Prospect theory Flashcards
two ways of having a preference relation
complete: always define preference between x and y transitive: if x>y and y>z then x>z
a preference relation between goods is rational if…
complete or transitive preference relationship
what is monotone
more is preferred to less
what is convex
diminishing marginal rates of substitutions (agents prefer diversification)
what is independence
if x>y then (x,z)>(y,z)
what is continuity
if A>B>C then there is always a p such that A and C weighted equals B (5/31 don’t rly get)
what are main assumptions of expected utility theory
continuity independence linear in probability
what is linear in probability
V(q) = Σpiu(xi)
what are the other assumptions in expected utility theory
utility defined over final wealth rather than gains and losses, preferences are independent on the manner the prospects are described
what are the puzzles of EU theory
framing effects (dying and saving people) loss aversion (losses loom larger than gain), utility not defined over final wealth (100k vs 50k happy 100k vs 500k sad), linear decision weights
what is the Allais paradox (linear decision weights)
A=(4000,.80) or B=(3000,1) C=(4000,0.20) or D=(3000,0.25) people prefer B to A and C to D. C&D obtained by dividing probabilities by 4. reducing probability of winning from 1 to 0.25 has a greater effect than reducing it from 0.8 to 0.2 (certainty effect)
what does it mean that individuals are risk averse in gains and risk lovers in losses
diff between gain of 100 to 200 appears larger than 1100 and 1200, diff between loss of -100 and -200 appears larger than -1100 and -1200. hence v’‘(x)<0 for x>0 and v’‘(x)>0 for x<0
what does risk loving in losses mean
in order to avoid losses you will do crazy things (irrational risk)
what is π(p)
weighting function: probability is a function of π
in prospect theory how is the decision weight used
the value of an uncertain outcome is multiplied by a decision weight π(p) which is a monotonic function of p but is not a probability (in EU just multiplied by probability)
explain mug experiment and who wrote it*
kahneman et al (1990), market for mugs (6 USD) some were endowed a mug some others with money to buy, median WTP=2.75 mediam WTA=5.25
why is mug experiment of note
standard assumptions imply WTA≈WTP, evidence of endowment effect: value things you own more than things you don’t. this type of loss aversion implies asymmetry in treatment of losses and foregone gains
WTP and WTA d
willingness to accept: minimum compensation demanded by owner to sell willingness to pay: max price individuals want to pay for a good
what is the disposition effect in terms of stocks
individuals hold stock that have lost value for too long and are eager to sell stocks that have gained value
first field experiment of brokerage firm*
shefrin and statman (1985) field experiment brokerage firm investors held losing stocks median 124 days and held winners only 104 days
what is another similar example to investors holding stocks that have lost value for too long and sell gainers
similar effect in housing market when house price falls the volume of sales falls as well
Odean (1998)*
info from discount brokerage house 1987-1993. share of realised gains PGR=realisedgains/realisedgains+papergains (PLR opposite)(this controls for the market) PGR greater than PLR people more reluctant to realise losses than gains however in December PLR>PGR because if you have more losses you get taxed less at end of year
why do you need paper gains as well
because if bull market would naturally have more winners than losers. need to look at frequency with which they sell winners and losers relative to their opportunities to sell winners and losers
talk about cab driver paper*
Camerer et al. (1997), cab drivers lease cabs for fixed fee, they work long hours when there is low demand (sunny) and short hours when high demand (rainy), this is consistent with loss aversion: fix a daily target and averse to fall short standard theory says should respond positively to wage changes (work more when wage higher,(leisure cost more))
