Behavioural Economics, PSYC3310, Seminar 5, PDF

Behavioural Economics mark.hurlstone @uwa.edu.au Behavioural Economics Outline Expected Utility Theory Axioms Risk Aversion PSYC3310: Specialist Topics In Psychology Anomalies In EUT...

Behavioural Economics mark.hurlstone @uwa.edu.au Behavioural Economics Outline Expected Utility Theory Axioms Risk Aversion PSYC3310: Specialist Topics In Psychology Anomalies In EUT Mark Hurlstone Prospect Univeristy of Western Australia Theory Two Stages Editing Evaluation Seminar 5: Decision Making Under Risk and Uncertainty What can it explain? Loss aversion Risk seeking Nonlinear CSIRO-UWA Behavioural BEL preferences Economics Laboratory [email protected] Behavioural Economics  Today Behavioural Economics mark.hurlstone Examine preferences (4), beliefs (3), and utility @uwa.edu.au maximisation (1) in standard model—Expected Utility Outline Theory (EUT; von Neumann & Morgenstern, 1947) Expected (1) (2) (3) (4) Utility Theory Axioms Risk Aversion Anomalies In EUT Prospect Theory Two Stages Editing Evaluation What can it explain? Decision Making Under Risk and Uncertainty Loss aversion Risk seeking anomalies in EUT Nonlinear preferences behavioural economic alternative—Prospect Theory (Kahneman & Tversky, 1979) [email protected] Behavioural Economics  Today Behavioural Economics mark.hurlstone Examine preferences (4), beliefs (3), and utility @uwa.edu.au maximisation (1) in standard model—Expected Utility Outline Theory (EUT; von Neumann & Morgenstern, 1947) Expected (1) (2) (3) (4) Utility Theory Axioms Risk Aversion Anomalies In EUT Prospect Theory Two Stages Editing Evaluation What can it explain? Decision Making Under Risk and Uncertainty Loss aversion Risk seeking anomalies in EUT Nonlinear preferences behavioural economic alternative—Prospect Theory (Kahneman & Tversky, 1979) [email protected] Behavioural Economics  Expected Utility Theory Behavioural Economics mark.hurlstone @uwa.edu.au Decision making under risk can be considered a Outline process of choosing between different prospects or Expected gambles Utility Theory Axioms Risk Aversion A prospect consists of a number of possible outcomes Anomalies In along with their associated probabilities EUT Prospect A simple example of a decision under risk would involve Theory Two Stages choosing between the following two courses of action Editing Evaluation Prospect A: 50% chance to win 100; 50% chance to What can it explain? Loss aversion win nothing Risk seeking Nonlinear Prospect B: Certainty of winning 45 preferences [email protected] Behavioural Economics  Expected Utility Theory Behavioural Economics mark.hurlstone @uwa.edu.au A prospect can be described formally as Outline Expected q = (x1 , p1 ;... xn , pn ) Utility Theory Axioms where xi represents the outcomes and pi represents the Risk Aversion associated probabilities Anomalies In EUT Prospect A on the previous slide could be represented Prospect Theory as q = (100, 0.5; 0, 0.5) or more simply as (100, 0.5) Two Stages Editing Evaluation Prospect B on the previous slide could be represented What can it explain? Loss aversion as r = (45) Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics mark.hurlstone @uwa.edu.au The axioms of EUT were developed by von Neumann Outline and Morgenstern (1947), and are related to the axioms Expected of preference discussed in Seminar 3 Utility Theory Axioms Risk Aversion Completeness Anomalies In EUT This requires that for all q, r : Prospect Either q  r or r  q or both Theory Two Stages Editing Transitivity Evaluation What can it explain? If we take any three prospects, q, r, s Loss aversion Risk seeking if q  r and r  s, then q  s Nonlinear preferences [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics mark.hurlstone @uwa.edu.au Independence Outline Any state of the world that results in the same outcome Expected regardless of one’s choice should be cancelled or Utility Theory Axioms ignored Risk Aversion If you prefer the prospect q = ($3000) to the prospect r Anomalies In EUT = ($4000, 0.8)... Prospect... you should prefer the prospect q’ = ($3000, 0.25) to Theory Two Stages the prospect r’ = ($4000, 0.2) Editing Evaluation The final two prospects have 25% of the probabilities of What can it explain? Loss aversion the first two prospects Risk seeking Nonlinear preferences These should cancel one another out [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics Monotonicity mark.hurlstone Objective imrovements to a prospect—increasing some of its @uwa.edu.au payoffs while holding others constant—should make it at least as Outline attractive if not more so than before Expected Utility Theory Which of the following lotteries do you prefer? Axioms Risk Aversion Option A Anomalies In EUT 90% white 6% red 1% green 1% blue 2% yellow Prospect Theory $0 win $45 win $30 lose $15 lose $15 Two Stages Editing Evaluation What can it explain? Option B Loss aversion Risk seeking Nonlinear preferences 90% white 6% red 1% green 1% blue 2% yellow $0 win $45 win $45 lose $10 lose $15 [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics Monotonicity mark.hurlstone Objective imrovements to a prospect—increasing some of its @uwa.edu.au payoffs while holding others constant—should make it at least as Outline attractive if not more so than before Expected Utility Theory Which of the following lotteries do you prefer? Axioms Risk Aversion Option A Anomalies In EUT 90% white 6% red 1% green 1% blue 2% yellow Prospect Theory $0 win $45 win $30 lose $15 lose $15 Two Stages Editing Evaluation What can it explain? Option B Loss aversion Risk seeking Nonlinear preferences 90% white 6% red 1% green 1% blue 2% yellow $0 win $45 win $45 lose $10 lose $15 [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics mark.hurlstone @uwa.edu.au Outline V(A) = (0.9×0)+(.06×45)+(.01×30)+(.01×−15)+(.02×−15) Expected Utility Theory (1) Axioms Risk Aversion V(A) = 2.55 (2) Anomalies In EUT Prospect Theory Two Stages Editing V(B) = (0.9×0)+(.06×45)+(.01×45)+(.01×−10)+(.02×−15) Evaluation What can it explain? (3) Loss aversion Risk seeking Nonlinear V(B) = 2.75 (4) preferences [email protected] Behavioural Economics  Expected Utility Theory: Axioms Behavioural Economics Expectation principle mark.hurlstone @uwa.edu.au EUT states that decision makers seek to maximise the Outline following preference function Expected V(q) = P Utility Theory pi u(xi ) Axioms Risk Aversion Where q is any prospect, and u(.) is a utility function Anomalies In EUT defined on the set of consequences (x1 , x2 ,... xn ) Prospect Theory We have covered a simple example of this previously, Two Stages Editing where an individual must choose between taking one of Evaluation What can it explain? two 3310 topics Loss aversion Risk seeking Nonlinear In addition to the axioms mentioned so far, there is preferences another important assumption—viz. risk aversion [email protected] Behavioural Economics  Expected Utility Theory: Risk aversion Behavioural Economics mark.hurlstone A person is risk averse if she/he would reject a gamble @uwa.edu.au in favour of a sure amount equal to its expected value Outline For example, most people would prefer $500 than a Expected Utility Theory 50–50 chance of $1000 Axioms Risk Aversion In EUT, risk aversion is caused by the concavity of the Anomalies In EUT utility function Prospect This characteristic is caused in turn by the law of Theory Two Stages Editing diminishing marginal utility—the more you have of Evaluation What can it explain? something, the less you appreciate it Loss aversion Risk seeking Nonlinear Concavity and risk aversion are best illustrated with a preferences figure... [email protected] Behavioural Economics  Expected Utility Theory: Risk aversion Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Risk Aversion U(X) Anomalies In EUT Prospect Theory Two Stages Editing Evaluation What can it explain? X Loss aversion Risk seeking Nonlinear preferences The EUT utility function conforms to a power function of the form u = xb , where b < 1 [email protected] Behavioural Economics  Expected Utility Theory: Risk aversion, risk seeking & risk neutrality Behavioural Economics mark.hurlstone @uwa.edu.au Risk Averse (b1) Outline Expected Utility Theory Axioms Risk Aversion Anomalies In U(X) U(X) U(X) EUT Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion X X X Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Expected Utility Theory: Risk aversion Behavioural Economics mark.hurlstone @uwa.edu.au When performing expected utility calculations, we need Outline to transform monetary values into utility values, using a Expected utility function Utility Theory Axioms Risk Aversion For example, the utility function two slides ago was Anomalies In created by setting the parameter b to a value of 0.5 EUT Prospect Suppose