10 Questions
What is the Hawthorne effect?
A change in behavior of subjects due to being studied rather than due to any specific experimental manipulation.
Which editing technique involves simplifying prospects by combining probabilities associated with identical outcomes?
Combination
What property of the value function states that losses are perceived as more impactful than equivalent gains?
Loss aversion
How do decision weights behave in terms of certainty according to the text?
They sum to less than one, exhibiting subcertainty.
What does the Allais' paradox imply about decision-making?
Decision-making under uncertainty is inconsistent with expected utility theory.
According to prospect theory, what explains the reflection effect?
Segregation operation
In stripped-down prospect theory, what happens when more probability is moved onto a better outcome?
Stochastic dominance can be violated
How does a risk averse person typically react to a 'fair' prospect?
Always refuse
What does the independence axiom state in relation to lotteries with a common consequence?
Common consequence does not affect preference between lotteries A and B
How does event-splitting effect (ESE) differ from the way it is treated in expected utility theory (EUT)?
EUT prefers 2A over 2B if 1A is preferred over 1B
Study Notes
Prospect Theory
- The reflection effect is explained by Prospect Theory (PT) due to diminishing sensitivity during the editing phase.
- The full version of PT is unable to account for Event-Splitting Effects (ESEs) because the two events with a common payoff would be combined under the Combination operation during the editing phase.
Stripped-Down Prospect Theory
- Dropping the assumption of Combination in PT explains the reflection effect.
- Moving more probability onto a better outcome has two effects on expected utility: a direct effect (always positive) and an indirect effect (can be positive or negative).
Risk Attitudes
- A 'fair' prospect has an expected value of zero.
- A risk-averse person will always refuse a fair prospect, a risk-neutral person is indifferent, and a risk-loving person will always accept a fair prospect.
Stochastic Dominance
- The stochastic dominance axiom states that if A stochastically dominates B, then A is always preferred to B.
Event-Splitting Effect (ESE)
- EUT treats two lottery pairs as identical, but PT can explain the ESE.
The Protective Belt
- Microeconomists impose additional assumptions on the utility function, leading to testable predictions, but protecting the 'hard core' from scrutiny.
Disadvantages of Experiments
- The Hawthorne effect is a form of reactivity where subjects modify their behavior in response to being studied.
Editing Phase in Prospect Theory
- Coding: outcomes are perceived as gains and losses relative to a reference level (usually the current asset position).
- Combination: prospects are simplified by combining the probabilities associated with identical outcomes.
- Segregation: some prospects contain a riskless component that is segregated from the risky component.
- Cancellation: discarding components shared by offered prospects.
Value Function
- Loss aversion: losses loom larger than gains, and the value function is steeper for losses.
- Diminishing sensitivity: marginal utility falls as we move further away from the reference point.
- Reference point: V(0) = 0, and outcomes are judged in terms of gains and losses.
Weighting Function
- w(0) = 0 and w(1) = 1.
- The weighting function is increasing in p.
- It is not defined close to zero and one.
- Overweighting occurs for small probabilities.
- Subcertainty: decision weights sum to less than one.
- Subproportionality: log(w(p)) is a convex function of log(p).
Test your knowledge on the additional assumptions microeconomists impose on the utility function, and the Hawthorne effect in experiments. Learn about the protective belt's role in forming testable predictions and how the Hawthorne effect impacts research outcomes.
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