Prospect Theory and Mental Accounting

Question 1

What is Expected Utility Theory (EUT)?

Answer 1

• explains how people choose between risky options by considering both the possible outcomes and the probabilities of the outcomes
  It’s the standard theory of decision making under risk in economics.
  It is often referred to as: neoclassical model of decision making or rational choice theory.

Question 2

What is an advantage of prospect theory?

Answer 2

It is very general - it can be applied to very different situations

Question 3

What is Utility in EUT?

Answer 3

a subjective value an individual derives from an alternative

Question 4

Criticism of Expected Utility Theory

Answer 4

• There are many empirical phenomena that are inconsistent with the theory, e.g., sellers value their goods and assets higher than buyers (endowment effect), negative intertemporal elasticity of labour supply (wages increases, labour supplied decreases - inexperienced taxi drivers with a desired sum earned may decrease hours when wage increases, wage increase means they will make the desired amount in fewer hours)
• It is not psychologically plausible: e.g. it does not capture the phenomenon of loss aversion, EUT ignores framing effects: how a decision situation is presented may matter.

Question 5

What is Prospect Theory and its key features?

Answer 5

• Outcomes expressed as positive or negative deviations (gains or losses) from a neutral reference outcome, which is assigned a value of zero
• Value function as alternative to utility function
• The value function has a kink at the reference point and is steeper to the left than to the right of the origin - “losses loom larger than gains”
• while utility function ranges over total endowments, value function ranges over changes in endowment to capture reference dependence
• possible sources of references points include: previous experience, expectations, status of others

Question 5

Two phases in choice process:

Answer 5

Phase 1: Acts, outcomes, and contingencies are framed
Phase 2: Evaluation

Question 6

What at the key features of the value function:

Answer 6

• S-shaped: concave above reference point, convex below: risk averse in gains region, risk loving in losses region
• Diminishing marginal sensitivity in both gains and losses regions: difference in subjective values between
• Losses loom larger than gains: response to losses more extreme than responses to gains (steeper in losses domain)

Question 7

What are the differences between EUT and PT?

Answer 7

EUT - explains how people choose between risky options by considering both the possible outcomes and the probabilities of the outcomes
It’s the standard theory of decision making under risk in economics.
Prosepct theory is outcomes exressed as positive or negative deviations (gains or losses) from the natural reference outcome that is usually assinged a value of zero.
In PT, no probabilities are used: instead, the value of each outcome is multiplied by a decision weight, decision weights are not probabilities (do not obey the probability axioms)
- Decision weights are inferred from choices between prospects
- The usual assumption is that low probabilities are overweighted, whereas high probabilities are underweighted

Question 8

Dynamic models of labour supply predict “rational” workers should:

Answer 8

work more when wages are high and consume more leisure when wages are low

Question 8

What is wage elasticity of labour supply

Answer 8

a change in amount of labour supplied due to a % change in wages

Question 8

What is Mental Accounting?

Answer 8

Mental Accounting is the set of cognitive operations used by individuals and households to code, categorize and evaluate financial activities - Thaler

Question 9

According to Thaler (1999) mental accounting may be helpful to:

Answer 9

• facilitate comparison on the trade-offs of different uses of funds
• as a self-control device (e.g., saving for child’s college fund)

Question 10

Why does bundling matter in mental accounting and prospect theory?

Answer 10

due to the fact that the value function is concave in the domain of gains and convex in the domain of losses

Question 11

What type of gain is valued more?

Answer 11

Segregated gains are valued more

Question 12

Implications of Prospect Theory to how joint outcomes are evaluated; according to the Hedonic Editing Hypothesis it would be best to:

Answer 12

• segregate gains (because the gain function is concave due to diminishing marginal sensitivity)
• integrate losses (because the loss function is convex due to diminishing marginal sensitivity) - does not seem to be supported empirically
• integrate smaller losses with larger gains (to offset loss-aversion)
• segregate larger losses from smaller gains (utility of a small gain can exceed the utility of slightly reducing a large loss, again due to diminishing marginal sensitivity)

Question 13

What is Fungibility?

Answer 13

Substitutability of different spending categories

Question 14

What theory is considered a key alternative to Expected Utility Theory for decision making under risk

Answer 14

Prospect Theory - outcomes are expressed as positive or negative deviations (gains or losses) from the natural reference outcome, which is usually assinged a value of zero
- Its assumptions are derived from experimental observations on how individuals behave under risk and hence are often more behaviourally plausible
- It can help account for instability of preferences (e.g. risk averse under one framing, risk loving under another) that cannot be accounted for by Expected Utility Theory
- It can also explain some behaviour that expected utility theory cannot explain (framing effects, endowment effect).

Question 15

What is marginal sensitivity?

Answer 15

refers to how sensitive a consumer’s behaviour is to changes in price or income

Question 16

Why is the gain function concave?

Answer 16

Due to Diminshing Marginal Sensitivity

Question 17

Why is the loss function convex?

Answer 17

Due to Marginal Sensitivity

Question 18

while utility function ranges over total endowments what does value function range over?

Answer 18

value function ranges over changes in endowment to capture reference dependence

Question 19

Choosing a sure bet over a gamble with the same expected value is indicating of what?

Answer 19

risk aversion

Question 20

Choosing a gamble over a sure bet with the same expected value is indicative of

Answer 20

risk lovingness

Question 21

When is a person indifferent between a gamble and a sure bet with the same expected value?

Answer 21

if the decision maker is risk neutral

Question 22

What is Diminishing marginal sensitivity?

Answer 22

means that the more you gain or lose, the less additional impact each extra unit of gain or loss has on your perceived value or utility. This concept helps explain why people value small changes more when they have little, but become less responsive as amounts increase.

Question 23

Name 3 key differences between EUT and Prospect Theory. How are they incorporated in the theory?

Answer 23

• Prospect theory incorporates reference dependence and loss aversion, whereas in EUT preferences are independent of endowment
• In Prospect theory, the value function (counterpart of utility function) has a kink at the reference point (origin). Value function ranges over changes gains or losses relative to some reference point
• The value function is steeper in the losses than in the gains region - “losses loom larger than gains”. The value function is concave above reference point and convex below (captures risk aversion in gains region and risk proneness in losses region). It is often assumed that there is diminishing marginal sensitivity both in the gains and the losses region (S-shaped value function)
• In EUT, an individual is EITHER risk averse OR risk loving OR risk neutral implying a particular utility function, but preferences cannot vary.
• In EUT the payoff from a given alternative in a given state of the world is multiplied by the probability assigned to the state of the world by the decision maker. In Prospect Theory no probabilities are used, instead, the value of each outcome is multiplied by a decision weights are not probabilities ( do not obey the probability axioms)