prospect theory

Question 1

Expected U.Theory is..

Answer 1

Normative. It talks about what people should do.

Question 2

Prospect Theory:

Answer 2

By Hakneman and Tversky, is based on observations of ACTUAL behavior.
Prospect theory developed because people often behave contrary to EUT. This is an alternative to expected utility theory.

Question 3

The two main elements of PT:

Answer 3

1. value function (replaces the EU function)

2. Decision weights (Replace EU probabilities)

Question 4

EUT function values: Utility function

Answer 4

1. care only about final wealth
2. Consistently risk averse
3. differentiable everywhere.

Question 5

EUT: Probabilities:

Answer 5

4. objective probabilities.

Question 6

Prospect theory: Value function

Answer 6

1. changes in wealth matter
2. Risk seeking in the domain of losses and risk averse in the domain of gains.
3. kinked at origin, loss aversion

Question 7

Prospect theory value function

Answer 7

1. value function is in terms of gains or losses relative to a reference point.
2. risk averse in gain domain, risk seeking in loss domain
3. loss aversion.

Question 8

Prospect theory Weighting function

Answer 8

• People distort probabilities in their thinking in a way that violates EUT.
• We prefer certainty (which is called the certainty effect) and underweight near certain events.
• People overweight low probability events. Explains lotteries and insurance.
• Instead of using simple probabilities as in EUT, prospect theory uses a weighting function.

Thus: Decision weights: we overweight low probability events and prefer certainty.

Question 9

Expected Utility Theory

Answer 9

Powerful framework based on rational choice and utility maximization. Describes how rational people deal with risk. Utility functions describe demand at the individual level. But assumes people make rational decisions based on utility function that captures all perferences.