LEC 4 - PROSPECT THEORY AND MENTAL ACCOUNTING

Question 1

What are the two phases of prospect theory

Answer 1

editing phase - look at prospect given and add them in your head to make them easier to compare

evaluating phase - find the value and you evaluate them

Question 2

if you had 99, 0.51. what would you do

Answer 2

round it to 100, 0.5

make things easier

Question 3

how do u choose the best prospect

Answer 3

Choose the prospect with tChoose the prospect with the highest value V, measured via

subjective value v(x) of outcome x, and decision weight π(p)
associated with probability pChoose the prospect with the highest value V, measured via subjective value v(x) of outcome x, and decision weight π(p) associated with probability phe highest value V, measured via
subjective value v(x) of outcome x, and decision weight π(p)
associated with probability p

Question 4

what are the 4 key aspects of prospect theory

Answer 4

reference point - changes in wealth or welfare. measures of deviations from a reference point

loss aversion - losses loom larger than gains

diminishing marginal sensitivity

decision weighting - subadditivity: overweighting of small probabilities.

sub certainty: Subjects tend to overweight outcomes that are considered certain to outcomes that are merely probable

Subproportionality: People judge probabilities that are the same compared in relative terms (1 to 0.8 and 0.25 to 0.2) to be more similar (in terms of decision weights) when probabilities are small (0.25 is judged more similar to 0.2 than 1 is to 0.8)

Question 5

draw the prospect theory diagram

Answer 5

convex prefer the gamble to the certain, the gamble is less negative

V is values

Concave for gains and convex for losses

Risk-aversion in gains and risk-seeking in losses (see example)

Steeper for losses than for gainsnLosses loom larger than gains

Question 6

Answer 6

ncl is students
kt is an actual paper

Question 7

what’s the reflection effect

Answer 7

The preference between negative prospects is the mirror image of the preference between positive prospects

Question 8

how are certain gains and losses interpreted

Answer 8

certain positive outcomes are overweighed

certain negative outcomes are underweighted

Question 9

what does subadditivity mean

Answer 9

Overweighting of small probabilities

Question 10

what’s subcertainty

Answer 10

An example of Allais Paradox.

Common ratio effect. One prospect is certain

Subjects tend to overweight outcomes that are considered certain to outcomes that are merely probable

Question 11

what’s subproportionality

Answer 11

People judge probabilities that are the same compared in relative terms (1 to 0.8 and 0.25 to 0.2) to be more similar (in terms of decision weights) when probabilities are small (0.25 is judged more similar to 0.2 than 1 is to 0.8)

Question 12

what is mental accounting

Answer 12

Mental accounting is the set of cognitive operations used by individuals and households to code, categorize and evaluate financial activities

Question 13

what are the 3 components of mental accounting

Answer 13

1.Framing and editing
Perceptions of outcomes and decision making

2.Budgeting and fungibility
Assignment of activities to specific accounts

3.Choice bracketing and dynamics
Determination of the time periods to which different mental accounts relate

Question 14

what is the problem with mental accounting

Answer 14

don’t see fungibility

Fungibility relates to the substitutability of different budget categories;
If budgets are fungible, overspending in one category can be compensated by underspending in another category and vice versa

Question 15

implications of prospect theory

Answer 15

Segregate gains

the gain function is concave due to diminishing marginal sensitivity

Who is happier, someone who wins two lotteries that pay £50 and £25 respectively, or someone who wins a single lottery paying £75? 64% say the two-time winner is happier

Segregate small gains from larger losses

value of a small gain may exceed that of slightly reducing a large loss, diminishing marginal sensitivity

Before price £20. Save 2£ (a gain) Might be better than “new low price £18”

Question 16

Imagine you are shopping for a calculator and a jacket, and you find them both at the same department store. The calculator costs £25, and the jacket costs £120. You are told that a store across town has both items, but the calculator is £15 cheaper at that store. Do you buy the items at that store or do you go across town?

Most people would go across town

If the jacket is £15 cheaper, most people say no

Answer 16

Hedonic editing can account for the difference in choice

Saving on the calculator; v(-10) - v(-25)

Saving on the jacket; v(-110) - v(-125)

Because of diminishing marginal sensitivity to loss; the saving (the difference between the losses) on calculator has a greater value

Question 17

with mental accounting, what are the two types of utility from transactions

Answer 17

§Acquisition utility

§value of the good obtained relative to its price, equivalent to the concept of consumer surplus

§Transaction utility

§perceived value of the ‘deal’, i.e. difference between reference price and price paid

Question 18

what is the whole idea of budgeting and fungibility in mental accounting

Answer 18

Firms set budgets or targets for spending in various categories, and allocate expenses to different categories

Fungibility ; substitutability of different budget categories

In standard model; budgets completely fungible:

buy if MB > MC

marginal benefits>marginal costs

Question 19

what is choice bracketing

Answer 19

individuals segregate or aggregate choices over time periods

•Consumers are less willing to replace a lost Theatre ticket than if they had lost an equivalent amount of money as the theatre ticket is “same category”

Question 20

How would standard economics predict people react to a small windfall? How would mental accounting predict people react to a small windfall?

Answer 20

No effect. Permanent Income Lifecycle Theory

mental accounting people - A positive effect. Mental account (e.g. ‘grocery spending per week’)

Question 21

whats the aim and conclusion of Milkman et al.. 2009. Mental accounting and small windfalls:

Answer 21

nDoes the redemption of a $10-off coupon increases an individual’s spending on online groceries (predicted by mental accounting)

nDoes the increase in spending stimulated by the redemption of a $10-off coupon focus on groceries that customers would not purchase in the absence of such a coupon (“marginal” goods)

The regression results indicate that the effect of a coupon used corresponds to $1.59 in additional spending

The results indicate that the effect of coupon use corresponds to $1.56 in additional spending on marginal groceries