Week 2 Flashcards
What does the utility function of a risk neutral person look like?
a straight line between subjective value (utility) and monetary value
What does the utility function of a risk averse person look like?
A concave, utility increases with wealth, but at a decreasing rate. This implies loss aversion.
Wortelfunctie
When are we risk averse and when are we risk-seeking according to Prospect theory?
We are risk averse when dealing with gains and risk-seeking when dealing with losses?
What is risk aversion?
Valuing a sure thing higher than a risky thing, even though the expected utility of the two is the same. Risk aversion is incorporated into Expected Utility Theory
What is prospect theory (Kahneman & Tversky 1979)
We hate risk, unless it enables us to see a path out of a bad situation.
What is the 0-point in the s-shaped utility curve (prospect theory)
The 0-point is at the currents situation
What is the S-shaped utility curve?
Losses loom larger than gains. Loss convex, gain concave.
What is the certainty effect?
Outcomes that are almost, but not entirely, certain are valued lower than their probability justifies.
What are the two main elements in prospect theory?
S-shape and framing
What does the utility function of a risk-seeking person look like?
a convex, increasing at a increasing rate. This implies risk loving
kwadratische functie.
What is the possibility effect?
Highly unlikely outcomes are valued higher than their probability justifies (airplanes/lotto).
What are two special cases in Prospect theory?
Certainty effect and Possibility effect
What is the ellsberg paradox?
Ambiguity aversion: we are willing to pay less for a vague choice than for a clear choice
What is ambiguity
Both outcome and chances are uncertain.
What is loss aversion?
Losses weigh heavier than same size gains
What is the endowment effect?
We attach higher value to things that we own than to things that we do not own (wine or salty pizza example).
What is the ikea effect?
We disproportinately value things that we worked hard for.
What is the zero price effect?
Difference between no cost and a very small cost has a disproportionate impact. Free means only gain, paying is gain and loss.
What is framing?
Describes the way a choice is presented, as either gain (risk averse) or loss (risk-seeking). We can change people’s preferences by formulating choices differently (disease problem).
What effectively happens with framing in our minds?
System 1 kicks in, causing us to become risk averse with gains and risk-seeking with losses. System 1 causes us to make wrong choices.
What is the Tom Sawyer effect?
Framing an unpleasant task as a privilege or unique opportunity.
What is mental accounting?
A set of cognitive processes based on two main (related) elements: transaction utility and Use of mental accounts.
What is transaction utility?
Utility not only comes from the product (outcome), but also the process through which it is acquired. The process how you acquire the product influences the price.
What are mental accounts?
People have different accounts in their mind, with each a different purpose. Transferring between accounts feels wrong. Gains and losses feel different, depending on which account they are “booked”. One euro doesn’t feel the same as another.
