week 6 - prospect theory Flashcards
what should the second derivative of a utility function = for one to be risk averse
2nd deriv. < 0
if you reject [W + 11, W -10], you reject any value of Y no matter how high, why?
due to decreasing marginal utility, no matter how much more you earn, the less utility each additional £ gives you compared to the original W - 10 even if the value is larger than 10 (also known as concavity)
what does concavity show us in terms of how someone is behaving
as one gets wealthier, they become more risk averse
what is the explanation for why people turn down small bets with positive expected value
loss aversion and mental accoutning
why do people overweight low prob. and underweight high prob., give some examples
loss aversion, e.g. people will overpay on insurance or warranty in order to avoid small risks,
what are the four properties of prospect theory
- reference dependent: value function depends on changes in wealth as opposed to wealth
- loss aversion: value function is steeper in losses than gains
- diminishing sensitivity: value function is less steep future from the reference point
- probability weighting: people are risk-seeking in losses
what is the status quo bias
people tend to want to stick to the same current state than change, showing uncertainty aversion
what experiment did madrian and shea (2000) conduct
- examined american pension participation in US firm
- they changed the pension plan from opt out to opt in, automatic enrollment increased participation by 50%
- the default shifted due to new reference point
what experiment did kahneman et al. (1990) conduct
- treatment group received a mug, control group did not
- both groups were asked the minimum price they would receive or pay for the mug (buying and selling in a market)
- created a supply and demand market, intersection was were transaction could take place
