Lecture 11 (End of Chapter Questions)

Question 1

Why does the Allais Paradox violate EUT?

Answer 1

• In EUT utility is linear in probabilities however in reality people overvalue small and undervalue large probabilities
• > Independence Axiom is violated

Question 2

Explain the “certainty effect”.

Answer 2

The DM values the difference between sure and pretty sure more than the difference between probably and a bit less.

Question 3

What are the main differences between EUT and PT?

Answer 3

1. Value function: PT uses a reference point has a concave function above and a convex function below
2. Non-linear probability weighting -> solves Allais Paradox

Question 4

What does the reference point dependence mean?

Answer 4

Outcomes are perceived as gains or losses depending on the reference point.

Question 5

What is loss aversion? What is endowment effect?

Answer 5

Loss Aversion: The value function is steeper for losses than for gains.

Endowment effect: People value things higher if they are part of their endowment.

Question 6

What are the characteristics of the value function in PT?

Answer 6

1. Concept of a value function: A is better than b if V(A) > V(b)
2. Additive Form: V(a) = Sum (v(a_i) * pi(p_i)
3. Deviations are captured from a reference point
4. Non-linear probability weighting