Utility Theory & Prospect Theory

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    Chapter 6Prospect Theory

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    Theory for decision making under risk

    Normative Theory

    Expected Utility Theory(von Neumann and Morgenstern, 1944)

    Objective probability judgment

    A set of intuitive axioms

    Roots to be found in Bernoulli

    (1738)

    Descriptive Theory

    Prospect Theory(Kahneman and Tversky, 1979)

    Explicitly not normative

    Positive application (summarizes

    what people actually do)

    Probably the most widely cited

    (influential) social science paper

    ever published

    eike.kroll@ovgu.de

    Advice how you should decide Prediction of what you will decide

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    Prospect Theory

    eike.kroll@ovgu.de

    Editing Phase

    Choice problem

    Evaluation Phase

    Probability

    weighting Value Function

    Decision

    Prospect theory is strictly defined for choice

    situations involving risk, although it has found its

    way into other disciplines as well (e.g. marketing)

    This is the preparation before options are evaluated.

    Based on perception and psychological processes,

    the presented information is organized.

    This the link between observing information and

    performing a choice. In contrast to expected utility

    theory, risk is evaluated on two different dimensions.

    (1) Probabilities and (2) payoffs

    In contrast to normative choice theories, the goal of

    prospect theory is to provide good prediction of

    choices

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    Editing Phase: Coding

    In contrast to expected utility theory, decision makers do not consider their final

    wealth. They consider gains and losses compared to a reference point.

    During the editing phase, decision makers will decide what reference point to use

    (e.g. opportunity cost, minimum wage requirement, etc.)

    The payoffs of the lottery will then be coded as a gain or a loss

    eike.kroll@ovgu.de

    Choice Problem Modification

    Option L

    200.50

    Option S

    10

    Expected

    earnings in an

    experiment

    10

    Option L

    100.5-10

    Option S

    0

    or

    Reference Point

    orEvaluation

    Phase

    Coding

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    Editing Phase: Combination

    In the evaluation phase, as in expected utility theory, only payoffs and

    probabilities are considered

    Therefore, probabilities of events with identical outcomes are combined

    to one event.

    eike.kroll@ovgu.de

    Choice Problem

    Option L

    20E1(0.1)20E2(0.5)0

    Option S

    10

    Option L

    200.60

    Option S

    10

    or

    Reduction to Payoffs and Probabilities

    orEvaluation

    Phase

    Combination

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    Editing Phase: Simplification

    People have difficulties to pick up small numerical differences in

    probabilities and payoffs

    For both, probabilities and payoffs, are modified to simpler numbers

    eike.kroll@ovgu.de

    Choice Problem

    Option L

    210.490

    Option S

    10

    Option L

    200.50

    Option S

    10

    or

    Rounding up/down to simpler numbers

    orEvaluation

    Phase

    Simplification

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    Editing Phase: Segregation

    People perceive situations involving risk different than situations involving

    sure outcomes (i.e. sure payoffs are not risky payoffs with probability 1)

    Sure gains are segregated from the lottery, the same is true for sure losses

    eike.kroll@ovgu.de

    Choice Problem

    Option L

    300.2510

    Option S

    15

    Option L

    10 + 200.250

    Option S

    15

    or

    Disentangle safe from risky payoffs

    orEvaluation

    Phase

    Segregation

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    Editing Phase: Cancellation (Type I)

    People focus on differences rather than similarities when evaluating

    prospects

    Equal payoffs of two options are therefore not considered when

    performing a choice (are considered not to have an influence on wealth)

    eike.kroll@ovgu.de

    Choice Problem

    Option L

    200.250.5-5

    Option S

    200.2150.5-10

    Option L

    00.250.5-5

    Option S

    00.2150.5-10

    or

    Identical payoffs are not considered

    orEvaluation

    Phase

    Cancellation

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    Editing Phase: Cancellation (Type II)

    In expected utility theory we have the Reduction of Compound Lotteries

    axiom

    In prospect theory: two-stage lotteries are reduced to the reduced form

    If in the first stage one payoff is zero, the first stage is neglected all

    together

    eike.kroll@ovgu.de

    Two-stage Lottery Neglecting of the first stage

    Evaluation

    Phase

    Cancellation

    0

    20

    000.25

    0.75

    0.8

    0.2

    20

    00

    0.8

    0.2

    h l

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    Editing Phase

    Note:

    The sequence of editing

    procedures may differ between

    decision makers and choice

    problems

    The sequence of editingprocedures probably depends on

    the task and framing of the

    choice problem

    The application of some editing

    procedures may prevent othersfrom being applied

    eike.kroll@ovgu.de

    Coding

    Combination

    Simplification

    Segregation

    Cancellation

    B h i l Fi

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    Note down your decisions for the following scenario

    Story: 600 people are attacked by a fatal disease

    Choice: Which program would you prefer

    Program A: Saving 200 lives for sure

    Program B: Saving 600 lives with 1/3 probability

    eike.kroll@ovgu.de

    S1

    B h i l Fi

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    Note down your decisions for the following scenario

    Story: 600 people are attacked by a fatal disease

    Choice: Which program would you prefer

    Program A: Losing 400 lives for sure

    Program B: Losing 600 lives with 2/3 probability

    eike.kroll@ovgu.de

    S2

    Behavioral Finance

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    Note down your decisions for the following scenario

    Story: Imagine that you have just been given 1000 Euro

    Choice: Which option would you prefer

    Option A: You receive 500 Euro for sure

    Option B: You receive 1000 Euro with 50% chance

    and nothing otherwise

    eike.kroll@ovgu.de

    S3

    Behavioral Finance

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    Note down your decisions for the following scenario

    Story: Imagine that you have just been given 2000 Euro

    Choice: Which option would you prefer

    Option A: You have to pay back 500 Euro for sure

    Option B: You have to pay back 1000 Euro with 50% chance

    and nothing otherwise

    eike.kroll@ovgu.de

    S4

    Behavioral Finance

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    Framing effect

    Story: 600 people are attacked by a fatal disease

    Choice: Which program would you prefer

    Live-saving frame:

    Program A: Saving 200 lives for sure Program B: Saving 600 lives with 1/3 probability

    Live-losing frame:

    Program A: Losing 400 lives for sure

    Program B: Losing 600 lives with 2/3 probability

    Program A and B are identical in both scenarios.

    Only the Frame of choice tasks changes

    eike.kroll@ovgu.de

    S1

    S2

    Blacked Out

    To be revealed in the lecture

    Behavioral Finance

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    Framing Effect

    Story: Imagine that you have just been given 1000 Euro

    Choice: Which option would you prefer

    Option A: You receive 500 Euro for sure

    Option B: You receive 1000 Euro with 50% chanceand nothing otherwise

    Story: Imagine that you have just been given 2000 Euro

    Choice: Which option would you prefer

    Option A: You have to pay back 500 Euro for sure

    Option B: You have to pay back 1000 Euro with 50% chance

    and nothing otherwise

    Option A and B are identical in both scenarios.

    Only the Frame of choice tasks changes

    eike.kroll@ovgu.de

    S3

    S4

    Blacked Out

    To be revealed in the lecture

    Behavioral Finance

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    Evaluation Phase: Value Function

    Three characteristics

    Decreasing marginal utility for

    gains (risk-aversi