
2 Nobel prize winning psychologists including Daniel Kahneman, yet they won their Nobel Prizes in economics!
What are the main components which comprise Prospect Theory?
Editing
Value Function
Weighting Function
Explaining the anomolies
What is the expected utility of a prospect with payoffs xi given by?
EU= ΣipiU(y+xi)
Prospect Theory generalises EUT so that (edited) prospects are evaluated according to…
EUprospect =Σw(pi)V(y+xi-r) Where w(p) = decision weights V() is a value function r is a reference level (if r=y then there is no role for initial income)
If an individual with initial income £2 faces the prospect (-1,0.5;1,0.5), under Prospect Theory, what are their two outcomes?
V(-1) and V(1)
In prospect theory if the currrent asset= the reference then what do we think in terms of?
Purely gains and losses.
What is the editing process called a combination?
Where prospects are simplified by combining the probabilities with identical outcomes.
What is the editing process called a segregation?
Some prospects contain a riskless component that is segregated from the risky component.
Under segregation, what would (£300,0.8; £200, 0.2) change to?
£200+ (£100, 0.2; £0, 0.2)
What is the editing process called cancellation?
The discarding of components that are shared by the offered prospects.
What does the value function look like?
Like an S shape
What is the reference level?
The neutrality point- something you would consider as neither a gain or a loss.
Is the S symmetrical?
No, it goes further low more than it does high- due to loss aversion.
What is loss aversion?
The idea that losses loom larger than gains- so therefore the value function is steeper for losses.
What is diminishing sensitivity?
Marginal utility falls as we move further away from the reference point- we are more sensitive the closer we are to the reference point.
What is the relevance of the left side of the graph being convex and the right side being concave?
it indicates that people switch their risk preference around, depending on whether they’re thinking about an outcome, as a gain (concave) or whether they’re thinking about an outcome as a loss (convex).
Are decision weights directly observed?
No, “decision weights are inferred from choices between prospects. Decision weights are not probabilities: they do not o bey the probability axioms and they should not be interpreted as measures of degree or belief.”- Kahneman and Tverksy.
Do we generally overweight or underweight vanishingly small probabilities (e.g. winning the National Lottery)?
Overweight
Why do we not always overweight vanishingly small probabilities?
Because sometimes we just ignore the,, eg we don’t focus on the low odds of a bridge collapsing, we just walk across it. This makes the value function very difficult to work out at such low levels of actual probability.
According to the Weighting Function, do people mainly underweight or overweight probabilities?
Underweight
According to subcertainty- what do decision weights add up to?
Less than 1.
What does Allais’ paradox imply?
Subcertainty.
Why does the Prospect Theory give us Reflection Effect?
Due to diminishing sensitivity.
What can the Isolation Effect by explained by>
The Segregation operation during the editing phase of Prospect Theory.
Why can’t the full version of Prospect Theory account for Event Splitting Effects?
Because the two events with a payoff of b would be combined during the Combination operation during the editing phase.
How can we then explain Event Splitting through Prospect Theory?
By ignoring the Combination operation, in what we called “stripped down Prospect Theory”.
How can stochastic dominance be violated?
If the indirect effect is negative and outweighs the direct effect.
