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What key concept does Prospect Theory emphasize in relation to how individuals evaluate outcomes?
In the context of biological roots, which aspect of human perception is highlighted concerning reference dependence?
How is utility defined according to reference-dependent utility?
What does the concept of loss aversion imply about human attitudes toward gains and losses?
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What effect does establishing a reference point have on the evaluation of outcomes in Prospect Theory?
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Which of the following is a characteristic of the visual system in relation to reference dependence?
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How can utility be mathematically formulated according to reference-dependent utility theory?
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What does the term 'adaptation level' refer to in the context of reference dependence?
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What role does context play in the determination of a reference point according to Prospect Theory?
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What does reference dependence in prospect theory indicate?
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How does loss aversion affect decision-making according to prospect theory?
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In the context of prospect theory, what characterizes diminishing sensitivity?
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Which problem illustrates the tendency for risk-averse behavior over potential gains?
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What is a primary implication of non-linear probability weighting?
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In prospect theory, what prompts risk-seeking behavior in individuals?
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What role does a reference point play in decision-making according to prospect theory?
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What does loss aversion imply about people's reactions to monetary losses compared to gains?
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Which scenario exemplifies reference dependence?
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What is a key factor determining the reference point according to prospect theory?
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Which brain response does loss aversion specifically correlate with?
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How do traditional expected utility theory and prospect theory differ in evaluating risk?
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How do loss aversion and risk aversion differ according to the content?
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What effect does the framing of a problem have as suggested by the theory discussed?
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In the cab driver scenario, what is likely to be the cab driver's decision based on loss aversion principles?
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What is a common misconception about loss aversion?
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In the context of expected utility, how might loss aversion cause inconsistencies?
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What effect can a cold day have on a New York cab driver's decision-making, according to the principles discussed?
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What might be a rational economic decision for someone facing potential losses, as per loss aversion theory?
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How do cab drivers' work hours relate to their hourly wages according to the data presented?
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What psychological motivation leads people to become risk-seeking in the loss domain?
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According to the principles of prospect theory, how does loss aversion specifically impact utility derived from losses?
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What is the effect of diminishing sensitivity on utility as gains or losses increase in magnitude?
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What implication does the Weber-Fechner law have in the context of prospect theory?
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In terms of utility functions, what does concavity represent in prospect theory?
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What happens to the utility function when individuals are risk-seeking according to the content provided?
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What is indicated by the variable λ in the context of loss aversion?
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Which statement best describes the overall impact of reference points in decision-making as outlined in the content?
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What observable behavior do cab drivers exhibit concerning their work hours related to target income?
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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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Description
This quiz covers the key components of Prospect Theory, developed by Kahneman and Tversky in 1979. It explores concepts like reference dependence, loss aversion, and non-linear probability weighting, providing insights into decision-making processes. Test your understanding of how these elements influence human behavior and economic choices.