Kahneman: s. 278-288 (Prospect theory) Flashcards
Prospect theory.
Developed by Kahneman & Tversky in 1979. (Built upon Bernoulli’s work disproving expected utility theory.)
Essence in one sentence: We hate losing more than we like winning.
Ratio on average: 2-3:1.
Kahneman explains the ratio like this: Flip a coin, if you lose, you lose 10 dollars. If you would like to play, you would have to be able to win 25 dollars.
Expected utility theory.
Is based on decreasing marginal utility:
Marginal utility decreases as wealth increases.
Important note: The graph starts with 0 dollars, this means we are measuirng absolute wealth.
Kahneman & Tversky looked at Expected utility theory and suggested some modifications.
Explain Kahneman’s graph about prospect theory.
X-axis: Outcome.
Y-axis: Value.
Curve for gains: Like expected utility theory (concave).
Curve for losses: Exponential.
Reference point is not zero, instead it is your current subjective state of wealth. The reference point is subjective and created in the framing of the decision problem.
Example: A and B both have 10 million. A came from 5 million, but B came from 15 million.
Example 2: Stock prices. If a stock gains value we think it will keep going up. If it falls 50% we would like to sell, because we lost money. But in reality we should asses not based on our gain/loss but on the future of the stock price’s development. (Cost sunk fallacy.)
Altså: Gains and losses are assessed from the reference point.
Are we risk averse or risk seeking?
We tend to be risk averse about gains.
We tend to be risk seeking in loses.
Why?
When we have lost a lot, another loss is not painful. But the thought of winning it all back, makes us more risk seeking.
And vise versa for winning.
Prospect theory is an example of which two other theories?
It explains escalation of commitment and cost sunk fallacy.
Escalation of commitment: An individual or group facing increasingly negative outcomes from a decision, action, or investment nevertheless continues the behaviour instead of altering course.
Cost sunk fallacy: We consider costs already incurred in the past when making a decision about continuing or discontinuing investment.
Weighted probability function.
Another aspect of prospect theory: Weighted probability function.
If we acted completely rational, our decision weight would be proportional to the stated probability. But that is not how we operate.
When very low probability we see it as 0%.
But we tend to overrate a small probability. Example: Dying of corona.
High probability = certainty.
We are therefore insensitive to very high and very low probabilities.
Hvad kan prospect theory ikke fortælle os om?
Hvis der var en stor chance for at vinde $1 million, føltes det at vinde ingenting, som at tabe, selvom du startede med ingenting og derfor intet tabte (værdi nul). Prospect theory kan altså ikke forklare skuffelse (disappointment).
Prospect theory og utility theory kan heller ikke forklare fortrydelse (regret).
