Week 4 - Risk preferences & loss aversion Flashcards
Uncertainty
We cannot estimate the probability of outcomes arising
Risky
What will happen isn’t sure, but we can quantify the probabilities of events
3 types of risk tolerance
*The amount of money we are willing to risk depends heavily on the amount of money we already have.
- Risk averse agents
- Risk neutral
- Risk loving
Certainty equivalent (of a lottery)
The amount of money that given to the agent makes them indifferent between the gamble and the certain amount
u(CV) = EU(l) to find CV
CV < EV(l) for a risk-averse agent
CV = EV(l) for risk-neutral ppl. Indifferent to risk
CV > EV(l) for a risk-loving agent.
Why do insurance contracts exist?
Ppl’s risk aversion creates demand for insurance.
- Insurance co.s allow ppl to lower their risk at a price
2 reasons why the estimation of prob. of something happening can go wrong
- Overconfidence
- reweighting of probabilities in favour of some outcomes (probability weighting) - Framing
- reference point
**how choices are presented (framing) matters!
Endowment effect
Ppl value more things they own than things they don’t
- Justified why WTA > WTP
3 main criteria of prospect theory
- Reference dependence
- Loss aversion
- the function is steeper for losses than for gains - Diminishing sensitivity
- MARGINAL VALUE of both gains and losses decreases w/ their size
Read the paper by Barberis (2013) and use its findings to argue why understanding whether workers are loss averse is complicated. Suggest another area where studying workers’ loss aversion is relatively easy. (from PS4)
*For wage earners studying these reactions would be far more complicated, as changes in the intensive margin (the hours of work) are not easy, as workers are typically hired for a given amount of hours each week. The literature suggests that instead of these adjustments we might expect to see adjustments in the effort level workers exert, but these are far harder to measure.
Barberis (2013) summarises the evidence on loss aversion in different domains.
- He mentions studies on labour supply and explains that authors mainly focused on taxi drivers when studying loss aversion in LABOUR SUPPLY decisions.
- This is largely due to the fact that they can easily choose the HOURS they WORK, as they have no fixed shift.
- Also, they are PAID IMMEDIATELY, so there is a direct correspondence between hours worked on a given day and money taken home.
The paper suggests that taxi drivers set two types of target on any given day:
1. the INCOME from that day 2. a target amount of HOURS worked
- Drivers stop working when when the 2nd target (hours target) is hit;
- note that if the driver’s earnings early in the shift are lower than expected, they will keep working until the target income is reached.
An easy field to see this type of adjustment is tutoring (but also food drivers, task rabbit users, etc.) + babysitters
Thirty Years of Prospect Theory in Economics: A Review and Assessment, Barberis (2013)
Challenges in applying prospect theory
The fundamental difficulty in applying prospect theory in economics is that it is often UNCLEAR what a GAIN or LOSS represents in any given situation.
Köszegi and Rabin (2006, 2007, 2009) ideated that the reference point ppl use is their EXPECTATIONS or BELIEFS held in the recent past about outcomes.
Thirty Years of Prospect Theory in Economics: A Review and Assessment, Barberis (2013)
6 applications of prospect theory
*check notes for full explanation
- Finance
» Some securities have higher average returns than others.
- author proposes that investors OVERWEIGHT the unlikely outcome that the POSITIVELY SKEWED STOCK will make a lot of money
» Loss aversion can explain the famous equity premium puzzle: the average return of the US stock market has historically exceeded the average return of Treasury bills by a much greater margin than predicted by traditional consumption-based models of asset prices
» Investors & mutual fund managers are more likely to sell stocks that have risen in value since purchase than sell stocks that have fallen in value, although stock returns exhibit “momentum”. - Insurance
» Households are willing to pay a higher premium for an insurance policy with a lower deductible.
- Households OVERWEIGHT TAIL EVENTS - the unlikely but unpleasant outcome in which a claim occurs and they have to pay the deductible. - The endowment effect
» Typically WTA > WTP b/c loss aversion - Consumption-savings decisions
» Precautionary savings - Industrial organisation
» Supermarkets and other retails alternate between high and low prices & can induce consumers to pay an average price that exceeds their valuation of the good. - Labour supply (cab drivers)
*more in next flashcard
