Prospect Theory

Question 1

What is Prospect Theory

Answer 1

-Theory for simple prospects with monetary outcomes and stated probabilities
Distinguishes two phases in the choice process:
1. Editing - consists of coding, segregation, separation etc.
2. Evaluation - where the prospect with the highest value is chosen.

• The value of a prospect V is expressed in terms of two scales - the Weighting Function π(p) and the Value Function V(x)
• π - associates with each probability p a decision weight π(p), which reflects the impact of p on the overall value of the prospect – not a probability measure!
• v - associates each outcome x a number v(x) = value of that outcome, relative to a reference point.
  see diagram, p.13

Question 2

Endowment Effect

Answer 2

Kahneman, Knetsch and Thaler (1990)

Standard assumptions - WTP=WTA

WTP < WTA = the value an individual assigns to an object increases as soon as the individual is given the object.
contrary to standard theory, and Coase’s theorem according to which property rights should have no impact on decisions - in this case, they do, and people assign ownership.

no effect on goods that are meant for resale e.g. money - no ownership effect.

Question 3

Equity Premium Puzzle

Answer 3

Stocks have more volatile prices than bonds - therefore stock returns are higher to compensate the risk.

Benartzi and Thaler (1997) - investors are not averse to the variability of returns, but to loss - value losses much higher - more probable with stocks, more negative more frequently

Higher average return to stocks means that the cumulative return over a longer horizon is more likely to be positive as the horizon lengthens – investors must take a short horizon, where they are more likely to lose money

Two factors:
1. loss aversion
2. short evaluation period
=> myopic loss aversion

Question 4

Mental Accounting

Bertrand et al. (2004)

Answer 4

Money is not fungible - we should not treat it as such
liquidity, current account , assets are perceived differently - even if they are all in terms of money

current income - MPC is high
current assets - MPC is intermediate
future income - MPC is low

=> consumption therefore is overly dependent on income, using this – important to nudge people to save

Question 5

Disposition Effect

Answer 5

Odean (1998)

The tendency of investors to hold on to losing investments for too long, and sell winning investments too soon.
This suggests risk-seeking in losses and risk-aversion in gains. As losses are in the convex portion of the Value Function, prospect theory predicts risk seeking, making them more willing to hold on to investments rather than realise the loss ==> consistent with Prospect Theory.

Question 6

Camerer et al. (2003)

Answer 6

NYC Cab Drivers - find little evidence for intertemporal substitution in wages, even during busy periods.
Standard theory would predict workers work longer when demand is high e.g. on rainy days, but they do not.

Possible explanations:

1. Target-level based income, where if they reach their target they stop working.
2. Loss-aversion/Risk-aversion and therefore do not raise the target level, in fear of not reaching the higher target.
3. One-day-at-a-time horizon length - doesn’t allow for intertemporal substitution, work longer for one day to substitute for another day.

Inexperienced drivers feature this behaviour more.