08 Prospect Theory Feb 4

8/11/2019 08 Prospect Theory Feb 4

1/43

BehavioralTheories

History

andResearch Evidence


2/43

PSYCHOLOGY MEETS ECONOMICS


3/43

What Is Behavioral

Economics? The study of choices actually made by

economic decision makers in an effort to

assess the strengths and weaknesses of therational choice model that is the mainstay ofmodern economics.


4/43

The Rational Choice Model A decision makers choice is rationalif it is a most

preferred choice from the choices that are

available to the decision maker. By most measures the rationalchoice model is

very successful when applied to choice problemswithout uncertainty. For these problems it

predicts well how people choose.

But there are some predictions that are incorrect.

It suggests that people are sometimes irrational.


5/43

The Journey Begins

Let us begin

our journey!!


6/43

The Value of Behavioral

Economics Behavioral economists have demonstrated

that the rational choice model systematically

predicts behavior less well in certaincircumstances.

These demonstrations suggest thateconomists must improve on the rational

choice model.

What are these circumstances?

And how can we improve?


7/43


8/43

Behavioral Economics:

Framing Effects How a choice is framed(i.e.,presented)

strongly affects the choice that results.

Would you pay $10 for a bottle of hairshampoo in an expensive hair salon?


9/43


Framing Effects How a choice is framed(i.e.,presented)

strongly affects the choice that results.

Would you pay $10 for a bottle of hairshampoo in an expensive hair salon?

Would you pay $10 for a bottle of hairshampoo in a discount supermarket?


10/43


11/43


Framing Effects The rational choice model with full

information predicts that the consumer would

pay the lower price for shampoo sincepackaging is less important than the hair-cleaning agents.

But many people prefer to buy the more

expensive shampoo.


12/43


Framing Effects 600 lives are threatened.

Action (a) saves 200 lives.

Action (b) saves all 600 lives withprobability 1/3 and saves nobody withprobability 2/3.

Which action would you choose? (a) or (b)?


13/43


Framing Effects 600 lives are threatened.

Action (c) causes 400 to die.

Action (d) causes 600 to die withprobability 2/3 and causes nobody to diewith probability 1/3.

Which action would you choose? (c) or (d)?


14/43

600 lives are threatened.

Action (a) saves 200lives.

Action (b) saves all 600lives with probability 1/3and saves nobody withprobability 2/3.

600 lives are threatened.

Action (c) causes 400 todie.

Action (d) causes 600 todie with probability 2/3and causes nobody to diewith probability 1/3.


Framing Effects

These are identical problems, apart from how they are framed.Yet the most common (highlighted) choices are different.


15/43


Framing EffectsThese problems are identical, apart from how theyare framed.

Yet the most common (highlighted) choices aredifferent.

Why?

People overweight outcomes that they view ascertain or near certain, relative to outcomes thatare merely probable.


16/43

Behavioral Economics:Certainty Effects Maurice Allais (1953)

Problem 1:Choose Between the following two risky bets A or B:

A. $2,500 with probability of 0.33, $2,400 with a probability of0.66, 0 with a probability of .01

B. $2,400 with certainty

Out of 72 people, 18% chose A and 82% chose B

People preference suggests the following:U(2,400) > 0.33U(2,500) + 0.66U(2,400)


17/43


Problem 2:Choose Between the following two risky bets A or B:

A. $2,500 with probability of .33, $0 with probability of 0.67

B. $2,400 with probability of 0.34, $0 with probability of 0.66

Out of 72 people, 83% chose A and 17% chose B

Peoples preference suggests the following:0.33U(2,500) > 0.34U(2,400)


18/43


The choices in problem 1 implies

U(2,400) > 0.33 U(2,500) + 0.66 U(2,400)

Therefore, 0.34U(2,400) > .33U(2,500)

The choices in problem 2 implies 0.33U(2,500) > 0.34U(2,400)


19/43


This is a clear violation of the principle oftransitivity!

What is the difference between problem 1 andproblem 2?

Problem 2 is just Problem 1 without the 0.66

chance of winning $2,400.


20/43


The presence of an alternative and thecertainty of one of the options changed the

problem. It seems that a reduction in probability of

winning, say from 80% to 20%, creates apsychological distaste to individuals. Theyinterpret or perceive this as a loss (relative tothe original probability) and therefore tend tofavor a risk-averse decision.


21/43

Behavioral Economics:Social Norms

Think of the following game.

You, and only you, will decide how to divide

$1 between yourself and one other person.This will happen only once. You dont knowwho is the other person and other persondoes not know who you are.

How would you divide the $1?


22/43






$100?


23/43






$100?

