EUT / Prospect theory / Endowment Effect Flashcards
Axioms of EUT
Completeness
Transitivity
Continuity
Independence
Violations of EUT
Allais paradox
Ellsberg paradox
Common consequence effect
Bounded rationality
Agent has imperfect information and limited computational ability
Makes the use of heuristics necessary
Heuristics
Computational shortcuts that simplify decision-making procedures
Editing phase
Preliminary analysis of the offered prospects
Provides a simpler representation of these prospects
Editing phase operations
Coding
Combination
Segregation
Cancellation
Simplification
Detection of dominance
Evaluation phase
Decision-maker chooses the prospect with the highest value
Prospect theory describes
How individuals assess their loss and gain perspective in an asymmetric manner
The behaviour of actual people rather than perfectly rational agents (EUT)
Main elements
Reference points
Loss-aversion
Probability-weighting
Utility function
Reference point example
Happiness treadmill
US average income up 40% in last 50 years but Americans no happier than before
Reference points affected by
Expectation
Status quo
Relative position
Loss-aversion example
Asymmetric price elasticities of demand for consumer goods
The marginal value of losses is greater than the marginal value of gains of the same magnitude
Consumers dislike price increases more than they like price gains
v’(-x) > v’(x)
Probability-weighting
Overweighting of low probability events
Underweighting of high probability events
Utility function
Diminishing marginal sensitivity to gains and losses
Concavity for gains - risk aversion
Convexity for losses
Steeper for losses than for gains
Endowment Effect
People are more likely to retain an object they own than acquire that same object when they do not own it
Does not decrease with age
Harbaugh 2001
Subject pool: year 5-10, undergrad students
Allais paradox
Demonstrates an inconsistency of observed choices with EUT
Violates the independence axiom, which states that equal outcomes should cancel out
Argues that it isn’t possible to evaluate choices independently of the other choices presented
Overlooks the notion of complementariness
Ellsberg paradox
Ambiguity aversion
People prefer quantifiable risks over those with incalculable risk, even in instances where the unknown alternative will likely produce greater utility
eg. Two urns with 100 balls each
Total value of a prospect V expressed in terms of two scales v and π
π (p)v(x) + π (q)v(y)
π
Converts objective probabilities into decision weights
v
Assigns a number v(x) to each outcome x
Coefficient of loss aversion
λ
Loss/gain
Endowment boost
The average across the two goods of the increase in the likelihood that a person chooses a good when they are originally endowed with it, relative to being endowed with the other good.
