ECON 440: Lecture 6 - Prospect Theory and Endowment Effect
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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?

    <p>Losses are perceived to have a greater psychological impact than equivalent gains</p> Signup and view all the answers

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

    <p>It introduces an extra degree of freedom to the evaluation process</p> Signup and view all the answers

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

    <p>It is sensitive to differences in light intensity over absolute levels.</p> Signup and view all the answers

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

    <p>u(c|c r ) = v(c - c r )</p> Signup and view all the answers

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

    <p>A dynamic reference for evaluating changes in stimuli</p> Signup and view all the answers

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

    <p>It influences how individuals perceive and evaluate outcomes.</p> Signup and view all the answers

    What does reference dependence in prospect theory indicate?

    <p>Choices are evaluated by comparing outcomes to a reference point.</p> Signup and view all the answers

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

    <p>Individuals experience losses as more impactful than equivalent gains.</p> Signup and view all the answers

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

    <p>Individuals are less sensitive to changes as outcomes become larger.</p> Signup and view all the answers

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

    <p>Choosing between winning $900 for certain or taking a 90% chance of winning $1000.</p> Signup and view all the answers

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

    <p>Lower probabilities are often overestimated in terms of outcomes.</p> Signup and view all the answers

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

    <p>When they are confronted with certain losses.</p> Signup and view all the answers

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

    <p>It influences how individuals perceive gains and losses.</p> Signup and view all the answers

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

    <p>Losses provoke a stronger emotional response than equivalent gains.</p> Signup and view all the answers

    Which scenario exemplifies reference dependence?

    <p>Opting for a certain loss of $200 versus a 50% chance of losing $500.</p> Signup and view all the answers

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

    <p>Current wealth levels and societal norms.</p> Signup and view all the answers

    Which brain response does loss aversion specifically correlate with?

    <p>Different brain regions are activated for losses versus gains.</p> Signup and view all the answers

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

    <p>Expected utility theory focuses solely on potential outcomes, while prospect theory considers relative perception.</p> Signup and view all the answers

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

    <p>Loss aversion is solely about the rejection of risk; risk aversion encompasses broader decision-making.</p> Signup and view all the answers

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

    <p>It can significantly influence perceived risk levels.</p> 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?

    <p>They will likely work shorter hours to avoid potential losses.</p> Signup and view all the answers

    What is a common misconception about loss aversion?

    <p>Loss aversion is only applicable in economic contexts.</p> Signup and view all the answers

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

    <p>It can lead individuals to make choices contrary to expected utility predictions.</p> 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?

    <p>It will likely encourage longer hours due to higher demand.</p> Signup and view all the answers

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

    <p>Eliminating the risk by opting out of the uncertain decision.</p> Signup and view all the answers

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

    <p>They are negatively correlated with hourly wages.</p> Signup and view all the answers

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

    <p>The goal of reaching their reference point.</p> Signup and view all the answers

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

    <p>Losses hurt more than gains feel good.</p> Signup and view all the answers

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

    <p>The impact of gains and losses decreases as they move further from the reference point.</p> Signup and view all the answers

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

    <p>The just-noticeable difference varies with the magnitude of stimuli.</p> Signup and view all the answers

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

    <p>Risk-averse preferences.</p> Signup and view all the answers

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

    <p>The function is convex.</p> Signup and view all the answers

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

    <p>It quantifies how much more losses hurt than equivalent gains feel good.</p> Signup and view all the answers

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

    <p>People are more motivated to avoid losses than to pursue gains.</p> Signup and view all the answers

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

    <p>They adjust hours based on daily wage fluctuations.</p> Signup and view all the answers

    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.

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