$1,000,000?


24/43


$1? $100? $1,000,000?

Strategic reasoning predicts that since the

other person must take what he is given, andhas no power to influence this, he will getnothing; i.e.,you take everything.


25/43


$1? $100? $1,000,000?

Strategic reasoning predicts that since the

other person must take what he is given, andhas no power to influence this, he will getnothing; i.e.,you take everything.

But most people give at least something tothe other person. The smaller is the amountto be divided, the more likely it is to bedivided equally.


26/43


Think of a new game.

You make an offer on how to divide $1. If

the other person accepts then this is how the$1 is divided. If the offer is rejected thenboth get nothing.



27/43


Strategic reasoning predicts that you will offerat most one cent to the other, since he gets

nothing if he refuses. The evidence is that most offers of about 30

cents or less are refused as unfair. Mostoffers are about 40 cents and are accepted.


28/43


The explanation is that the other person isoffended if you try to keep a large part of the

$1. Also, the cost to the other of refusing theoffer decreases as you keep more foryourself. You understand this and so offerclose to, but less than, $.

The social normof fair suggests a 50-50share and results in a desire by the other topunish you if you are unfair.


29/43

Status quo bias and defaults in organdonation (Johnson-Goldstein Sci 03)


30/43


31/43

Behavioral Economics:Status Quo Bias

Another explanation is that they trust thatthe first option must be the best one.

Another explanation is that the first option isalready available, meaning that they almostfeel like they own it and do not want to

disown it. (akin to the endowment effect)

Another explanation is that they have doubtsabout their own ability to compare andanalyze the two options.


32/43

Behavioral Economics:Status Quo Bias

Lastly they are merely expressing an aversionto loss, i.e., what if they choose the newer

option and it is worse. By choosing the statusquo they are preventing a potential loss.


33/43

People value athing more once

it becomes theirsOne of thecentral themesin a capitalist

economyOwnershipincreases onesutility

The Endowment Effect: Valueof Ownership

St d t i th


34/43

Students who did not geta mug reported the pricethey would be willing to

pay to get one.

What do you think happened?a) Did the students with mugs price them higher/lower than

students with no mugs?b) Did both sets of students price them about the same?

Students in every otherseat were givenuniversity mugs. Thenreported how much theywould be willing to sellthe mug for.

St dents ith the Students with no mugs


35/43

Students with themugs were willing tosell them, on average,

for

$4.50

Students with no mugswere willing to buythem, on average, for

$2.25


36/43

Class B Class CClass A


37/43

Class B

10%chose

coffee mug

Class C

59%chose

coffee mug

Class A

89%chosecoffee

mug

??

?


38/43


39/43

The Endowment Effect: Valueof Ownership

So what is happening? Why doesownership add value?Investing in something increases ones sense of

attachment to a product and hence increaseperceived value. [IKEA effect]

Marketing ExamplesMoney back guarantees not only reduces downside

risk but also reduces chances of returnGood vivid ads will transport a consumer into a

world where they feel like they virtually own theproduct, thus enhancing the value of the yet-to-bepurchased product(s).


40/43


41/43

Is too much choice bad?

Jams study (Iyengar-Lepper): 6 jams 40% stopped, 30% purchased 24 jams 60% stopped, 3% purchased

Assignment study: Short list 74% did the extra credit assignment Long list 60% did the extra credit assignment

Participation in 401(k) goes down 2% for every 10 extra funds Shoe salesman: Never show more than 3 pairs of shoes Medical

65% of nonpatients said they would want to be in charge of medicaltreatmentbut only12% of ex-cancer patients said they would

Camerer conjecture: The curse of the composite Paraphrased personals ad: I want a man with the good looks of Brad

Pitt, the compassion of Denzel Washington Is there too much mate choice in big cities?


42/43

Choice-aversion

How to model too much choice? Anticipated regret from making a mistake

grass is greener/buyers remorse

Direct disutility for too-large choice set (e.g. too complex)

Policy question: Markets are good at expandingchoicewhat is a good

institution for limiting choice?

Example: Bottled water in supermarkets

Limit useless substitution? What is the right amount? Pro-govt example: Swedish privatized social security

Offered hundreds of funds

Default fund is low-fee global index (not too popular)

Most popular fund is local tech, down 80% 1styr

Features of Prospect Theory


43/43

p y

(1)Reference Dependence

(2) Loss Aversion

(3) Risk aversion in gains and risk seeking in the losses (strictlyspeaking this is not correct: 4-fold pattern or risk).

Axiomatics: see al-Nowaihi, Bradley and Dhami (2008, Economics

Documents

08 Prospect Theory Feb 4