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EC4394 L2
Outline
Review of expected utility
Prospect theory
Value function
Experimental Evidence
Expected utility vs Prospect theory
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1
4
Mean: U=
2+
4+
1 + 1 + 1 + = +
1
8
8+=
But you will not pay a large amount for the game
Mean is not a good measure of utility
Expected utility: () = , U=
1
4
1
8
1
2
ln2 +
ln4 +
ln8 + =
+
[ =1( )] 2 = 22
2
Expected Utility
A lottery specifies the probability for each prize.
= (, ; , 1 ), occurs with probability
and occurs with probability 1 .
The expected utility that represents the decision
maker - DMs preference would be U =
+ 1 , where () and () is
utility for and .
Note that is the utility function over lottery,
while is the utility over outcome/money. Thus,
the preference over lottery solely depends on
function
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Risk Aversion
DM is risk averse if she prefers the mean of
the gamble over the gamble.
DM is risk averse if u is concave.
( + (1 )) () + (1 )() for
any , , and [0,1]; OR (x)0
An Example
= ($100, 0.5; 0, 0.5)
The mean of the lottery is $50
If u() = 0.5 ,
The expected utility of the lottery is U() =
0.5(1000.5 )+0.5(00.5 )=5
The expected utility of $50 is
50 = 50 = 500.5
50 > U , so DM prefers $50 over the lottery
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An Example
If 50 100, 0.5; 0, 0.5 , independence implies
50, 0.02; 0, 0.98 100, 0.01; 0, 0.99 .
Why? = 50, = 100, 0.5; 0, 0.5 , R = 0, and
= 0.02
+ (1 ) = 50, 0.02; 0, 0.98
+ 1 = 100, 0.01; 0, 0.99 .
Expectation: ( , ; ; , )
= ( ) + + ( )
1
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Asset Integration
In addition to whatever you own, you have
been given 1,000. You are now asked to choose
between A1: (1,000, 0.5), and B1: (500)
Most people would choose: 1 1
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Asset Integration
(1) = 0.5( + 1000 + 1000) + 0.5( + 1000)
= 0.5 + 2000 + 0.5 + 1000
1 = + 1000 + 500 = + 1500
(2) = 0.5( + 2000 1000) + 0.5( + 2000)
= 0.5 + 1000 + 0.5 + 2000
(2) = ( + 2000 500) = ( + 1500)
Expected utility with asset integration could not account
for the observation.
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Reference Dependence
1/22/2015
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Reference Dependence
Consider the following example
Ice water in left hand bowl; hot water in right
hand bowl; room temperature in the middle bowl.
Immerse left hand in left bowl, and right hand in
right bowl.
And then dip both hand in the middle.
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Reference Dependence
DM separates gain and loss relative to a
reference point without asset integration
1 = 0.5 1000 + 0.5 0 , and (1) =
(500)
2 = 0.5 0 + 0.5 1000 , and
2 = 500
We could have both 1 1 and 2 2 given
some function.
1/22/2015
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Risk Aversion
You are asked to choose between A1: (3,000)
and B1:(4,000,0.8).
Most people choose A1 B1, risk averse in the
gain domain
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Diminishing Sensitivity
Principle of diminishing sensitivity applies to
sensory dimensions (Weber-Fechner law).
Turning on a weak light in a dark room versus
turning on a weak light in a bright room
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Loss Aversion
You are asked to choose between A1: 0 and
B1: 100, 0.5; 100, 0.5
Most people choose A1 B1, risk averse across
gain and loss domain
0.5(100) + 0.5(100) < (0) = 0
=> (100) < (100)
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Loss Aversion
0.5 + 0.5 < 0
=> () < ()
Loss looms larger than gain.
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Valuation Function
Gain/loss relative to reference dependence
Diminishing sensitivity towards gain and loss
Loss aversion (Loss looms larger than gain)
Reference
point
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Sensitivity to probability
Russian roulette: a potentially lethal game of
chance in which a player places n bullets in a
revolver (full with 6 bullets), spins the cylinder,
places the muzzle against his or her head, and
pulls the trigger. What is your willingness to pay
for each of the reduction of bullets as follows.
6 to 5 (From sure to 5/6 chance)
3 to 2
1 to 0 (From 1/6 chance to impossible)
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22
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0.45
0.90
<
3000
6000
<
0.001
0.002
Subproportionality:
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<
25
26
1-33 (0.33)
2500
34 (0.01)
0
35-100 (0.66)
2400
Gamble B1
Gamble A2
2400
2500
2400
0
2400
0
Gamble B2
2400
2400
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Subcertainty: + 1 < 1
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< 0.001
If () > 0,
contradiction!
5
5000
> 0.001,
29
5
5000
> 0.001
30
3000
6000
> 0.5,
contradiction!
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Subproportionality
Subcertainty
Overweighting for small p
Subadditivity for small p
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Theory
Editing Phase
Coding
Combination
Cancellation
Simplification
Detection of Dominance
Evaluation Phase
Valuation
Probability Weighting
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Theory
2 or 3 outcomes
N-outcomes
Violation of dominance
What is reference point?
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Earlier Works
Markowitz (1952)
Karmarkar (1978)
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Earlier Works
Columbus is viewed as the discoverer of America, even
though every school child knows that the Americas were
inhabited when he arrived, and that he was not even the
first to have made a round trip, having been preceded by
Vikings and perhaps others. What is important about
Columbus discovery of America is not that it was the
first, but that it was the last. After Columbus, America
was never lost again.
Al Roth
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