Week2

Question 1

How do we use editing to get prospect theory (4 things)?

Answer 1

1) Coding - separating the gains and losses relative to a reference level.
2) Combination - we combine the probabilities with identical outcomes.
3) Segregation - we can separate a riskless component from the lottery.
4) Cancellation - we can discard the components that are share by the offered prospects.

Question 2

What are the three properties of the value function?

Answer 2

1) Loss aversion - losses loom larger than gains, therefore, the value function has a steeper curve for losses.
2) Diminishing sensitivity - The MU falls as we move further away from the reference point, implying risk averse preference over gains and risk loving preferences over losses.
4) Reference point - we have v(0) = 0 and the outcomes are judged in terms of gains and losses.

Question 3

What are the properties of the weighting function?

Answer 3

1) w(0) = 0 and w(1) = 1.
2) We have overweighting for small probabilities.
3) Subcertainty - w(p) + w(1-p) < 1, meaning large probabilities are underweighted (implied by Allais’ paradox).

Question 4

How may stochastic dominance be violated?

Answer 4

When more probability is moved onto a better outcome has two potential outcomes: direct effect (p weight on good outcome in increased) and indirect effect (sum of decision weights may increase/decrease). If indirect effect is negative and outweighs the direct effect then stochastic dominance is violated.