Lecture 4: prospect theory and beyond

Question 1

Von Neumann & Morgenstern

Answer 1

you can calculate the cardinal utility of an outcome based on 3 assumptions
1. risky propositions can be ordered in desirability
2. concept of expected utility is behaviorally meaningful
3. choices among risky alternatives are made in a way to maximize expected utility

if you adhere to certain rules maximizing utility is rational. objective value of money isn’t linear, but marginal value is.

Question 2

cardinal and ordinal utility

Answer 2

• cardinal gives a numerical value to utility
• ordinal is on a preference scale

Question 3

Maurice Allais

Answer 3

researched a number of inconsistencies within the utility theory in the choices that people make. he published a paper revolving around this Allais paradox.

Question 4

common consequences principle

Answer 4

if two options have the same probability for a given consequence, then you should ignore this option when choosing between the options and base your choices on the aspects of the options that differ.
however people violate this when making choices

or sure thing principle

Question 5

Ellsberg paradox

Answer 5

people aren’t consistent in their assumptions. red, blue and yellow balls.

Question 6

hypotheses that explain the Allais paradox

Answer 6

• people’s decisions are influenced by anticipated regret
• people’s perception of probability is nonlineair

Question 7

hypotheses that explain the ellsberg paradox

Answer 7

• people tend to avoid ambigious probabilities in the domain of gains
• people tend to seek ambigious probabilities in the domain of losses

Question 8

prospect theory

Answer 8

PT = ∑π(p) * V(X)
it is probability and value transformed, but still a multiplication of probability and form of outcome

Question 9

Kahneman and Tversky (1979)

Answer 9

describe several choice problems in which preferences systematically violate the EUT and the reflection effect

Question 10

several choice problems in which preferences systematically violate expected utility theory

Kahneman and Tversky (1979)

Answer 10

• if B is preferred to A, not any probability mixture of B is preferred to A.
• demonstrated the certainty effect with non monetary outcomes; people choose the certain outcome, but if everything becomes risky, people choose the most attractive option.
• show a difference in possibility and probability. if winning is probable they choose the option that is most probable. when winning is merely possible people choose the largest gain.

Question 11

reflection effect

Kahneman and Tversky (1979)

Answer 11

also made a loss version of some of the problems that showed that people are risk averse for choices with sure gain, but risk seeking for choices with a sure loss.
- people prefer a small change of a bigger loss than a big change on a small loss.
- this is inconsistent with EUT and with the idea that people like certainty and dislike risk

Question 12

framing effect

Answer 12

the structure of the problem may affect choices. (For example live indicates a gain situation and die a los situation).

Question 13

characteristics of prospect theory

Answer 13

• you look at what you have and what will be added
• defined on gains and losses rather than total wealth
• concave in the gain domain and convex in the loss domain. reflection effect; caused by the shape of the graph.
• considerably steeper for loss than gain. Loss aversion; caused by the steepness of the graph.

Question 14

the weighting of probabilities

Answer 14

• moderate and high probabilities are underweighted
• low probabilities are overweighted
• highly likely and highly unlikely events are either ignored or overweighted

the graph is not finished because we don’t know what happens at the end. Pi is not well behaved near the end.

Question 15

positive theory

Answer 15

a theory that aims to describe behavior. published by Thaler and Shafir. they used prospect theory to form this theory. Through an experiment from this article they found the endownment effect.

Question 16

the endownment effect

Answer 16

the moment someone gets something in their possession they don’t want to give it up anymore.
there is a disparity between willingness to pay and to accept payment.

for example buying wine feels as an investment and not a loss, drinking it 10 years later feels free or even as a profit.

Question 17

Knetsch and Sinden

endownment effect

Answer 17

another experiment where they gave people a lottery ticket or 3 dollars that they could either keep or buy a lottery ticket with. only 38% of people that got 3 dollars bought a lottery ticket, but 82% of the people that got the ticket kept it.
Knetsch later did a similair experiment with mugs and chocolate
- conclusion is that people don’t want to give up what they have, because losing is painful.

the same effect was shown in chimpanzees

Question 18

sunk costs

Answer 18

sunk costs make you feel like you are already in the loss domain, so making more losses hurts less and people are motivated to invest more to make up for the costs. For example eating until your uncomfortably stuffed at a all you can eat restaurant you already paid for