1. Behavioral Finance
Economics 437

2. 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”

3. 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

4. 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”

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

6. 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

7. End