Expected utility theory
Rational. What we should be doing.
- U = expectation overall prospect
- Asset integration = u accept prospect when integration assets > assets alone. Final states instead of losses and gain
- Concavity of utility function = risk aversion
Which phenomenon violate the EUT?
100% - red reflection - dark alone
- certainty = overweight certain prospects
- Reflection Effect = we are risk-seeking when it comes to losses
*probabilistic insurance
When winning is probable -> we take higher probability. When its possible -> higher gain
- Isolation effect = to simplify choice ppl disregard components that the alternatives share.
EUT is not realistic => Prospect theory
Explain how Certainty violates EUT
- certainty = overweight certain prospects vs probable outcomes. As soon as a certain outcome is mentioned people choose that and underweights the probable option
EUT is not realistic => Prospect theory
Explain why reflection effect violates EUT
- certainty = overweight certain prospects
- Reflection Effect = we are risk-seeking when it comes to losses
- probabilistic insurance, reduces risk -> EUT
- regular, eliminate risk -> PT
When winning is probable -> we take higher probability. When its possible -> higher gain
Explain why the Isolation effect violates the EUT
EUT is not realistic => Prospect theory
- Isolation effect = to simplify choice ppl disregard components that the alternatives share, and focus on components that distinguish them. Leads to inconsistent preferences!!!!
EUT is not realistic => Prospect theory
What are the 2 phases people use in PT
- editing phase = to simplify choice
Coding/ combination/ segregation/ cancellation/ simplification/ detection of dominance - Evaluation phase = look at vie of each prospect and choose. Split in V= subjective value of outcome, deviation from reference point. and ~= decision weights ( perceived stated probability)
Coding phase (6)
Coding/ combination/ segregation/ cancellation/ simplification/ detection of dominance
(3) Value Function
V= subjective value of outcome, deviation from reference point.
- Reference point depends on framing
- Concave / convex: diminishing marginal value over time
- Steeper for losses than for gains. Losses hurt more. And faster.
(4) weighting function
and ~= decision weights ( perceived stated probability)
- Overweighting: when p=small, we put extra weight on it because its hard for us to understand how small it is. We therefore overestimate.
* beginning graph - Subaddivity: the tendency to judge the probability as a whole to be LESS than prob of its parts. E.g. Deceases
- Subcertainty: doesn’t happen for impossible or certain events. Weight of event A+B < 1. *End graph
- Subproportionality: for small p (lottery ticket) the sum is closer to unity (=rational line) due to convex curve. *highlight in graph
