Lecture 8

Question 1

Decision making in a risky world

Answer 1

When faced with risky choice, compare EUs of all options to pick option with highest EU. Normative model: Expected utility theory. Descriptive model: Prospect theory (which says choice is affected by other factors than just probability and utility)

Question 2

Prospect Theory

Answer 2

Options are evaluated based on value and decision weights. Represented via two functions: value function and weighting function. These functions/graphs are based on data of peoples’ decisions and preferences

Prospect Theory = π[p(1)]v[u(1)] + π[p(2)]v[u(2)] + … π[p(n)]*v[u(n)]
π translates p1 on the weighting function,
v translates u1 on the value function. Each person has own π and v

Question 3

Prospect Theory Value Function

Answer 3

Based on EU utility function. Value is the subjective value of relative deviations from a reference point. Different as it emphasizes losses as well as gains (relative to reference point). Losses are felt more acutely than gains (loss aversion) and there is diminishing sensitivity at the extremes. EU: normative, total absolute utility, only considers gains. Prospect theory: descriptive, relative to reference point, behavior different for gains v losses.

Question 4

Reference point

Answer 4

Starting point can impact additional utility. Reference point is given value of 0, determines if outcomes seen as gains or losses. Can be: current assets, expected asset position (current $ + end of year bonus), dictated by social norms.

Question 5

Hedonic editing

Answer 5

Changing the way you view a gain or loss can maximize utility - coding losses as costs or relative gains for example. According to PT value function, segregate gains (feel them all separately) and integrate losses (diminishing marginal utility). Segregate small gains from large losses. First units felt more strongly than additional ones.

Question 6

Loss aversion

Answer 6

Under PT value function, losses felt heavier than gains.

Question 7

Endowment Effect

Answer 7

Once you have something it becomes more valuable/harder to give up. Ownership endows value. Loss aversion adds value to things we own, especially for objects with sentimental value. Depends on comparability - the less easily goods can be compared, the greater the endowment effect

Question 8

Status Quo Bias

Answer 8

When considering changes from status quo, possible losses seem more important than possible gains

Question 9

PT and Risk

Answer 9

We are risk-seeking for losses and risk-averse for gains. This happens because of loss aversion - we are more willing to take risks to avoid losses. Framing effects can impact our decision-making.