Risk

and uncertainty
18 fevral 2017, nb 01:32

In almost all choices we make, we are confronted with uncertainty as to what the
outcome will be

Differences between Uncertainty and Risk:

Situation of risk: we know what could happen and how likely it will be happen
Situation of uncertainty: we dont know some of the possible outcomes and how
likely they are
We face more uncertainties than risk in reality

Properties of Preferences:
Completeness and transitivity
Continuity (average better than extremes)
Independence (third alternative doesnt alter preferences)
If these are satisfied, individual is rational
These preferences can be represented by utility

However, sometimes third alternative might change the preferences, which would violate
independence property. => Allais Paradox
Changing a sure thing to a risk matters more than changing a risk to another risk
Individuals favor outcomes that are perceived certain rather than possible->certainty
effect

We observe higher risk aversion if outcomes are positive and risk-loving if outcomes are
negative
No general risk-aversion, risk-aversion depends on the outcome ->reflection effect

Allais Paradox:
Disappointment: The basic idea is to measure outcome utility relative to some prior
expectation of what utility will be. If outcome utility is below the expected level,
disappointment, vice versa situation is elation. Disappointment measure utility
relative to some prior expectation of what utility will be:

() = ( [() + ((( ) )]
If u(x)<prior=> D<0 disappointed
If u(x)>prior => D>0 elation
Result: Small probability of disappointment change preferences order in Allais
Paradox.
Rank-dependent expected utility
 () = ( [() + ((( ) )]
If u(x)<prior=> D<0 disappointed
If u(x)>prior => D>0 elation
Result: Small probability of disappointment change preferences order in Allais
Paradox.
Rank-dependent expected utility
Modeling how probability is percieved
23
() = , if =1, no weighting. If <1, therea re two things
7

( 234( 562) 3) 3
happen:
There is an overweighting of small probabilities (small probability is
given a relatively bigger weight)
There is an udnerweighting of large probabilities
) V W : () by using a weighting function that gives an s-shape
Capture pessimist/optimism by overweighting of small probabilities &
underweighting of large probabilities

Risk Aversion

Prospect Theory:
consists of two phases:
Editing phase- organization and reformulation of prospects
Evaluation phase- probabilities are weighted and the value of a prospect evaluated

Value Function:
Essential feature: carriers of value are the changes in wealth/welfare and not the
final states
Humans evaluate changes or differences rather than absolute magnitudes
Reference point or status-quo matters
Value function is concave above reference point, convex below the reference point
Value Function is S-shaped but not symmetrical:
Response to losses is stronger than responds to corresponding gains (v(x)<-v(-
x))
Value can be seen as a function of 2 arguments:
Current asset position as a reference point
Magnitude of change from this reference point
Weighting Function:
Value of each outcome is multiplied by a decision weight
It models how individuals value probabilities
Weighting function () relates decision weights to stated probabilities
23 ab
Weighting function: () = with
7 > 0, (0) = 0, (1) = 1
a2
( 234( 562)3) 3
Function form of weighting function takes into account that individuals overweight
tails of any distribution
Individuals overweight extreme outcomes

Challenges of Applying Prospect Theory

Central Idea: People derive utility from gains and losses realtive to a reference point
Challenge: it is often unclear what defines a loss and a gain
Challenge: how to determine a reference point
Modification and Extension
Extent the model in a way that individuals derive utility of gains and losses
and from consumption levels

PAPER: Prospect Theory

Preferences are not independent of current entitlements.
More recent field experimental evidence supports the notion that the endowment effect
can be attenuated with market experience.

Finding of the paper: Inexperienced traders do exhibit behavior consistent with prospect
theory. However, experienced traders show consistency with neoclassical predictions.
=> Consumers learn to overcome the endowment effect in situations beyond specific
problems they have previously encountered.

Experimental Design:
This exercise represents a particularly strict test of the role of market experience on
shaping preferences since psychological research suggests that transfer of learning across
situations is quite weak.
problems they have previously encountered.

Experimental Design:
This exercise represents a particularly strict test of the role of market experience on
shaping preferences since psychological research suggests that transfer of learning across
situations is quite weak.

