ECON 440: Lecture 6 - Prospect Theory and Endowment Effect

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Questions and Answers

What key concept does Prospect Theory emphasize in relation to how individuals evaluate outcomes?

Differences relative to a reference point (correct)
Independent from past experiences
Absolute magnitudes of outcomes
Evaluations based solely on future expectations

In the context of biological roots, which aspect of human perception is highlighted concerning reference dependence?

Emotional responses are independent of reference points
Perceptual systems emphasize absolute values over differences
Evaluation of differences is central to perception (correct)
The ability to remember past events accurately

How is utility defined according to reference-dependent utility?

Independently of past reference points
Only through absolute measures of wealth
As a constant value regardless of the reference level
Based on the current consumption and an established reference level (correct)

What does the concept of loss aversion imply about human attitudes toward gains and losses?

Losses are perceived to have a greater psychological impact than equivalent gains (C) Signup and view all the answers

What effect does establishing a reference point have on the evaluation of outcomes in Prospect Theory?

It introduces an extra degree of freedom to the evaluation process (D) Signup and view all the answers

Which of the following is a characteristic of the visual system in relation to reference dependence?

It is sensitive to differences in light intensity over absolute levels. (B) Signup and view all the answers

How can utility be mathematically formulated according to reference-dependent utility theory?

u(c|c r ) = v(c - c r ) (D) Signup and view all the answers

What does the term 'adaptation level' refer to in the context of reference dependence?

A dynamic reference for evaluating changes in stimuli (B) Signup and view all the answers

What role does context play in the determination of a reference point according to Prospect Theory?

It influences how individuals perceive and evaluate outcomes. (A) Signup and view all the answers

What does reference dependence in prospect theory indicate?

Choices are evaluated by comparing outcomes to a reference point. (D) Signup and view all the answers

How does loss aversion affect decision-making according to prospect theory?

Individuals experience losses as more impactful than equivalent gains. (D) Signup and view all the answers

In the context of prospect theory, what characterizes diminishing sensitivity?

Individuals are less sensitive to changes as outcomes become larger. (C) Signup and view all the answers

Which problem illustrates the tendency for risk-averse behavior over potential gains?

Choosing between winning $900 for certain or taking a 90% chance of winning $1000. (B) Signup and view all the answers

What is a primary implication of non-linear probability weighting?

Lower probabilities are often overestimated in terms of outcomes. (D) Signup and view all the answers

In prospect theory, what prompts risk-seeking behavior in individuals?

When they are confronted with certain losses. (C) Signup and view all the answers

What role does a reference point play in decision-making according to prospect theory?

It influences how individuals perceive gains and losses. (A) Signup and view all the answers

What does loss aversion imply about people's reactions to monetary losses compared to gains?

Losses provoke a stronger emotional response than equivalent gains. (D) Signup and view all the answers

Which scenario exemplifies reference dependence?

Opting for a certain loss of $200 versus a 50% chance of losing $500. (C) Signup and view all the answers

What is a key factor determining the reference point according to prospect theory?

Current wealth levels and societal norms. (D) Signup and view all the answers

Which brain response does loss aversion specifically correlate with?

Different brain regions are activated for losses versus gains. (C) Signup and view all the answers

How do traditional expected utility theory and prospect theory differ in evaluating risk?

Expected utility theory focuses solely on potential outcomes, while prospect theory considers relative perception. (D) Signup and view all the answers

How do loss aversion and risk aversion differ according to the content?

Loss aversion is solely about the rejection of risk; risk aversion encompasses broader decision-making. (D) Signup and view all the answers

What effect does the framing of a problem have as suggested by the theory discussed?

It can significantly influence perceived risk levels. (C) Signup and view all the answers

In the cab driver scenario, what is likely to be the cab driver's decision based on loss aversion principles?

They will likely work shorter hours to avoid potential losses. (A) Signup and view all the answers

What is a common misconception about loss aversion?

Loss aversion is only applicable in economic contexts. (B) Signup and view all the answers

In the context of expected utility, how might loss aversion cause inconsistencies?

It can lead individuals to make choices contrary to expected utility predictions. (C) Signup and view all the answers

What effect can a cold day have on a New York cab driver's decision-making, according to the principles discussed?

