1. Behavioral Finance
Economics 437

2. Readings
Richard Thaler, “Misbehaving” -- the main reading, along with Kahneman, for the April 14 mid term examination
There may be other readings as well, but these are the main readings
Expected to know Dan Kahneman’s “Thinking: Fast and Slow” for April 14 mid term examination

3. Anomalies
There are many, many strange things discovered in psychology experiments and in experimental economics
Are they just random and unconnected?
Are do they have important “predictable” consequences
If they don’t have “predictable” consequences, then the may just cancel each other out, leaving the EMH in the driver’s seat

4. Unexplained (by EMH) anomalies
The Equity Premium Puzzle
The Endowment Effect
The Status Quo Effect (selling winners, not losers)
Framing problems (where one presentation frames as “saving” lives and another presentation frames as “killing” people
Could these lead to a common prediction?

5. Two Ways of Valuing Lotteries (uncertain chances)
Expected Value of the lottery (think, average if repeated over time)
Expected Utility of the lottery
And then, assume risk aversion (diminishing marginal utility

6. Expected Value Utility Utility is linear in expected value of wealth

8. Expected Utility Utility Expected Utility (note
assumption of risk aversion
Wealth

9. Loss Aversion
The idea here is that an individual suffers more from a loss than he would enjoy and equal amount of a gain
Losing $ 100 is more painful than
Gaining $ 100
One doesn’t balance the other
The loss is much more severe than the gain
Thus, individuals try desperately to avert losses, even if it is irrational to do so (emotion outweighing rationality)

10. Two persons whose wealth is $ 5 million today
Loss Aversion Implies That Your Utility is mainly about changes in wealth, not actual level of wealth
Two persons whose wealth is $ 5 million today
Person A was worth $ 1 million yesterday
Person B was worth $ 10 million yesterday
Isn’t one of these persons really, really happy and the other person really, really sad, even though there wealth is identical?
So, is the “level” of wealth really the determinant of utility (happiness)

11. Consider Civil Litigation
Mr. Jones sues Mr. Smith for $ 1 million
All agree that
Mr Jones has a 90% chance of winning
And 10% chance of getting nothing at all
Jones is offered $ 800,000 to settle

12. Jones Utility Function (shows risk aversion)
Exp Value of Suit
0.8
1.0
Wealth (in $ millions)

13. Consider Civil Litigation
Mr. Jones sues Mr. Smith for $ 1 million
All agree that
Mr Jones has a 90% chance of winning
And 10% chance of getting nothing at all
Smith is offered the opportunity to pay $ 800,000 and the suit will be dropped

14. Smith Utility Function (shows risk preference)
Exp Value of Suit
0.8
1.0
Wealth (in $ millions)

15. Could Jones and Smith Be the Same Person?
Would someone take $ 800,000 to settle, but refused to pay $ 800,000 to settle
Evidence shows that people are eager to take money, but reluctant to pay to settle (rather take their chances)
Why?

16. Answer: Loss Aversion Risk averse when contemplating gains
Risk preferring when contemplating losses

17. Utility Function
Utility
Gains
A reference point
Losses

18. The End