Experimental Design Properties 1A (private allocations):

Two goods: mugs and candy bars
Each subject is randomly placed in one treatment, which differs by only the initial
endowment: Emug, Ecandybar, Eboth,Eneither.
Subject endowing mug (or candybar) can trade it for candybar (or mug) or just keep
his initial endowment. Subject with both, has to trade both for for either a mug or a
candy bar. Subject with nothing can choose one of the teo.
Some of subjects are professional dealers, some are ordinary consumers (non-
dealers)

Experimental Design Properties 1B (Collective Choice mechanism):

Only non dealers
Everybody has to agree to exchange the good

Theoretical Predictions
For preferences to be consistent under neoclassical theory, the proportion of
subjects who trade the mug for the chocolate bar should be equal to one minus the
proportion who trade the chocolate bar for the mag. Similarly, for Eboth and
Eneither there should be independence between the point of endowment and the
final entitlement
Prospect Theory conjectures that a value function exists that is
Measured over deviations from a reference point
Convex for losses and concave for gains
Initially steeper for losses than gains
So, prospect theory conjectures that mere ownership of a commodity will induce a
kink of the value function at the point of endowment, making the proportion fo
subjects who opt to trade the mug for the candy bar considerably less than one
minus the proportion who trade the candy bar for the mug. Likewise, prospect
theory predicts that subjects in Treatments Eboth and Eneither will opt for a mug
more often than subjects initially endowed with a candy bar or mug.

Conclusion:
Prospect theory Is found to have strong predictive power for inexperienced
consumers=>subjects about 4 times more likely to exit the experiment with their
endowed good. Prospect Theory also predicts that losses weight more than gains.

For those consumers that have had a considerable amount of exchange opportunity
in the sportscard marketplace, neoclassical theory predicts reasonably well, as I find
sharp evidence that behavior approaches the neoclassical prediction for
 consumers=>subjects about 4 times more likely to exit the experiment with their
endowed good. Prospect Theory also predicts that losses weight more than gains.

For those consumers that have had a considerable amount of exchange opportunity
in the sportscard marketplace, neoclassical theory predicts reasonably well, as I find
sharp evidence that behavior approaches the neoclassical prediction for
experienced agents. The result is consistent with the notion that via previous
market interaction and arbitrage opportunities, agents have learned to treat goods
leaving their endowment as an opportunity cost rather than a loss. => agents
learned to treat goods leaving their endowment as an opportunity cost rather than
a loss

While psychological effects have been extremely popular in explaining the

endowment effect anomaly, the data suggest that psychological effects may also
help to explain the attenuation of the anomaly

Paper: Thirty Years of Prospect Theory

Prospect Theory demonstrates that, in laboratory setting, people symmetrically violate
the predictions of expected utility theory, economists' workhorse model of decision
making under risk.
Prospect theory with value function has four elements:
1. reference dependence; -people derive utility from gains and losses measured
relative to some reference point, rather than from absolute levels of wealth
2. loss aversion; -people are much more sensitive to losses-even small losses- than to
gains of the same magnitude
3. diminishing sensitivity; - value function is concave in the region of gains but convex
in the region of losses. It implies that while replacing a 100$ gain with a 200$ gain
has a significant utility impact, replacing a 1100$ with a 1100$ gain has a smaller
impact. The concavity over gains captures the finding tht people tend to be risk
averse over moderate probability gains; they typically prefer a certain gain of 500$
to a 50% chance of winning 1000$. However, people also tend to be risk seeking
over losses: they prefer 50% chance of losing 1000$ to losing 500$ for sure. This
motivates the convexity over losses
4. probability weighting - In prospect theory, people do not weight outcomes by their
objective probabilities p, but rater by transformed probabilities or decision weights
. Probability weighting leads the individual to overweight the tails of any
distribution - namely they overweight unlikely extreme outcomes.

Endowment effect:
Exchange asymmetries- People tend to stay witht their initial endowment rather
than to trade it
WTA/WTP gaps
Both reflect the same underlying psychology of loss aversion. In the excahnge
asymmetry experiment, participants view an exchange as 'losing' the item they
were initially given and 'gaining' the other item. Since they are more sensitive to
losses than to gains, an exchange is unattractive, which explains why most of
 than to trade it
WTA/WTP gaps
Both reflect the same underlying psychology of loss aversion. In the excahnge
asymmetry experiment, participants view an exchange as 'losing' the item they
were initially given and 'gaining' the other item. Since they are more sensitive to
losses than to gains, an exchange is unattractive, which explains why most of
them stic with their initial endowment. Similarly, in the WTA/WTP experiment,
loss aversion predicts that people will demand much more money in order to
give up a mug they have previously received- here, giving up the mug is a 'loss' -
than they will be willing to pay in order to get one; getting a mug is the
corresponding 'gain'.