WEEK 8 Cumaltive Prospect Theory and Critics

Question 1

What are prospect decision theory weights

Answer 1

Describes subjective perception of probabilities to events compared to their actual likelihood, essentially what i think will occur rather than what actually will occur

Question 2

Low probabilities tend to be overestimated like winning the lottery, high probabilities tend to be underestimated like heart cancer. What are the names for these two statements and what is the equation for each?

Answer 2

Subadditivity for the first one. Equation is pi(rp)>rpi(p) where r is any value between 0 and 1.
Subcertainty. Equation is pi(p) + pi(1-p) <1
shows how we underestimate high probs

Question 3

Explain subproportionality

Answer 3

People are less sensitive on probabilities that are not on the extreme ends.

Question 4

Explain rank dependent utility and the order when it is a gain and when it is a loss

Answer 4

Rank dependent utility is the order from best to worst outcome / worst to best outcome
# is pi , #g or #l just means gain or loss
FOR GAIN:
wi = #g(p1+…+pn) - #g(pi+1+..+pn)

FOR LOSS:
wi = #l(p1+…+pi) - #l(pi+..+pi-1)

Question 5

In prospect theory there is a formula that incorporates the sensitivity felt at both extremes. There is one for gains and one for loss. Same formula except the power sign is either y or alpha. What is this equation?

Answer 5

p^y / (p^y + (1-p)^y)^1/y

can replace y with alpha for loss

Question 6

Can you explain to me a test that was done to see if people weight their decision due to their own perception rather than the objective probability. It involves a certain equivalent

Answer 6

They had a gamble of losing a 100 pounds or winning a hundred pounds and was asked how much they needed to get paid to NOT take the bet or how much they would pay to not take the bet (if there was guaranteed loss).

For example, (100, 0.75;0,0.25)
The expected value here is 0.75->75. If people said they needed to get paid 80 in order to not take the gamble then their certainty equivalent is higher than expected value so they are risk seeking. If they asked for 60 then it is below expected value so they are risk averse.

Question 7

Draw prospect theory graph

Answer 7

Google it

Question 8

What are some theoretical critics of prospect theory

Answer 8

Reference points can be interpreted differently and can change based on new information but the actual derivication of reference points is not clear

Lacks normative prowess. It describes how people make decisions not what people should do. EUT states people maximise utility and PT strays away from that at times.

Ambiguity Aversion. PT only discusses decisions when probabilities are known but does not give a satisfactory answer on if they probabilities are unknown.

Question 9

Give empirical critics of prospect theory

Answer 9

The tests conducted may not reflect how people actually make choices in real life, the test oten asked for answers immediately and the choices were assumed to be what the individiuals desired but that may not be accurate.

May not be accurate to hetrogenity.

Fails to explain the Allais Paradox