Prospect Theory

Two Worlds Economist: “The agent of economic theory is rational, selfish, and his tastes do not change” “To a psychologist, it is evident that people are neither fully rational, nor completely selfish, and their tastes are anything but stable.” Expected Utility Theory: If you prefer and apple to a banana, then you also prefer a 10% chance to win an apple to 10% chance to win a banana

Then comes Bernoulli 80% chance to win $100 and 20% chance to win $10 OR A $80 note?? Depends on peoples relative wealth, so comes the concept of utility Consider the following: Equal chances to have 1 million or 7 million OR 4 million with certainty?? Wealth Utility

Problem with Utilities Today, Jack and Jill each have a wealth of 5 mil Yesterday, Jack had 1 mil and Jill had 9 mil Do they have the same utility? Another one: The gamble: equal chances to end up owning 1 million or 4 million OR The sure thing: own 2 million for sure Lets say 2 players – A with current wealth of 1 million, and B with current wealth of 4 million So where was Bernoulli wrong?

Outcomes as Gains and Losses Problem 1: Get $900 for sure OR 90% chance to get $1000? Problem 2: Lose $900 for sure or 90% chance to lose $1000 Problem 3: In addition to your wealth, you are given $1000. Now choose: 50% chance to win $1000 OR get $500 for sure Problem 4: In addition to you wealth, you are given $2000. Now choose: 50% chance to win $1000 OR get $500 for sure

To SUM UP Expected value theory focuses on the expected value of the outcome Utility theory only focused on a utility of the outcome Bernoulli’s correction was that utility depends also on the present state of wealth Finally, PROSPECT THEORY shows errors in Bernoulli’s corrections. It suggests: There is a reference point for every decision (not only todays wealth, but also what was yesterday) – A before and after effect From this point, we consider gains and losses In general people are more loss averse

Is prospect theory the end? Consider the following: A.One chance in a million to win 1 mil B.90% chance to win 12 and 10% chance to win nothing C.90% chance to win 1 mil and 10% to win nothing