Behavioral Economics: Prospect Theory Quiz
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Questions and Answers

What is the main purpose of Prospect Theory as developed by Kahneman and Tversky?

  • To explain risk aversion within Expected Utility Theory
  • To account for behavioral anomalies unexplainable by Expected Utility Theory (correct)
  • To eliminate the concept of loss aversion in decision-making
  • To refine the axioms of Expected Utility Theory

    • Which of the following is NOT a component of the two-stage process in Prospect Theory?

  • Outcome determination
  • Evaluation
  • Editing
  • Risk assessment (correct)

    • In the context of Prospect Theory, how are outcomes defined according to the theory?

  • Relative to a reference point as gains and losses (correct)
  • As probabilities of independent events
  • In terms of absolute values
  • Based on overall utility maximization

    • Which phenomenon describes individuals' tendency to prefer avoiding losses over acquiring equivalent gains within Prospect Theory?

    <p>Loss aversion</p> Signup and view all the answers

    What significant violation within Expected Utility Theory is highlighted by Prospect Theory?

    <p>Invariance axiom</p> Signup and view all the answers

    What does loss aversion imply about people's preferences when facing potential losses?

    <p>People are more sensitive to losses than to equivalent gains.</p> Signup and view all the answers

    According to Expected Utility Theory, what is required for transitivity to hold?

    <p>If q is preferred to r and r is preferred to s, then q must be preferred to s.</p> Signup and view all the answers

    What does the independence axiom state in the context of decision-making?

    <p>The outcome should remain unchanged regardless of the choice made.</p> Signup and view all the answers

    Which of the following best describes nonlinear preferences in behavioral economics?

    <p>Individuals experience varying levels of satisfaction from different outcomes.</p> Signup and view all the answers

    What is a key characteristic of risk aversion according to Expected Utility Theory?

    <p>Preferring certain outcomes over uncertain ones.</p> Signup and view all the answers

    What does Expected Utility Theory (EUT) primarily focus on?

    <p>Preferences, beliefs, and utility maximization</p> Signup and view all the answers

    What is a key characteristic of risk aversion in decisions?

    <p>Tendency to prefer certain outcomes over uncertain ones</p> Signup and view all the answers

    Which phenomenon refers to the tendency to prefer smaller, certain rewards over larger, uncertain ones?

    <p>Loss aversion</p> Signup and view all the answers

    What role does Prospect Theory play in behavioral economics?

    <p>It serves as an alternative to Expected Utility Theory.</p> Signup and view all the answers

    What are the two main stages in Prospect Theory?

    <p>Editing and evaluation</p> Signup and view all the answers

    What type of preferences does Prospect Theory specifically address?

    <p>Nonlinear preferences within risky contexts</p> Signup and view all the answers

    Which axiom is NOT part of Expected Utility Theory?

    <p>Risk neutrality</p> Signup and view all the answers

    Which of the following best describes 'nonlinear preferences' as referenced in behavioral economics?

    <p>Preferences that change in relation to probability</p> Signup and view all the answers

    What does prospect theory primarily address in decision-making?

    <p>Understanding risk aversion</p> Signup and view all the answers

    What is the expected utility for option A (V(A)) based on the given probabilities and outcomes?

    <p>2.55</p> Signup and view all the answers

    In option B, what is the main reason for the higher expected utility compared to option A?

    <p>More favorable outcomes with higher probabilities</p> Signup and view all the answers

    Which of the following statements best represents risk seeking in decision-making?

    <p>Opting for higher variance in potential outcomes</p> Signup and view all the answers

    What role does loss aversion play in behavioral economics?

    <p>Leading individuals to prefer avoiding losses over acquiring equivalent gains</p> Signup and view all the answers

    What is the definition of the utility function mentioned in the expected utility theory?

    <p>A mapping of probabilities to outcomes and their relative desirability</p> Signup and view all the answers

    Which axiom is not typically associated with expected utility theory?

    <p>Loss aversion</p> Signup and view all the answers

    What does the 'editing' stage in prospect theory involve?

    <p>Simplifying options for easier evaluation</p> Signup and view all the answers

    What does the editing phase in Prospect Theory aim to do?

    <p>Organize and reformulate the options for simpler evaluation</p> Signup and view all the answers

    Which of the following concepts is NOT a part of Prospect Theory?

    <p>Utility maximization</p> Signup and view all the answers

    In the context of Prospect Theory, what does loss aversion refer to?

    <p>The tendency to prefer certain losses over probabilistic gains</p> Signup and view all the answers

    Which of the following is NOT a major operation involved in the editing phase of Prospect Theory?

    <p>Valuation</p> Signup and view all the answers

    What does Prospect Theory primarily explain in decision-making?

    <p>How people evaluate potential losses and gains</p> Signup and view all the answers

    Which of these options signifies a characteristic of nonlinear preferences in Prospect Theory?

    <p>Disproportionate weighting of low and high probabilities</p> Signup and view all the answers

    In the evaluation stage of Prospect Theory, what is primarily assessed?

    <p>The final decision based on simplified prospects</p> Signup and view all the answers

    Which statement best describes risk-seeking behavior in the context of Prospect Theory?

    <p>Preferring to gamble even when potential losses are significant</p> Signup and view all the answers

    In expected utility calculations, how is utility derived from monetary values?

    <p>Through the use of an expected utility function</p> Signup and view all the answers

    What is the expected utility of accepting a gamble with a 50% chance of winning $1 and a 50% chance of losing $1 for a risk-averse individual?

    <p>1.37</p> Signup and view all the answers

    What outcome should a risk-neutral individual prefer in a gamble offering equal chances of winning and losing?

    <p>It does not matter; both options yield the same utility</p> Signup and view all the answers

    Which concept highlights the tendency of individuals to prefer avoiding losses rather than acquiring equivalent gains?

    <p>Loss aversion</p> Signup and view all the answers

    How is the expected utility for the prospect of $1000 with a 50% probability calculated?

    <p>As U(r) = 0.5 × 10000.5</p> Signup and view all the answers

    When faced with a $2 ownership and a gamble, what is the expected utility of rejecting the gamble?

    <p>1.41</p> Signup and view all the answers

    What characterizes the non-linear preferences observed in expected utility theory?

    <p>Diminishing sensitivity to changes in wealth</p> Signup and view all the answers

    What principle is illustrated when a decision-maker opts for a gamble despite having a guaranteed amount?

    <p>Risk seeking</p> Signup and view all the answers

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