Behavioural Economics and EUT

A way to represent possible outcomes and their probabilities associated with a decision.

A formal description of a prospect, where xi represents the outcomes and pi represents their probabilities.

A theory that assumes individuals make decisions based on maximizing their expected utility, which is the weighted average of the utilities of possible outcomes.

A person who prefers a sure thing over a gamble with the same expected value.

Inconsistencies in decision-making that violate the assumptions of Expected Utility Theory.

A theory that proposes people make decisions based on perceived gains and losses rather than absolute wealth.

The tendency to be more sensitive to potential losses than equivalent gains.

The tendency to prefer risky options over less risky ones, even if the expected value is lower.

A mental accounting process where individuals treat money differently depending on its source, even if it's functionally the same.

Refers to a cognitive bias where the preference for a certain outcome over a probable outcome is greater when the certain outcome is framed as a gain instead of a loss.

The editing phase of Prospect Theory involves organizing the decision problem into a simpler form. These editing rules are applied to simplify choices: 1) Coding: Defining outcomes as gains or losses relative to a reference point. 2) Combination: Combining outcomes of the same value. 3) Cancellation: Removing outcomes that are shared by different choices. 4) Segregation: Separating a certain outcome from a risky outcome. 5) Simplification: Rounding probabilities or outcomes to make the decision easier.

The concept that people's preferences for gains and losses aren't symmetrical. They don't value gains and losses equally.

The first stage of Prospect Theory, where people simplify their options and frame them as potential gains or losses.

The second stage of Prospect Theory, where people evaluate the potential outcomes based on their subjective value.

A set of rules used to make informed decisions, assuming people are rational and make choices that maximize their expected utility.

The first stage within prospect theory where individuals simplify complex decision problems by framing them in a way that is easier to understand.

The second stage within prospect theory where individuals evaluate the simplified options based on their perceived value and riskiness.

A key assumption of EUT stating that individuals will choose the option with the highest expected utility, calculated by summing the products of the utilities of each outcome and their associated probabilities.

The concavity of the utility function in EUT represents risk aversion. A concave utility function implies that the marginal utility of wealth diminishes as wealth increases. This means that an individual values an additional dollar less as their wealth grows.

The concept of diminishing marginal utility explains the concavity of the utility function. It states that each additional unit of a good or service provides less satisfaction than the previous one. This means that the more someone earns, the less they appreciate each additional dollar.

A power function in EUT is represented by the formula u = xb, where b < 1. This function describes the shape of the utility function and captures the concept of diminishing marginal utility.

Risk neutrality is a scenario where an individual is indifferent between a certain outcome and a gamble with the same expected value. A risk-neutral person would be equally happy with a guaranteed $500 or a 50% chance of winning $1000 and a 50% chance of winning nothing.