Behavioral Finance Economics 437

Two Big Conclusions (among many smaller ones) Loss Aversion Risk aversion for gains Risk preference for losses But, even beyond these two issues: Generally, loss aversion can make people make very bad choices, because losses are more painful that the gains of equal dollar amounts May account for endowment and status-quo effects Prospect Theory (is a specific way of developing a theory using loss aversion Uses “reference points” In application, uses risk aversion for gains, risk preference for losses Implies that utility is “path determined”

Prospect Theory Key idea – “reference point” The idea behind reference points are that utility depends upon where you start. It is not simply U(X), but U(X, R) where is the reference point This focuses on the utility of changes from the reference point, not simply utility of dollars

Prospect Theory “Prospect” means the same thing as a lottery “Prospect Theory” is about loss aversion Risk aversion for gains Risk avoidance for losses Loss function steeper than gain function Inevitably implies “path dependence” – literature says “reference points”

Two people worth $ 10 million Person A was worth $ 1 million yesterday Person B was worth $ 100 million yesterday Do they feel the same?

Fairness and “Reference Points” Shortage of cars develops Dealer raises prices $ 200 above list 71 % unfair Dealer has been selling these cars at a discount of $ 200 below list price. He now eliminates the discount Only 42 % unfair

End