we want to calculate the expected utilities of Theory Two Stages the prospects q = ($500) and r = ($1000, 0.5) Editing Evaluation What can it explain? The utility of the former is calculated as U(q) = 5000.5 = Loss aversion Risk seeking 22.36, whilst the latter is calculated as U(r) = 0.5 × Nonlinear preferences 10000.5 = 15.81 [email protected] Behavioural Economics  Expected Utility Theory: Risk aversion, risk seeking & risk neutrality Behavioural Economics mark.hurlstone Suppose you own $2 and are offered a gamble giving @uwa.edu.au you a 50% chance of winning $1 and a 50% chance of Outline losing a dollar Expected If you are risk averse, what should you do? Utility Theory Axioms Risk Aversion U(Accept) = (0.5 × 30.5 ) + (0.5 × 10.5 ) = 1.37 Anomalies In U(Reject) = 20.5 = 1.41 EUT Prospect If you are risk seeking, what should you do? Theory Two Stages U(Accept) = (0.5 × 31.5 ) + (0.5 × 11.5 ) = 3.1 Editing Evaluation U(Reject) = 21.5 = 2.83 What can it explain? Loss aversion Risk seeking If you are risk neutral, what should you do? Nonlinear preferences U(Accept) = (0.5 × 31 ) + (0.5 × 11 ) = 2 U(Reject) = 21 = 2 [email protected] Behavioural Economics  Next... Anomalies in EUT Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Speaker 1: framing effects Utility Theory loss aversion and violations of invariance Axioms Risk Aversion Speaker 2: bundling and mental accounting Anomalies In EUT loss aversion Prospect Speaker 3: Allais and Ellsberg problems Theory Two Stages violations of independence axiom Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory Behavioural Economics mark.hurlstone Prospect Theory (PT) was originally developed by @uwa.edu.au Kahneman and Tversky (1979) to take into account Outline behavioural anomalies that EUT is unable to incorporate Expected Utility Theory Axioms Risk Aversion Anomalies In EUT Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: At a glance Behavioural Economics mark.hurlstone @uwa.edu.au PT models choice as a two-stage process Outline stage 1 involves editing Expected Utility Theory stage 2 involves evaluation Axioms Risk Aversion The editing phase distinguishes the theory from EUT Anomalies In EUT The other major changes are as follows Prospect Theory Two Stages outcomes are defined in terms of gains and losses Editing Evaluation relative to a reference point What can it explain? there is a nonlinear probability decision weighting Loss aversion Risk seeking function that distorts individual probabilities Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Two stages Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Risk Aversion Editing Anomalies In EUT Evaluation Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Two stages Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Risk Aversion Editing Anomalies In EUT Evaluation Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected The editing phase involves a preliminary analysis of the Utility Theory Axioms offered prospects, often yielding a simpler Risk Aversion Anomalies In representation of these prospects EUT Prospect The aim is to organize and reformulate the options so Theory Two Stages as to simplify subsequent evaluation and choice Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Coding Behavioural Economics mark.hurlstone @uwa.edu.au Empirical evidence suggests that people perceive Outline outcomes as gains or losses relative to some reference Expected Utility Theory point, rather than as final states of wealth Axioms Risk Aversion The location of the reference point—and the Anomalies In EUT consequent coding of outcomes as gains or Prospect losses—can be affected by the formulation of the Theory Two Stages offered prospects and by expectations of the decision Editing Evaluation maker What can it explain? Loss aversion Risk seeking Allows for framing effects Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Combination Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Prospects can sometimes be simplified by combining Axioms Risk Aversion the probabilities associated with identical outcomes Anomalies In EUT For example, the prospect (200, 0.25; 200, 0.25) will be Prospect Theory reduced to (200, 0.50) and evaluated in this form Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Segregation Behavioural Economics mark.hurlstone Some prospects contain a riskless component that is @uwa.edu.au segregated from the risky