It will likely encourage longer hours due to higher demand. (B) Signup and view all the answers

What might be a rational economic decision for someone facing potential losses, as per loss aversion theory?

Eliminating the risk by opting out of the uncertain decision. (C) Signup and view all the answers

How do cab drivers' work hours relate to their hourly wages according to the data presented?

They are negatively correlated with hourly wages. (A) Signup and view all the answers

What psychological motivation leads people to become risk-seeking in the loss domain?

The goal of reaching their reference point. (A) Signup and view all the answers

According to the principles of prospect theory, how does loss aversion specifically impact utility derived from losses?

Losses hurt more than gains feel good. (A) Signup and view all the answers

What is the effect of diminishing sensitivity on utility as gains or losses increase in magnitude?

The impact of gains and losses decreases as they move further from the reference point. (D) Signup and view all the answers

What implication does the Weber-Fechner law have in the context of prospect theory?

The just-noticeable difference varies with the magnitude of stimuli. (C) Signup and view all the answers

In terms of utility functions, what does concavity represent in prospect theory?

Risk-averse preferences. (D) Signup and view all the answers

What happens to the utility function when individuals are risk-seeking according to the content provided?

The function is convex. (C) Signup and view all the answers

What is indicated by the variable λ in the context of loss aversion?

It quantifies how much more losses hurt than equivalent gains feel good. (A) Signup and view all the answers

Which statement best describes the overall impact of reference points in decision-making as outlined in the content?

People are more motivated to avoid losses than to pursue gains. (A) Signup and view all the answers

What observable behavior do cab drivers exhibit concerning their work hours related to target income?

They adjust hours based on daily wage fluctuations. (B) Signup and view all the answers

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Study Notes

Overview of Prospect Theory

Developed by Kahneman and Tversky in 1979.
Core components include:
- Reference dependence: decisions influenced by a reference point.
- Loss aversion: people experience losses more intensely than equivalent gains.
- Diminishing sensitivity: individuals exhibit risk aversion in gains and risk-seeking in losses.
- Non-linear probability weighting: subjective probabilities differ from objective probabilities.

Reference Dependence

Decisions evaluated relative to a reference point, which varies by context (e.g., current wealth, expected outcomes).
Example comparisons illustrate this, showing risk aversion in gains (certain win) and risk-seeking in losses (risky loss).
Reference point determination remains a challenge in the theory, giving flexibility but potential inconsistency.

Biological Roots

Perception focuses on changes rather than absolute values.
The brain evaluates differences, suggesting an evolutionary basis for reference dependence.

Reference-Dependent Utility

Utility based on the difference from the reference level:
- ( u(c|c_r) = v(c - c_r) ).
This formulation addresses how individuals assess consumption relative to what they are used to.

Loss Aversion

Losses create greater emotional impact than gains of the same size.
Different neural mechanisms may underlie the valuation of losses versus gains.

Distinction from Risk Aversion

Loss aversion does not equate to general risk aversion.
People may reject positive expected value gambles due to framing effects and reference points influencing perceived risk.

Field Evidence

Example of New York City cab drivers: work longer hours on low wage days to avoid perceived losses based on daily income targets.
Data contradict classic economic theory, highlighting how reference points dictate behavior.

Incorporating Loss Aversion into the Theory

To model loss aversion:
- Define utility changes to show losses weigh heavier than gains.
- Use ( v(-x) = -\lambda v(x) ); for example, if ( \lambda = 2 ), losses are twice as painful as equivalent gains are pleasurable.

Diminishing Sensitivity

Individuals are more risk-seeking when at a loss (below reference) but risk-averse when they stand to gain.
The psychological basis relates to the diminishing marginal impact of gains or losses relative to the reference point.
Aligns with Weber-Fechner law, where the perceived difference is proportional to the stimulus magnitude.

Theory Integration

Risk-averse and risk-seeking preferences integrated into utility models potentially using different exponents for gains (α) and losses (β).
This allows for a comprehensive model addressing reference dependence, loss aversion, and diminishing sensitivity.

Visual Representation

Prospect Theory can be visually summarized in a single graphic depicting the relationships and dimensions of the theory as articulated by Kahneman and Tversky.

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