prospect theory. two worlds economist: “the agent of economic theory is rational, selfish, and his...
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Prospect Theory
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Two Worlds
• Economist:“The agent of economic theory is rational, selfish, and his tastes do not change”
“To a psychologist, it is evident that people are neither fully rational, nor completely selfish, and their tastes are anything but stable.”
• Expected Utility Theory: If you prefer and apple to a banana, then you also prefer a 10% chance to win an apple to 10% chance to win a banana
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Then comes Bernoulli
80% chance to win $100 and 20% chance to win $10
OR A $80 note??
Depends on peoples relative wealth, so comes the concept of utility
Consider the following:
Equal chances to have 1 million or 7 million
OR 4 million with certainty??
Wealth 1 2 3 4 5 6 7 8 9 10Utility 10 30 48 60 70 78 84 90 96 100
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Problem with Utilities
Today, Jack and Jill each have a wealth of 5 milYesterday, Jack had 1 mil and Jill had 9 milDo they have the same utility?
Another one:The gamble: equal chances to end up owning 1 million or 4 millionOR The sure thing: own 2 million for sureLets say 2 players – A with current wealth of 1 million, and B with current wealth of 4 million
So where was Bernoulli wrong?
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Outcomes as Gains and Losses• Problem 1: Get $900 for sure OR 90% chance to get
$1000?• Problem 2: Lose $900 for sure or 90% chance to
lose $1000• Problem 3: In addition to your wealth, you are
given $1000. Now choose:• 50% chance to win $1000 OR get $500 for sure
• Problem 4: In addition to you wealth, you are given $2000. Now choose:• 50% chance to win $1000 OR get $500 for sure
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To SUM UP
• Expected value theory focuses on the expected value of the outcome• Utility theory only focused on a utility of the outcome• Bernoulli’s correction was that utility depends also on
the present state of wealth• Finally, PROSPECT THEORY shows errors in Bernoulli’s
corrections. It suggests:• There is a reference point for every decision (not only todays
wealth, but also what was yesterday) – A before and after effect
• From this point, we consider gains and losses• In general people are more loss averse
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Is prospect theory the end?
Consider the following:A. One chance in a million to win 1 milB. 90% chance to win 12 and 10% chance to win
nothingC. 90% chance to win 1 mil and 10% to win nothing