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    Presentation Prospect Theory Kahneman and Tversky

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    Ralitsa Aleksandrova
    This document provides an overview of prospect theory, an alternative theory to expected utility theory for how people make decisions under risk and uncertainty. It discusses critiques of expected utility theory, including that people overweight certainty and underweight low probabilities. It then outlines prospect theory, which proposes a value function that is concave for gains and convex for losses, and a weighting function that overweights small probabilities. The document also briefly discusses applications of prospect theory and criticisms of the theory.

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    Presentation Prospect Theory Kahneman and Tversky

    Uploaded by

    Ralitsa Aleksandrova
    375 views31 pages
    This document provides an overview of prospect theory, an alternative theory to expected utility theory for how people make decisions under risk and uncertainty. It discusses critiques of expected utility theory, including that people overweight certainty and underweight low probabilities. It then outlines prospect theory, which proposes a value function that is concave for gains and convex for losses, and a weighting function that overweights small probabilities. The document also briefly discusses applications of prospect theory and criticisms of the theory.

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    This document provides an overview of prospect theory, an alternative theory to expected utility theory for how people make decisions under risk and uncertainty. It discusses critiques of expected utility theory, including that people overweight certainty and underweight low probabilities. It then outlines prospect theory, which proposes a value function that is concave for gains and convex for losses, and a weighting function that overweights small probabilities. The document also briefly discusses applications of prospect theory and criticisms of the theory.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    375 views31 pages

    Presentation Prospect Theory Kahneman and Tversky

    Uploaded by

    Ralitsa Aleksandrova
    This document provides an overview of prospect theory, an alternative theory to expected utility theory for how people make decisions under risk and uncertainty. It discusses critiques of expected utility theory, including that people overweight certainty and underweight low probabilities. It then outlines prospect theory, which proposes a value function that is concave for gains and convex for losses, and a weighting function that overweights small probabilities. The document also briefly discusses applications of prospect theory and criticisms of the theory.

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    At a glance
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    The key takeaways are that prospect theory provides an alternative framework to expected utility theory for decision making under risk by incorporating concepts like reference dependence, loss aversion, and nonlinear probability weighting.

    The limitations of expected utility theory include that it does not account for certainty effect, reflection effect, and people's actual risk preferences in gains vs losses domains.

    Prospect theory differs from expected utility theory in that it incorporates concepts like reference dependence, loss aversion through an S-shaped value function, and nonlinear probability weighting through the weighting function.

    Prospect Theory: An Analysis of

    Decision under Risk

    Source: http://dilbert.com/strips/comic/2000-02-03/

    Yangda Di I6034331
    Ralitsa Sapunova I6128249
    1

    Agenda
    1. Introduction of Expected Utility Theory
    2. Critiques of the Expected Utility Theory
    a. Certainty, probability, and possibility
    b. The reflection effect
    c. Probabilistic insurance
    d. The isolation effect

    3.

    Prospect theory
    a. Phase of editing
    b. Phase of evaluation
    c. The value function
    d. The weighting function

    4. Prospect Theory Applications


    5. Prospect Theory Criticism
    6. Discussion

    Expected utility theory


    Expectation:
    Asset integration: is acceptable at asset position w if and
    only if:
    Risk aversion:

    u is concave(u<0)

    Expected utility theory

    An introduction of risk aversion

    Problem statement

    What are the limitations


    of the expected utility
    theory?

    Critique #1: certainty, probability and


    possibility
    Example: problem#3
    A:( 4000, 80%) , expected utility=3200
    B: (3000, 100%), expected utility=3000

    N=95
    A
    B

    Critique #1: certainty, probability and


    possibility
    Example: problem #4
    A: (4000,80% *0.25=20%) expected utility=800
    B:(3000,100% *0.25=25%) expected utility=750

    N=95
    A
    B

    Critique #1: certainty, probability and


    possibility
    1
    0.8
    0.6
    0.4
    0.2
    0

    B
    A
    problem 3

    problem 4

    Reducing the probability of winning from 1.0 to .25( for B ) has


    a greater effect than the reduction from .8 to .2( for A ). what
    does that imply?
    People overweight certain outcomes relative to possible outcomes
    Choices change if certainty is reduced, most people choose the
    prospect that offers the larger gain

    Critique #1: certainty, probability and


    possibility
    Problem #7
    The probabilities of
    A:(6000,45%) expected utility=2700
    winning are
    b:(3000, 90%) expected utility=2700substantial (.90 and .
    45), and most people
    choose the prospect
    N=95
    where winning is more
    probable.
    A
    B

    Critique #1: certainty, probability and


    possibility

    In this situation
    Problem #8
    where winning is
    A:(6000,0.1%) expected utility=6possible but not
    probable, most
    B:(3000,0.2%) expected utility=6
    people choose
    the prospect that
    N=95
    offers the larger
    A
    B gain.

    Critique #2:the reflection effect

    What happens when the signs of the outcomes are reversed so


    that gains are replaced by losses? What does it imply?

