Behavioral Economics Principles Quiz

The dual expected utility (dual-EU) model assumes that people's preferences are consistent when faced with varying probability weights, but it fails to explain how people's choices change when the potential gains or losses change (i.e., the 'stake').

Prospect Theory (PT) attempts to account for both probability distortions (like in Markowitz-EU) and stake variations by incorporating reference dependence, where people make decisions based on their subjective evaluation of potential gains or losses relative to a reference point.

The weighting function in prospect theory represents people's subjective perception of probabilities, where they tend to overweight small probabilities and underweight large probabilities. Therefore, the function is not linear, leading to deviations from expected utility.

Prospect Theory acknowledges that people make decisions based on their individual reference points (like current wealth, the status quo, or an ideal), which means that people's risk preferences can change depending on where they are in relation to their reference point.

Markowitz-EU is more severely violated by changes in probability than by changes in stakes (up to a certain amount). This suggests that people are more sensitive to changes in probabilities than to changes in potential gains or losses.

When stakes become extremely large (e.g., over 10 million), the violations of dual-EU may become more significant. This happens because the linear treatment of one dimension (either probability or stakes) fails to capture the complex decision-making process.

The dimension treated linearly in a model is the source of trouble, causing inconsistencies in the model's predictions. This suggests that a non-linear model is needed to better capture the complex human behaviour.

The focus of prospect theory is to address and reconcile two seemingly conflicting violations: one related to probability (Markowitz-EU) and the other related to stakes (dual-EU). The theory attempts to provide a more comprehensive explanation of how people make decisions under risk and uncertainty.

Both expected utility theory (EU) and dual expected utility theory (Dual-EU) could explain certain paradoxes, but they failed to account for all of them. M-EU struggled with probability variations, while Dual-EU faltered with stake variations.

Prospect theory (PT) is a model of decision-making under risk and uncertainty. It combines elements of M-EU and Dual-EU to account for the limitations observed in those earlier theories.

PT utilizes subjective decision weights for probabilities instead of the objective probabilities.

Both small and large probabilities are over-weighted, while mid-range probabilities are under-weighted in PT. This applies to both potential gains and losses.

Utility in PT is defined over changes in wealth rather than absolute wealth. For gains, it is concave (diminishing marginal utility) and for losses, it is convex (increasing marginal disutility).

PT postulates that the pain of losing a certain amount is greater than the pleasure of gaining the same amount. This key feature is known as loss aversion.

PT assumes independent treatment of gains and losses in a decision. You can separate your preferences for mixed gains and losses for a more accurate assessment.

In PT, a loss aversion parameter, denoted as '⁄', is introduced. This parameter is not employed for losses but affects the evaluation of risky choices where both gains and losses are involved.

The degree to which people are sensitive to changes in gains.

A measure of how much a person's utility changes when they receive a gain.

A measure of a person's sensitivity to changes in gains, specifically when those gains are part of a larger portfolio of gains.

The average Alpha value across a group of people.

The average Alpha_pt value across a group of people.

The comparison of average Alpha and average Alpha_pt across different countries.

A study that investigated differences in sensitivity to gains across countries.

The name of the researcher who conducted the Decision Theory - Part II study.

A decision-making pattern where individuals prefer a prospect with a higher probability of a smaller gain over a prospect with a lower probability of a larger gain, but reverse this preference when the probabilities are scaled down.

A theory of decision-making that assumes individuals make choices based on expected utility, where utility is a measure of satisfaction or value. This theory assumes probabilities are weighted linearly.

A variation of expected utility theory where probabilities are assigned non-linear weights. This means individuals may overweight low probabilities and underweight high probabilities.

A theory where individuals are assumed to have multiple utility functions, one for gains and another for losses. This allows for non-linear probability weighting and can explain the common ratio effect.

Similar to Dual EU but focusing on maximizing utility across domains. In this case, it can explain the common ratio effect through non-linear probability weighting across different domains.

The phenomenon of stocks consistently outperforming bonds in terms of returns over long periods, which is difficult to explain by traditional finance models.

A behavioral bias that focuses on short-term gains and losses, leading individuals to avoid potential losses in the near future even if it means missing out on long-term gains.

The tendency to treat each decision in isolation, without considering its connection to other decisions over time.

The tendency to prefer a known probability distribution over an unknown distribution, even if the expected value of the unknown distribution is higher.

The tendency to prefer the choice with the known proportion of colors, even if the expected value of choosing the unknown proportion is higher.

A behavioral model that seeks to explain how individuals make decisions under risk and uncertainty, incorporating the impact of both probability distortions and reference dependence.

A mathematical model that describes how people make decisions over time by considering the value of future rewards and the time value of money.

A model that assumes people are more sensitive to losses than they are to gains of the same amount.

A function that describes how people's subjective perception of probabilities differs from the actual probabilities. In prospect theory, people tend to overweight small probabilities and underweight large probabilities.

The point of reference that individuals use to evaluate potential gains or losses. It's often related to their current wealth or a desired outcome.

This type of discounting assumes that the rate at which people discount the future is constant over time, meaning that the value of a reward decreases by the same percentage for each unit of time passed.