Lecture 11: Prospect Theory

Question 1

Framing effect

Answer 1

The framing effect shows the the presentation of a problem affects the decision (e.g. 200 saved vs 400 die).

Question 2

What is the problem of a concave utility function?

Answer 2

People have different risk attitudes for gains (risk averse) and losses (risk prone) -> E.g. Asian disease problem (200 saved vs 400 die)

Question 3

What is the problem of EUT regarding the use of absolute levels?

Answer 3

• People care about changes not about absolute levels (final wealth)

Question 4

What is the Allais Paradox?

Answer 4

• In EUT expected utility is linear in probabilities (Independence Axiom)
• Allais Paradox shows that DM have non-linear decision weights
• People value small probabilities higher and large probabilities lower

Question 5

Where does EUT fail?

Answer 5

1. Framing effects (presentation of choices)
2. Individuals care about changes not the absolute levels (in EUT the domain of utility is final weals level and not gains or losses)
3. Different risk attitudes for gains and losses (EUT assumes that u is concave)
4. Non-linear decision weights (Allais Paradox)

Question 6

Prospect Theory (PT)

Answer 6

• Concept of a value function

- Additive

Question 7

PT - Differences from EUT

Answer 7

1. Value Function:
   - captures deviations from a reference point
   - is usually concave above the reference point (for gains) and convex below (for losses) -> steeper for losses then for gains
2. Non-linear probability weighting (Allais Paradox)

Question 8

PT - Reference point

Answer 8

• DM evaluates changes relative to a reference point

- The reference point is perceived as neutral

Question 9

PT - Gains and losses

Answer 9

• Concave utility function for gains
• Convex utility function for losses
• A power function with parameters Lamda (loss aversion parameter) and alpha (controls curvature) is commonly used

Question 10

PT - Loss aversion

Answer 10

• The utility function is usually steeper for losses than for gains -> easier to make people unhappy than happy

Question 11

Endowment Effect

Answer 11

• The value of something increases when it become spart of the person’s endowment (lord of the rings)

Question 12

PT - Diminishing Value sensitivity

Answer 12

The difference between gains of 10 and 20 € is greater than the difference between 110 and 120 €

Question 13

PT - Probability Weighting

Answer 13

• People overvalue small probabilities and undervalue large probabilities
• Solution: Probability Weighting

Question 14

Application of Prospect Theory

Answer 14

Uber: Motivate driver by statement: Your are only 10 € short of making 500 € -> Loss aversion: people are motivated by the threat of loss