Lecture 4: Prospect Theory and Beyond

Question 1

Expected value (EV) formula

Answer 1

Expected Value (EV) = ∑ p・X

Question 2

Expected utility (EU) formula

Answer 2

Expected Utility (EU) = ∑ p・U(X)

Question 3

Prospect theory (PT) formula

Answer 3

Prospect Theory (PT) = ∑ π(p)・V(X)

Question 4

Allais paradox

Answer 4

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

Question 5

possible explanations for the Allais paradox

Answer 5

• 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%)

Question 6

Ellsberg paradox

Answer 6

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

Question 7

possible explanation for the Ellsberg paradox

Answer 7

people tend to avoid ambiguous probabilities

Question 8

prospect theory

Answer 8

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

Question 9

expected utility theory

Answer 9

outcomes are multiplied by probability -> decisions

Question 10

certainty effect

Answer 10

in prospect theory, outcomes received with certainty are overweighted relative to uncertain outcomes

Question 11

probability and possibility

Answer 11

• when winning is probable (high %), people choose the option that is probable
• when winning is merely possible (low %), people choose the largest gain

Question 12

the reflection effect

Answer 12

moving to the loss/negative prospect changes preference

Question 13

expected utility theory (utility functions)

Answer 13

people are risk averse

Question 14

prospect theory (utility functions)

Answer 14

• risk aversion for choices with sure gain
• risk seeking for choices with a sure loss

Question 15

value function of prospect theory

Answer 15

• 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)

Question 16

framing

Answer 16

the way we frame a question or problem can impact our decision making and choices

Question 17

probability weighting function of prospect theory

Answer 17

• 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

Question 18

endowment effect

Answer 18

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)

Question 19

sunk costs

Answer 19

previous, historical costs affecting our current behavior
- economic theory implies that only incremental costs and benefits should affect decisions

Question 20

sunk cost effect

Answer 20

• 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

Question 21

expected utility theory vs prospect theory

Answer 21

Question 22

normative vs descriptive decision making analysis

Answer 22

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

Question 23

psychophysical approach to decision making (Daniel Bernoulli)

Answer 23

people do not evaluate prospects by the expectation of their monetary outcomes, but rather by the expectation of the subjective value of these outcomes

Question 24

dominance

Answer 24

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

Question 25

invariance

Answer 25

2 versions of a choice problem that are recognized to be equivalent when shown together should elicit the same preference even when shown seperately

Question 26

failure of invariance

Answer 26

attributed to the interaction of 2 factors
- the framing of probabilities
- the nonlinearity of decision weights

Question 27

pseudocertainty effect

Answer 27

when an event that is uncertain is weighted as if it were certain

Question 28

rational theory of consumer behavior

Answer 28

assumes invariance and does not recognize the effects of mental accounting

Question 29

status quo bias

Answer 29

a preference for the current state that biases the economist against both buying and selling something

Question 30

bounded rationality

Answer 30

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

Question 31

cash discount vs credit card surcharge

Answer 31

• cash discount viewed as an opportunity cost
• credit card surcharge viewed as an out-of-pocket cost

Question 32

price theory (Stigler)

Answer 32

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

Question 33

alternative price theory

Answer 33

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

Question 34

standard search theory

Answer 34

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

Question 35

self-control

Answer 35

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

Question 36

Strotz precommitment

Answer 36

a device used to solve problems of self-control

Question 37

positive vs negative investment goods

Answer 37

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)

Question 38

prospect theory and the planner-doer model

Answer 38

attempt to describe human decision-makers coping with a very complex and demanding world