Thinking and Decision Making
D. Risky Choice Tasks
Prospect Theory
Prospect Theory psychological extension of expected utility theory by Kahneman and Tversky (1979) outcomes are evaluated as deviations from a reference point risk aversion for perceived gains; risk seeking for perceived losses; loss aversion (“losses loom larger”)
Risk Attitudes Prospect theory predicts concave risk attitudes in domain of gains (i.e., risk aversion) and convex risk attitudes in domain of losses (i.e., risk seeking).
REFERENCE POINTS (Prospect Theory)
REFERENCE POINTS: EXPECTATIONS & “EXPERIENCE”
CERTAINTY EFFECT
Concluding Remarks: FRAMING
Mental Accounting
Imagine that you have decided to go to a play where the admission price is $40 per ticket. Just before entering the theatre, you discover that you have lost the ticket. The seat was marked and the ticket is not replaceable. Would you buy a new ticket for $40 (assuming that you have the money? Imagine that you have decided to go to a play where the admission price is $40 per ticket. Upon opening your wallet to pay for your ticket, you discover that you have lost $40 dollars in cash. Would you still pay $40 to see the play (assuming that you have the money)?
Opportunity costs and the “endowment effect” Underweighting of opportunity costs= endowment effect. * Tax cut= “Gain” or “Less of a loss”? * Credit card surcharge versus cash discount. Sunk costs Sunk cost effect= paying for the right to use a good or service will increase the rate at which the good/service will be used. * Snowstorm ballgame example * Tennis club membership/multipart pricing * Commitment to prior decisions (e.g., Vietnam War)
Ambiguity Avoidance
Ellsberg’s Paradox Imagine an urn known to contain 90 balls. Thirty of the balls are red, the remaining 60 are black and yellow in unknown proportions. One ball is to be drawn at random from the urn. Consider the following actions and payoffs: Situation X 30 60 Red Black Yellow Act 1. Bet on red $100 $0 $0 Act 2. Bet on black $0 $100 $0 Situation Y Act 3. Bet on red or yellow $100 $0 $100 Act 4. Bet on black or yellow $0 $100 $100
Omission vs. Commission Effect
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