Lecture 4: Prospect Theory and Beyond Flashcards
Expected value (EV) formula
Expected Value (EV) = ∑ p・X
Expected utility (EU) formula
Expected Utility (EU) = ∑ p・U(X)
Prospect theory (PT) formula
Prospect Theory (PT) = ∑ π(p)・V(X)
Allais paradox
if 2 options (within a choice set) have the same probability for a given consequence, then you should ignore this consequence when choosing between the options
- one should base the choice on the aspects of the options that differ
- violates the common consequence principle
possible explanations for the Allais paradox
- people’s decisions are influenced by anticipated regret
- people’s perception of probability is non-linear (jump from 0% to 1% is not the same psychologically as the jump from 89% to 90%)
Ellsberg paradox
illustrates how people often prefer choices with known probabilities over those with unknown probabilities, even when this violates the principles of rational decision-making
- it demonstrates our discomfort with uncertainty
possible explanation for the Ellsberg paradox
people tend to avoid ambiguous probabilities
prospect theory
an analysis of decision under risk
- describes several classes of choice problems in which people’s choices systematically violate the axioms of expected utility theory
expected utility theory
outcomes are multiplied by probability -> decisions
certainty effect
in prospect theory, outcomes received with certainty are overweighted relative to uncertain outcomes
probability and possibility
- when winning is probable (high %), people choose the option that is probable
- when winning is merely possible (low %), people choose the largest gain
the reflection effect
moving to the loss/negative prospect changes preference
expected utility theory (utility functions)
people are risk averse
prospect theory (utility functions)
- risk aversion for choices with sure gain
- risk seeking for choices with a sure loss
value function of prospect theory
- defined on gains and losses rather than on total wealth
- concave in the domain of gains and convex in the domain of losses
- considerably steeper for losses than for gains (losses loom larger than gains)
framing
the way we frame a question or problem can impact our decision making and choices
probability weighting function of prospect theory
- underweighting of moderate and high probabilities (= think they are less likely than they really are)
- overweighting of low probabilities (= think they are more likely than they really are)
- highly likely and highly unlikely events are either ignored or overweighted
endowment effect
people often demand much more to give up an object than they would be willing ot pay to acquire it
- willingness to accept (WTA) > willingness to pay (WTP)
sunk costs
previous, historical costs affecting our current behavior
- economic theory implies that only incremental costs and benefits should affect decisions
sunk cost effect
- in a sunk cost situation we are in a loss domain
- continuing is taking a risk that could either result in more loss or bring us back to the gain domain
- due to the shape of the utility function, moving back to the gain domain gives more joy than the pain of incurring additional loss
expected utility theory vs prospect theory
normative vs descriptive decision making analysis
normative
- concerned with the nature of rationality and the logic of decision making
descriptive
- concerned with people’s beliefs and preferences as they are, not as they should be
psychophysical approach to decision making (Daniel Bernoulli)
people do not evaluate prospects by the expectation of their monetary outcomes, but rather by the expectation of the subjective value of these outcomes
dominance
demands that if prospect A is at least as good as prospect B in every respect and better than B in at least one, then A should be preferred to B
invariance
2 versions of a choice problem that are recognized to be equivalent when shown together should elicit the same preference even when shown seperately
failure of invariance
attributed to the interaction of 2 factors
- the framing of probabilities
- the nonlinearity of decision weights
pseudocertainty effect
when an event that is uncertain is weighted as if it were certain
rational theory of consumer behavior
assumes invariance and does not recognize the effects of mental accounting
status quo bias
a preference for the current state that biases the economist against both buying and selling something
bounded rationality
the capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world – or even for a reasonable approximation to such objective rationality
cash discount vs credit card surcharge
- cash discount viewed as an opportunity cost
- credit card surcharge viewed as an out-of-pocket cost
price theory (Stigler)
to maximize his utility, the buyer searches for additional prices until the expected saving from the purchase equals the cost of visiting one more dealer
- then he stops searching, and buys from the dealer who quotes the lowest price he has encountered
alternative price theory
suggests that people evaluate the cost of a product or service not only by its monetary price but also by considering non-monetary factors like time, effort, or missed opportunities associated with obtaining it
standard search theory
a framework that explains how people decide when to stop searching for a better option, such as a job, product, or partner, by balancing the cost of continued search with the expected benefit of finding something better
self-control
choices in the future are reduced because the current self doesn’t trust the future self
- whenever choice can induce regret, consumers have an incentive to eliminate the choice
Strotz precommitment
a device used to solve problems of self-control
positive vs negative investment goods
positive
- goods whose benefits accrue later than their costs (such as education and exercise)
negative
- goods with the opposite time structure (such as alcohol and tobacco)
prospect theory and the planner-doer model
attempt to describe human decision-makers coping with a very complex and demanding world
