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.