    Critique #2:the reflection effect

    Maximizing gains and minimizing losses


    Certainty effect: risk aversion gain domain, and risk seeking
    loss domain
    People who are usually risk averse in case of gains are ready to
    take risk if faced with a probability of incurring a loss

    Critique #3: probabilistic insurance


    In case of damage, there is a 50% chance that you pay the other half
    of the premium and the insurance company covers all the losses; and
    there is a 50% chance that you get back your insurance payment and
    suffer all the losses.
    According to the EUT, the probabilistic insurance is superior to
    regular insurance.
    However, 80% of the respondents refused to accept the probabilistic
    insurance.

    YES
    NO

    Critique #4: the isolation effect


    Problem #10: In the first stage, there is a probability of 0 .75 to
    end the game without winning anything, and a probability of
    0.25 to move into the second stage. If you reach the second
    stage you have a choice between A: (4,000,80%) and B:
    (3,000,100%).

    Critique #4: the isolation effect


    Problem 3
    problem 10

    problem 4

    N=141

    A
    B

    According to EUT, the preferences of problem 4 and problem 10 are the


    same: (4000,20%) and (3000,25%).
    Nevertheless, people ignored the first stage of the game, whose
    outcomes are shared by both prospects, and considered Problem 10 as a
    choice between (3,000,100%) and (4,000,80%), as in Problem 3.
    15

    Prospect Theory
    An alternative model of individual decision making
    under risk
    unlike expected utility theory which concerns itself with
    how decisions under uncertaintyshouldbe made, prospect
    theory concerns itself with how decisions areactuallymade.
    Montier (2002, p. 20)

    Phase of editing
    Phase of evaluation

    16

    Phase of editing
    Preliminary analysis of the offered prospects
    Coding
    Combination
    Segregation
    Cancellation
    Simplification
    Detection of dominance
    17

    Phase of editing
    Preliminary analysis of the offered prospects
    Coding - Identifying gains and losses based on
    common reference points

    Combination - Combining probabilities associated


    with identical outcomes

    (100$, .2;
    100$*, .1)
    (100$, .3)
    18

    Phase of editing
    Preliminary analysis of the offered prospects
    Segregation Separate out guaranteed outcome
    component

    (100$, .8;
    200$, .2)
    100$ + (100$, .
    2)
    19

    Phase of editing
    Preliminary analysis of the offered prospects
    Cancellation Discarding the common components

    (100$, .2; 50$, .5;


    25$, .3)

    (100$, .2; 40$, .4;


    30$, .4)

    Simplification Rounding probabilities or


    outcomes
    Discarding of extremely unlikely
    outcomes

    20

    Phase of editing
    Preliminary analysis of the offered prospects
    Detection of dominance Rejecting dominated
    options without further evaluation

    (100$, .6; 50$, .


    4)

    (60$, .6; 20$, .4)

    21

    Phase of evaluation
    Regular

    prospect:

    If p+q<1, or x0 y or x0 y

    Strictly positive or negative prospect:


    If p+q=1 and etiehr x>y>0 or x<y<0

    Segregat
    ion
    22

    Phase of evaluation
    When are these formulas equivalent?
    V(x, p; y, q) = (p) (x) + (q) (y)
    V(x, p; y, q) = (y) + (q) [v(x)-v(y)]

    (p)+ (q)
    =1

    23

    The Value Function


    Valu
    e

    Loss
    es

    People think in terms of


    gains and losses
    Reference point

    Gain
    s

    Concave for gains and


    convex for losses
    Steeper in losses than
    in gains

    24

    The Value Function

    diminishing
    sensitivity
    25

    The Weighting Function


    1.
    0

    Decision weight
    (p)

    (p)=p

    Small probabilities
    Availability bias
    Certainty effect

    Stated
    probability p

    1.
    0
    26

    Prospect Theory Applications


    Finance
    Insurance
    Endowment effect
    Other Applications

    27

    Prospect Theory Criticism


    The theory holds for hypothetical choices, but
    does it also hold for real life choices?
    Relatively little guidance on how the reference
    point is determined.
    Endowment effect?
    Less useful in describing the behavior of
    experienced economic actors.

    28

    Discussion
    Do you think certain behavior of your can be
    explained by prospect theory?
    After seeing how your decisions can be
    influenced, would you change your decision making
    process?

    Do you think prospect theory could be essential


    to your career?

    29

    References
    Barberis, N. C. (2013). Thirty Years of Prospect Theory in Economics: A
    Review and Assessment. Journal of Economic Perspectives, 173196.
    Daniel Kahneman, A. T. (1979). Prospect theory: An Analysis of Decision
    under Risk. Econometrica, 263 292.
    Future prospects. (2013, Aug 5th). Retrieved from The Economist:
    http://www.economist.com/blogs/freeexchange/2013/08/prospect-theory-andeconomics
    List, J. A. (2003). Does Market Experience Eliminate Market Anomalies?
    Quarterly Journal of Economics, 4171.
    Montier, J. (2002). Darwin's Mind: The Evolutionary Foundations of
    Heuristics and Biases. Dresdner Kleinwort Wasserstein - Global Equity
    Strategy.
    To have and to hold. (2003, Aug 28th). Retrieved from The Economist:
    http://www.economist.com/node/2021010
    30

    THANK YOU FOR YOUR


    ATTENTION!

    31

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