EUT / Prospect theory / Endowment Effect

Question 1

Axioms of EUT

Answer 1

Completeness
Transitivity
Continuity
Independence

Question 2

Violations of EUT

Answer 2

Allais paradox
Ellsberg paradox
Common consequence effect

Question 3

Bounded rationality

Answer 3

Agent has imperfect information and limited computational ability
Makes the use of heuristics necessary

Question 4

Heuristics

Answer 4

Computational shortcuts that simplify decision-making procedures

Question 5

Editing phase

Answer 5

Preliminary analysis of the offered prospects
Provides a simpler representation of these prospects

Question 6

Editing phase operations

Answer 6

Coding
Combination
Segregation
Cancellation
Simplification
Detection of dominance

Question 7

Evaluation phase

Answer 7

Decision-maker chooses the prospect with the highest value

Question 8

Prospect theory describes

Answer 8

How individuals assess their loss and gain perspective in an asymmetric manner
The behaviour of actual people rather than perfectly rational agents (EUT)

Question 9

Main elements

Answer 9

Reference points
Loss-aversion
Probability-weighting
Utility function

Question 10

Reference point example

Answer 10

Happiness treadmill
US average income up 40% in last 50 years but Americans no happier than before

Question 11

Reference points affected by

Answer 11

Expectation
Status quo
Relative position

Question 12

Loss-aversion example

Answer 12

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)

Question 13

Probability-weighting

Answer 13

Overweighting of low probability events
Underweighting of high probability events

Question 14

Utility function

Answer 14

Diminishing marginal sensitivity to gains and losses
Concavity for gains - risk aversion
Convexity for losses
Steeper for losses than for gains

Question 15

Endowment Effect

Answer 15

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

Question 16

Allais paradox

Answer 16

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

Question 17

Ellsberg paradox

Answer 17

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

Question 18

Total value of a prospect V expressed in terms of two scales v and π

Answer 18

π (p)v(x) + π (q)v(y)

Question 19

π

Answer 19

Converts objective probabilities into decision weights

Question 20

v

Answer 20

Assigns a number v(x) to each outcome x

Question 21

Coefficient of loss aversion

Answer 21

λ
Loss/gain

Question 22

Endowment boost

Answer 22

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.