component during editing Outline For example, the prospect (100, 0.70; 150, 0.30) can Expected Utility Theory be decomposed into a sure gain of 100 and the risky Axioms Risk Aversion prospect (50, 0.30) Anomalies In viz. (0.7 × 100) + (0.3 × 100) = 100; (0.3 × 150) + (0.7 EUT Prospect × 150) = 150 = 150-100 = (50, 0.30) Theory Two Stages Similarly, the prospect (-200, 0.8; -300, 0.2) can be Editing Evaluation segregated into a sure loss of 200 and the risky What can it explain? Loss aversion prospect (-100, 0.2) Risk seeking Nonlinear preferences viz. (0.8 × -200) + (0.2 × -200) = -200; (0.2 × -100) + (0.8 × -100) = -200 = -200 - -100 = (-100, 0.2) [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Cancelation Behavioural Economics mark.hurlstone @uwa.edu.au When different prospects share certain identical Outline Expected components, these components may be discarded or Utility Theory Axioms ignored Risk Aversion Anomalies In For example, the prospect (200, 0.20; 100, 0.50; -50, EUT 0.30) and (200, 0.20; 150, 0.50; -100, 0.30) contain the Prospect Theory common element (200, 0.20) Two Stages Editing Evaluation These prospects can thus be reduced to (100, 0.50; What can it explain? Loss aversion -50, 0.30) and (150, 0.50; -100, 0.30) Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Editing Behavioural Economics mark.hurlstone @uwa.edu.au Outline The major operations of the editing phase are as Expected Utility Theory follows Axioms Risk Aversion Coding Anomalies In Combination EUT Segregation Prospect Theory Cancellation Two Stages Editing Simplification Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Simplification Behavioural Economics mark.hurlstone @uwa.edu.au Outline Prospects can be simplified by rounding either Expected Utility Theory outcomes or probabilities Axioms Risk Aversion For example, the prospect (99, 0.51) can be coded as Anomalies In EUT an even chance of winning 100 Prospect Outcomes that are extremely improbable are likely to Theory Two Stages be ignored, meaning the probabilities are rounded Editing Evaluation down to 0 What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Evaluation Behavioural Economics mark.hurlstone Once the editing phase is complete, the decision maker must @uwa.edu.au evaluate the edited prospects Outline Expected The decision maker is then assumed to choose the prospect Utility Theory with the largest value Axioms Risk Aversion According to PT, the overall value V of an edited prospect is Anomalies In EUT expressed in terms of two scales v and π Prospect Theory The first scale, v, assigns to each outcome x a number, v(x) Two Stages Editing which reflects the subjective value of that outcome Evaluation What can it explain? Loss aversion The second scale, π, associates with each probability p a Risk seeking Nonlinear decision weight π(p), which reflects the overall impact of p on preferences the value of the prospect [email protected] Behavioural Economics  Prospect Theory: Value function Behavioural Economics mark.hurlstone In PT, the EUT utility function u(x)b is replaced with the @uwa.edu.au following value function: Outline (x − r)α  Expected if x ≥ r Utility Theory v(x) = Axioms −λ(r − x)β if x < r Risk Aversion Anomalies In Where: EUT r = reference point (0) Prospect Theory α = diminishing maringal sensitivity for gains (0.88) Two Stages Editing β = diminishing maringal sensitivity for losses (0.88) Evaluation What can it explain? λ = coefficent of loss-aversion (2.25) Loss aversion Risk seeking Nonlinear Provides an explanation of reference points, loss preferences aversion, and diminishing marginal sensitivity [email protected] Behavioural Economics  Prospect Theory: Value function Behavioural Economics mark.hurlstone Lambda = 1 @uwa.edu.au Lambda = 2.33 Outline Expected Utility Theory Axioms Risk Aversion Anomalies In V(X) EUT Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences X [email protected] Behavioural Economics  Prospect Theory: Decision weighting Behavioural Economics mark.hurlstone @uwa.edu.au Outline The second scale, for probability weighting, involves an Expected inverted S-shaped curve, with the following form: Utility Theory Axioms Risk Aversion pγ π(p) = (5) Anomalies In (pγ + (1 − p)γ )1/γ EUT Prospect Where: Theory Two Stages γ = curvature of the weighting function (0.61) Editing Evaluation What can it explain? Provides an explanation of decision