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You are on page 1of 31

Source: http://dilbert.com/strips/comic/2000-02-03/

Yangda Di I6034331

Ralitsa Sapunova I6128249

1

Agenda

1. Introduction of Expected Utility Theory

2. Critiques of the Expected Utility Theory

a. Certainty, probability, and possibility

b. The reflection effect

c. Probabilistic insurance

d. The isolation effect

3.

Prospect theory

a. Phase of editing

b. Phase of evaluation

c. The value function

d. The weighting function

5. Prospect Theory Criticism

6. Discussion

Expectation:

Asset integration: is acceptable at asset position w if and

only if:

Risk aversion:

u is concave(u<0)

Problem statement

of the expected utility

theory?

possibility

Example: problem#3

A:( 4000, 80%) , expected utility=3200

B: (3000, 100%), expected utility=3000

N=95

A

B

possibility

Example: problem #4

A: (4000,80% *0.25=20%) expected utility=800

B:(3000,100% *0.25=25%) expected utility=750

N=95

A

B

possibility

1

0.8

0.6

0.4

0.2

0

B

A

problem 3

problem 4

a greater effect than the reduction from .8 to .2( for A ). what

does that imply?

People overweight certain outcomes relative to possible outcomes

Choices change if certainty is reduced, most people choose the

prospect that offers the larger gain

possibility

Problem #7

The probabilities of

A:(6000,45%) expected utility=2700

winning are

b:(3000, 90%) expected utility=2700substantial (.90 and .

45), and most people

choose the prospect

N=95

where winning is more

probable.

A

B

possibility

In this situation

Problem #8

where winning is

A:(6000,0.1%) expected utility=6possible but not

probable, most

B:(3000,0.2%) expected utility=6

people choose

the prospect that

N=95

offers the larger

A

B gain.

that gains are replaced by losses? What does it imply?

Certainty effect: risk aversion gain domain, and risk seeking

loss domain

People who are usually risk averse in case of gains are ready to

take risk if faced with a probability of incurring a loss

In case of damage, there is a 50% chance that you pay the other half

of the premium and the insurance company covers all the losses; and

there is a 50% chance that you get back your insurance payment and

suffer all the losses.

According to the EUT, the probabilistic insurance is superior to

regular insurance.

However, 80% of the respondents refused to accept the probabilistic

insurance.

YES

NO

Problem #10: In the first stage, there is a probability of 0 .75 to

end the game without winning anything, and a probability of

0.25 to move into the second stage. If you reach the second

stage you have a choice between A: (4,000,80%) and B:

(3,000,100%).

Problem 3

problem 10

problem 4

N=141

A

B

same: (4000,20%) and (3000,25%).

Nevertheless, people ignored the first stage of the game, whose

outcomes are shared by both prospects, and considered Problem 10 as a

choice between (3,000,100%) and (4,000,80%), as in Problem 3.

15

Prospect Theory

An alternative model of individual decision making

under risk

unlike expected utility theory which concerns itself with

how decisions under uncertaintyshouldbe made, prospect

theory concerns itself with how decisions areactuallymade.

Montier (2002, p. 20)

Phase of editing

Phase of evaluation

16

Phase of editing

Preliminary analysis of the offered prospects

Coding

Combination

Segregation

Cancellation

Simplification

Detection of dominance

17

Phase of editing

Preliminary analysis of the offered prospects

Coding - Identifying gains and losses based on

common reference points

with identical outcomes

(100$, .2;

100$*, .1)

(100$, .3)

18

Phase of editing

Preliminary analysis of the offered prospects

Segregation Separate out guaranteed outcome

component

(100$, .8;

200$, .2)

100$ + (100$, .

2)

19

Phase of editing

Preliminary analysis of the offered prospects

Cancellation Discarding the common components

25$, .3)

30$, .4)

outcomes

Discarding of extremely unlikely

outcomes

20

Phase of editing

Preliminary analysis of the offered prospects

Detection of dominance Rejecting dominated

options without further evaluation

4)

21

Phase of evaluation

Regular

prospect:

If p+q<1, or x0 y or x0 y

If p+q=1 and etiehr x>y>0 or x<y<0

Segregat

ion

22

Phase of evaluation

When are these formulas equivalent?

V(x, p; y, q) = (p) (x) + (q) (y)

V(x, p; y, q) = (y) + (q) [v(x)-v(y)]

(p)+ (q)

=1

23

Valu

e

Loss

es

gains and losses

Reference point

Gain

s

convex for losses

Steeper in losses than

in gains

24

diminishing

sensitivity

25

1.

0

Decision weight

(p)

(p)=p

Small probabilities

Availability bias

Certainty effect

Stated

probability p

1.

0

26

Finance

Insurance

Endowment effect

Other Applications

27

The theory holds for hypothetical choices, but

does it also hold for real life choices?

Relatively little guidance on how the reference

point is determined.

Endowment effect?

Less useful in describing the behavior of

experienced economic actors.

28

Discussion

Do you think certain behavior of your can be

explained by prospect theory?

After seeing how your decisions can be

influenced, would you change your decision making

process?

to your career?

29

References

Barberis, N. C. (2013). Thirty Years of Prospect Theory in Economics: A

Review and Assessment. Journal of Economic Perspectives, 173196.

Daniel Kahneman, A. T. (1979). Prospect theory: An Analysis of Decision

under Risk. Econometrica, 263 292.

Future prospects. (2013, Aug 5th). Retrieved from The Economist:

http://www.economist.com/blogs/freeexchange/2013/08/prospect-theory-andeconomics

List, J. A. (2003). Does Market Experience Eliminate Market Anomalies?

Quarterly Journal of Economics, 4171.

Montier, J. (2002). Darwin's Mind: The Evolutionary Foundations of

Heuristics and Biases. Dresdner Kleinwort Wasserstein - Global Equity

Strategy.

To have and to hold. (2003, Aug 28th). Retrieved from The Economist:

http://www.economist.com/node/2021010

30

ATTENTION!

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