Prospect Theory
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A _______________ Theory of Decision Making Under Uncertainty
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3 parts
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__________ value function
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Reflection (S-shape)
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______________ (steeper for losses)
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________ function (decision weights)
What decision biases can Prospect Theory explain?
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Framing
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Mental Accounting
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___________________
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Certainty Effect
Framing Effect Kahneman, D. & Tversky, A. (1984).
Choices, values, and frames. American Psychologist, 39, 341-350.
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Imagine that the U.S. is preparing for outbreak of an unusual disease,
which is expected to kill 600 people. Two alternative programs to
combat the disease have been proposed. Assume that the exact scientific
estimates of the consequences of the program are as follows:
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Gain Frame
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If Program A is adopted, 200 people will be saved. (72%)
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If Program B is adopted, there is a one-third probability that 600 people
will be saved and a two-thirds probability that no people will be saved.
(28%)
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Loss Frame
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If Program C is adopted, 400 people will die. (22%)
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If Program D is adopted, there is a one-third probability that nobody will
die and a two-thirds probability that 600 people will die. (78%)
Framing Effect
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Risk _________ for gains, risk _____________ for losses
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Explained by the __________ of the S-shaped value function
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_________ for gains
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_________ for losses
Mental Accounting
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1. Jacket & calculator example
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a. You are buying a calculator for $15 and a jacket for $125. The
clerk tell you that the calculator is on sale for $5 off at another branch
of the store that is a 20 minute drive away. Do you go to the other
store? (68% do)
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b. You are buying a calculator for $15 and a jacket for $125. The
clerk tell you that the jacket is on sale for $5 off at another branch
of the store that is a 20 minute drive away. Do you go to the other
store? (29% do)
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2. Theater ticket example.
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a. You are going to the theater and have already bought a $10 ticket.
When you arrive you realize that you have lost the ticket. Do you
spend $10 for another ticket? (46% do)
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b. You are going to the theater and plan to buy a $10 ticket when you get
there. When you arrive you realize you have lost a $10 bill.
Do you spend $10 for a ticket? (88% do)
Mental Accounting
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Explained by _________ of S-shaped value function
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______________________________________
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Losing $10 means less if you start out with a large amount.
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Nothing irrational about decreasing marginal utility
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But the ___________ into separate account is leads to inconsistency
Endowment Effect
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End up with _________ |
End up with ____________ |
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| Start out with _________ |
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| Start out with _________ |
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| Endowment |
% choose ________________ |
| ____________________ |
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| _____________________ |
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Certainty Effect
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Choice 1
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A: $30 with p=1.00 (74%)
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B: $45 with p=0.80 (26%)
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Choice 2
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C: $30 with p=0.25 (42%)
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D: $45 with p=0.20 (58%)
Why this is a bias
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Suppose u($45) = 1, u($0) = 0 and u($30) = 0.90.
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eu(A) = 1.00(0.90) = 0.90*
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eu(B) = 0.80(1.00) = 0.80
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eu(C) = 0.25(0.90) = 0.225*
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eu(D) = 0.20(1.00) = 0.20,
How PT explains the certainty effect
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Explained by the ____________________________
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Non-linear function of probability
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Normatively, these two differences should be treated the same
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The pi function is steeper at the _______ and flatter in the ___________.
Pi Function
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The ratio between pi(1.00) and pi(.80) is more than _______times larger
than the ratio between pi(.25) and pi(.20).
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____________ is very appealing.
Summary
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Reflection of the S-shaped value function
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_______________
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_______________
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Loss Aversion
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Pi Function