weighting Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Decision weighting Behavioural Economics mark.hurlstone 1.6 @uwa.edu.au 1.4 Outline Expected 1.2 Utility Theory Axioms Risk Aversion 1 Anomalies In PI EUT 0.8 Prospect Theory 0.6 Two Stages Editing Evaluation 0.4 What can it explain? Loss aversion Risk seeking 0.2 Nonlinear preferences 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Objective Probability [email protected] Behavioural Economics  Prospect Theory: Basic equation Behavioural Economics mark.hurlstone @uwa.edu.au Outline According to PT, the value of a regular prospect—one with Expected a positive and a negative outcome—V(x, p : y, q) is given by Utility Theory Axioms the following formula: Risk Aversion Anomalies In EUT V(x, p; y, q) = π(p)v(x) + π(q)v(y) (6) Prospect Theory Two Stages Editing As in utility theory, V is defined on prospects and v is Evaluation What can it explain? defined on outcomes Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  Prospect Theory: Example Behavioural Economics mark.hurlstone Consider the regular prospects (100, 0.50; -50, 0.5) and @uwa.edu.au (150, 0.50; -100, 0.5). The value, V, of the first prospect is: Outline Expected Utility Theory v(100, 0.50; −50, 0.5) = π(0.5)v(100) + π(0.5)v(−50) (7) Axioms Risk Aversion Anomalies In = (0.56 × 57.54) + (0.56 × −70.35) = -7.17 (8) EUT Prospect Theory Two Stages The value, V, of the second prospect is: Editing Evaluation What can it explain? v(150, 0.50; −100, 0.5) = π(0.5)v(150) + π(0.5)v(−100) (9) Loss aversion Risk seeking Nonlinear preferences = (0.56 × 82.22) + (0.56 × −129.47) = −26.46 (10) [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain?: Loss aversion Behavioural Economics mark.hurlstone Losses are felt longer and have more impact than @uwa.edu.au gains do Outline Expected For example, losing your house would be a more Utility Theory Axioms significant event than aquiring a new house Risk Aversion Anomalies In Another example is the reluctance to accept losses on EUT the stock market Prospect Theory volume of trades tends to be higher when prices are Two Stages Editing rising than when they are falling Evaluation What can it explain? Loss aversion The phenomenon of loss aversion is consistent with Risk seeking Nonlinear PT’s assumption that utility is coded in terms of gains preferences and losses relative to a reference point [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain?: Risk seeking Behavioural Economics mark.hurlstone @uwa.edu.au Individuals are not always risk averse, sometimes Outline they are risk seeking—e.g. gambling on unfair Expected prospects in a lottery Utility Theory Axioms Risk Aversion Tversky and Kahneman (1992) Anomalies In individuals are risk seeking for losses and risk averse EUT for gains for prospects of moderate to high probability Prospect Theory individuals are risk averse for losses and risk seeking Two Stages Editing for gains for prospects with low probabilities Evaluation What can it explain? Loss aversion Thus, individuals tend to prefer a large probability of a Risk seeking Nonlinear big loss than a sure smaller loss preferences [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain? Behavioural Economics mark.hurlstone @uwa.edu.au Outline Expected Utility Theory Axioms Loss aversion Risk Aversion Anomalies In Risk seeking EUT Non-linear preferences Prospect Theory Two Stages Editing Evaluation What can it explain? Loss aversion Risk seeking Nonlinear preferences [email protected] Behavioural Economics  What can it explain?: Nonlinear preferences Behavioural Economics The psychological weight assigned to an event may not mark.hurlstone @uwa.edu.au correspond to the stated probability of that event Outline A classic example is Russian roulette: Expected Utility Theory people will pay more to decrease the number of bullets Axioms Risk Aversion from 1 to 0 (1/6 – 0 = 0.17) than from 4 to 3 (4/6 – 3/6 = Anomalies In 0.17) EUT EUT predicts that this should not be the case Prospect Theory Two Stages We also see evidence of overweighting of small probabilities Editing (e.g., Availability heuristic) and underweighting of large Evaluation What can it explain? probabilities Loss aversion Risk seeking Nonlinear Implies people respond to probabilities in a nonlinear preferences manner, suggesting a nonlinear transformation of the probability scale—a la PT [email protected] Behavioural Economics