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Prospect Theory - Bounded Rationality
Prospect Theory - Bounded Rationality
Prospect Theory
Lecture 5
502 February 25 2016
Risk preferences
Loss aversion
Probability weighting
Time preferences
Reference point
Risk aversion
Risk seeking
Diminishing sensitivity
Loss aversion
Implications: Framing
The US is preparing for the outbreak of an unusual
Asian disease, which is expected to kill 600
people. Two alternative programs have been
proposed:
For a group of 600 people.
Version 1:
Program A: 200 people will be saved.
Program B: There is 1/3 P that 600 people will be saved and 2/3
P that no people will be saved
Version 2:
Program A: 400 people will die.
Program B: There is 1/3 P that nobody will die and 2/3 P that
600 people will die.
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Negotiation obstacles:
My concessions are losses to methey hurt
Your concessions are gains to methey mean little
Market rigidities:
Reluctance to sell at loss
Change from 0 to 5%
Change from 5% to 10%
Change from 60% to 65%
Change from 95% to 100%
How much
humans
weight the
probability
Psychophysics of chance
Certainty
effect
How much
humans
weight the
probability
Possibility
effect
Diminishing sensitivity
Reference points
Loss aversion
Probability weighting: Possibility and certainty
effects
Temporal discounting
Temporal discounting
Loss of subjective value of gains over time
Important for policy: delayed outcomes are not
valued as highly as immediate ones.
Implications for saving, investment in health,
education
Intertemporal choice exhibits decreasing impatience
Decreasing impatience
Do you want $100 today, or $110 1 year from
now?
$100 in 10 years, or $110 in 11 years?
Decreasing impatience
Intertemporal choices often exhibit decreasing
impatience: more patient in the long run than in
the short run
Other names: present bias; myopia; hyperbolic
discounting
But how does it really work? ....it's quite simple actually. The SnzNLz uses the very
complex psychological phenomemon known as 'HATRED'. Basically it's human nature
to wish harm upon your enemies. Similarly, it's human nature not to give your enemies
gobs of cash so that they can grow big and dominate the world with their totally wrong,
stupid and invalid point of view... That's why every time you hit the snooze button, the
SnzNLz will donate a specified amount of your real money to a non-profit you hate.
The problem of sleeping in is solved.
EXTRA SLIDES
Gains
Losses
Hi P
(Certainty effect)
Hi P
(Certainty effect)
Gains
Fear of disappointment
Risk aversion
LIKE SURE GAINS
($900) > ($1,000, .9)
Accept unfavorable settlement
Losses
How do we choose?
Choice conflict
Proliferation of alternatives
A US supermarket
6 jams on
display:
24 jams on
display:
30% bought
one
3% bought one
6 jams on
display:
24 jams on
display:
30% bought
one
3% bought one
6 jams on
display:
24 jams on
display:
30% bought
one
3% bought one
Temporal discounting
Choosing 100 today over 110 next month is
discounting the future (declines sharply with time)
Discounting declines with magnitude of choice:
$10 today* vs. $15 in one year
$1000 today vs. $1500 in one year*