Lecture 9 Flashcards
Misuse of Probability
When making decisions, under-weight high probabilities and over-weight low probabilities. Even when we correctly estimate these probabilities, we act differently. This is why people are afraid of vaccinations and less afraid of common illnesses
The Certainty Effect
A reduction of probability carries more weight if the initial outcome was certain. Reduction from 80% to 79% not felt as acutely as reduction from 100% to 99%. This is why the Prospect Theory Weighting Function has steeper slope at the ends
Prospect Theory Weighting Function
Shows the impact of the misuse of probability and the certainty effect
Expected Utility vs. Prospect Theory
EU = p(1)u(1) + p(2)u(2) + … + p(n)*u(n)
PT = π[p(1)]v[u(1)] + π[p(2)]v[u(2)] + … + π[p(n)]*v[u(n)]
Where π translates p on the weighing function and v translates u on the value function
Equity Premium
Higher returns for stocks because people are risk averse for gains. Shows risk aspect of prospect theory in real life.
Disposition Effect
People tend to hold on to losing stocks and sell winning ones, while ignoring sunk costs. Shows risk and loss aversion.
Lottery ticket demand
Demand increases as people participate, even though probability decreases. Over-weighting small probabilities
Mental accounting
We perceive money to be nonfungible - objectively, money in the pocket should be the same as money in checking/savings, but we don’t experience it that way. We treat money differently depending on situation - saving $5 on $15 seems better than saving $5 on $750. We tend to keep artificial, separate budgets for different things. This happens because it is easier to keep track of money if we reset our reference point for each account we keep.
Sunk cost effect
Once already invested, don’t want to quit even if odds against. Failure to adjust a reference point appropriately to take in only future costs and gains. We keep mental accounts open in order to balance, when in fact we should ignore what happened in the past. Increased risk taking
Framing effects
The way choices are framed has a big impact on our decisions. Recall risky choice framing (framed as gain or loss) discussed earlier
Attribute framing
We like hearing 90% lean rather than 10% fat; 95% success rate rather than 5% failure rate
Do different frames provide different information?
Some argue that they do, as they emphasize different information and suggest different inferences/opinions
Goal framing
Framing policies differently to influence behavior. Saving environment vs. destroying environment vs. cutting jobs vs. hurting the economy. Goes a step further than attribute framing by changing the issue, highlighting certain aspects and ignoring others
Revealed vs. Constructed Preference
People have stored preferences that can be discovered or inferred via behavior vs. people do not have pre-stored preferences but construct when asked - flexible. Evidence is against revealed preference because framing causes preference reversals.
