Behavioural Economics A presentation by - Alex Godwin, William Pratt, Lucy Mace, Jack Bovey, Luke Baker and Elise Girdler.

Expected Utility Theory Originally proposed by Daniel Bernoulli (1798) Reinterpreted by Neumann and Morgenstern (1944) Based on expected monetary value except the utility function (u) is used to show diminishing marginal utility Expected Monetary Value is the sum of the probabilities multiplied by the value of the outcome Expected Utility Theory (Neumann and Morgenstern) Expected Utility Theory instead uses the utility of the potential monetary outcome instead of the monetary value itself

Outcome 1 Outcome 2 Problem A £4000 at 80% (20%) 3000 at 100% (80%) x0.25 Problem B £4000 at 20% (65%) 3000 at 25% (35%) £3000, 0.25 £3000, 1.00 Outcome 2 Outcome 2 £0, 0.75 Problem A Problem B £4000, 0.2 £4000, 0.8 Outcome 1 Outcome 1 £0, 0.8 £0, 0.2 20% - Outcome 1 80% - Outcome 2 65% - Outcome 1 35% - Outcome 2 The substitution axiom of utility theory states that if A is preferred to B then for any probability p, (A,p) should be preferred to (B,p). This is not the case in the example 1.

Prospect Theory: An analysis of decision under risk Kahneman and Tversky 1979 A critique of expected utility theory as a descriptive model of decision making under risk, developing an alternative model now known as prospect theory The paper presents situations and proof which violate the axioms of expected utility theory The theory is based on simple prospects, monetary outcomes and stated probabilities But, can be later applied to real life situations Evaluates situations involving risk and shows that people respond differently to a risk depending on whether the outcome is a gain or a loss

Non-risk taking Text Risk Taking 1. 2. £240 £1000 £0 0.25 0.75 Gains 1. 84% Non-risk taking 16% -£750 -£1000 £0 0.75 0.25 Losses 2. 13% Text Risk Taking 87% In the first example individuals are less likely to take the risk in order to win £1000 However when it comes to losses people suddenly become risk takers and more individuals are willing to take the £1000 gamble.

A hypothetical value function The curve is concave above the line as decision makers will be risk averse when choosing between gains. The curve convex below the line as decision makers are risk seeking when choosing between losses. The line at this point is steeper because decision makers are extreme risk takers.

Myopic Loss Aversion and the Equity Premium Puzzle - Benartzi and Thaler An Application of Prospect Theory Mehra and Prescott discovered “the equity premium puzzle” It leaves us with two questions: i. Why is the equity premium so large? ii. Why is anyone willing to hold bonds? Concepts from the psychology of decision making used: i. Loss aversion ii. Mental accounting methods “I won’t bet because I would feel the $100 loss more than the $200 gain” Two factors contribute to unwillingness to hold equities: i. Loss aversion ii. Short evaluation period Benartzi and Thaler conclude that a combination of high sensitivity to losses and high tendancy to frequently monitor ones wealth explain the equity premium puzzle.