LEC 4 - PROSPECT THEORY AND MENTAL ACCOUNTING Flashcards
What are the two phases of prospect theory
editing phase - look at prospect given and add them in your head to make them easier to compare
evaluating phase - find the value and you evaluate them
if you had 99, 0.51. what would you do
round it to 100, 0.5
make things easier
how do u choose the best prospect
Choose the prospect with tChoose the prospect with the highest value V, measured via
subjective value v(x) of outcome x, and decision weight π(p)
associated with probability pChoose the prospect with the highest value V, measured via subjective value v(x) of outcome x, and decision weight π(p) associated with probability phe highest value V, measured via
subjective value v(x) of outcome x, and decision weight π(p)
associated with probability p
what are the 4 key aspects of prospect theory
reference point - changes in wealth or welfare. measures of deviations from a reference point
loss aversion - losses loom larger than gains
diminishing marginal sensitivity
decision weighting - subadditivity: overweighting of small probabilities.
sub certainty: Subjects tend to overweight outcomes that are considered certain to outcomes that are merely probable
Subproportionality: People judge probabilities that are the same compared in relative terms (1 to 0.8 and 0.25 to 0.2) to be more similar (in terms of decision weights) when probabilities are small (0.25 is judged more similar to 0.2 than 1 is to 0.8)
draw the prospect theory diagram
convex prefer the gamble to the certain, the gamble is less negative
V is values
Concave for gains and convex for losses
Risk-aversion in gains and risk-seeking in losses (see example)
Steeper for losses than for gainsnLosses loom larger than gains
ncl is students
kt is an actual paper
what’s the reflection effect
The preference between negative prospects is the mirror image of the preference between positive prospects
how are certain gains and losses interpreted
certain positive outcomes are overweighed
certain negative outcomes are underweighted
what does subadditivity mean
Overweighting of small probabilities
what’s subcertainty
An example of Allais Paradox.
Common ratio effect. One prospect is certain
Subjects tend to overweight outcomes that are considered certain to outcomes that are merely probable
what’s subproportionality
People judge probabilities that are the same compared in relative terms (1 to 0.8 and 0.25 to 0.2) to be more similar (in terms of decision weights) when probabilities are small (0.25 is judged more similar to 0.2 than 1 is to 0.8)
what is mental accounting
Mental accounting is the set of cognitive operations used by individuals and households to code, categorize and evaluate financial activities
what are the 3 components of mental accounting
1.Framing and editing
Perceptions of outcomes and decision making
2.Budgeting and fungibility
Assignment of activities to specific accounts
3.Choice bracketing and dynamics
Determination of the time periods to which different mental accounts relate
what is the problem with mental accounting
don’t see fungibility
Fungibility relates to the substitutability of different budget categories;
If budgets are fungible, overspending in one category can be compensated by underspending in another category and vice versa
implications of prospect theory
Segregate gains
the gain function is concave due to diminishing marginal sensitivity
Who is happier, someone who wins two lotteries that pay £50 and £25 respectively, or someone who wins a single lottery paying £75? 64% say the two-time winner is happier
Segregate small gains from larger losses
value of a small gain may exceed that of slightly reducing a large loss, diminishing marginal sensitivity
Before price £20. Save 2£ (a gain) Might be better than “new low price £18”
Imagine you are shopping for a calculator and a jacket, and you find them both at the same department store. The calculator costs £25, and the jacket costs £120. You are told that a store across town has both items, but the calculator is £15 cheaper at that store. Do you buy the items at that store or do you go across town?
Most people would go across town
If the jacket is £15 cheaper, most people say no
Hedonic editing can account for the difference in choice
Saving on the calculator; v(-10) - v(-25)
Saving on the jacket; v(-110) - v(-125)
Because of diminishing marginal sensitivity to loss; the saving (the difference between the losses) on calculator has a greater value
with mental accounting, what are the two types of utility from transactions
§Acquisition utility
§value of the good obtained relative to its price, equivalent to the concept of consumer surplus
§Transaction utility
§perceived value of the ‘deal’, i.e. difference between reference price and price paid
what is the whole idea of budgeting and fungibility in mental accounting
Firms set budgets or targets for spending in various categories, and allocate expenses to different categories
Fungibility ; substitutability of different budget categories
In standard model; budgets completely fungible:
buy if MB > MC
marginal benefits>marginal costs
what is choice bracketing
individuals segregate or aggregate choices over time periods
•Consumers are less willing to replace a lost Theatre ticket than if they had lost an equivalent amount of money as the theatre ticket is “same category”
How would standard economics predict people react to a small windfall? How would mental accounting predict people react to a small windfall?
No effect. Permanent Income Lifecycle Theory
mental accounting people - A positive effect. Mental account (e.g. ‘grocery spending per week’)
whats the aim and conclusion of Milkman et al.. 2009. Mental accounting and small windfalls:
nDoes the redemption of a $10-off coupon increases an individual’s spending on online groceries (predicted by mental accounting)
nDoes the increase in spending stimulated by the redemption of a $10-off coupon focus on groceries that customers would not purchase in the absence of such a coupon (“marginal” goods)
The regression results indicate that the effect of a coupon used corresponds to $1.59 in additional spending
The results indicate that the effect of coupon use corresponds to $1.56 in additional spending on marginal groceries
