College 1
Behavioral economics: improve economic analysis by incorporating psychologically more realistic
assumptions about human behavior
‘standard’ assumption: don’t always hold
- Rational
- Behave as planned
- Egoistic
Framing important in behavioral economics
Time preferences: preference changes over time, depends on patience
College 2
Excluding probability triangles
Risk averse: prefer EV of prospect over prospect itself (concave function)
Risk seeking: prefer risky prospect over EV of prospect (convex function)
Risk neutral: indifferent between EV& prospect (linear function)
Risk attitudes are determined by how much extra utility people derive from additional outcomes
Independence axiom: if prospect X preferred to prospect Y, then (p:X,(1-p):Z) preferred over (p:Y, (1-
p):Z) for all p & Z
u( x )' '
Absolute risk aversion: AR ( x )=
u(x )'
u ( x) ' '
Relative risk aversion: RR ( x ) = ∗x
u (x) '
r
RR ( x ) =AR ( x )∗x= ∗x=r
x
Certainty equivalent (CE): certain amount that makes indifferent between prospect and certain
amount
1
( )
macht utility function
CE=E U
Rabin’s paradox: risk averse small stakes implies implausible degree big stakes
Allais paradox: overweight certainty= certainty effect
Disappointment theory:
- Outcome >EV: elation
- Outcome<EV: disappointment
Rank-dependent utility (RDU):
- Overrate small probabilities: optimism
- Underrate large probabilities: pessimism
, RDU steps
1. Rank outcomes from best to worst
2. Probability of outcome itself or better outcome (=q)
3. Probability strictly better outcome (=b)
4. Determine decision weight: π i=w ( q ) + w(b)
5. Transform outcomes by utility function and multiply resulting utility with decision weight
Expected utility reigning normative theory of decision making under risk
College 3
Reference dependence: utility of prospect depends on the reference point: U
Important to study role framing= mental accounting
Cumulative prospect theory (CPT) extends RDU by incorporating reference dependence
Probability weighting: different for gains & losses
- Gains: w+(p)
- Losses: w-(p)
- Both assumed to be inverse S-shaped
o Large probabilities underweighted
Pessimism gains
Optimism losses
o Small probabilities overweighted
Optimism gains
Pessimism losses
Diminishing sensitivity:
- Concave gains: risk aversion
- Convex losses: risk seeking
Loss aversion: ratio left derivative & right derivative. Loss hurts more than gains gives you pleasure
Different utility functions for gains, losses and loss aversion
Disposition effect: sell rising assets to quick and keep losing assets too long
Loss aversion only when both gain& loss possible
Endowment effect: value owned goods higher
WTA-WTP disparity:
- WTA: willing to accept not to have
- WTP: willing to pay
- Disparity: higher valuation under WTA than under WTP
Scale compatibility: importance of one aspect of option is enhanced by compatibility with the
decision a person is asked to make
Behavioral economics: improve economic analysis by incorporating psychologically more realistic
assumptions about human behavior
‘standard’ assumption: don’t always hold
- Rational
- Behave as planned
- Egoistic
Framing important in behavioral economics
Time preferences: preference changes over time, depends on patience
College 2
Excluding probability triangles
Risk averse: prefer EV of prospect over prospect itself (concave function)
Risk seeking: prefer risky prospect over EV of prospect (convex function)
Risk neutral: indifferent between EV& prospect (linear function)
Risk attitudes are determined by how much extra utility people derive from additional outcomes
Independence axiom: if prospect X preferred to prospect Y, then (p:X,(1-p):Z) preferred over (p:Y, (1-
p):Z) for all p & Z
u( x )' '
Absolute risk aversion: AR ( x )=
u(x )'
u ( x) ' '
Relative risk aversion: RR ( x ) = ∗x
u (x) '
r
RR ( x ) =AR ( x )∗x= ∗x=r
x
Certainty equivalent (CE): certain amount that makes indifferent between prospect and certain
amount
1
( )
macht utility function
CE=E U
Rabin’s paradox: risk averse small stakes implies implausible degree big stakes
Allais paradox: overweight certainty= certainty effect
Disappointment theory:
- Outcome >EV: elation
- Outcome<EV: disappointment
Rank-dependent utility (RDU):
- Overrate small probabilities: optimism
- Underrate large probabilities: pessimism
, RDU steps
1. Rank outcomes from best to worst
2. Probability of outcome itself or better outcome (=q)
3. Probability strictly better outcome (=b)
4. Determine decision weight: π i=w ( q ) + w(b)
5. Transform outcomes by utility function and multiply resulting utility with decision weight
Expected utility reigning normative theory of decision making under risk
College 3
Reference dependence: utility of prospect depends on the reference point: U
Important to study role framing= mental accounting
Cumulative prospect theory (CPT) extends RDU by incorporating reference dependence
Probability weighting: different for gains & losses
- Gains: w+(p)
- Losses: w-(p)
- Both assumed to be inverse S-shaped
o Large probabilities underweighted
Pessimism gains
Optimism losses
o Small probabilities overweighted
Optimism gains
Pessimism losses
Diminishing sensitivity:
- Concave gains: risk aversion
- Convex losses: risk seeking
Loss aversion: ratio left derivative & right derivative. Loss hurts more than gains gives you pleasure
Different utility functions for gains, losses and loss aversion
Disposition effect: sell rising assets to quick and keep losing assets too long
Loss aversion only when both gain& loss possible
Endowment effect: value owned goods higher
WTA-WTP disparity:
- WTA: willing to accept not to have
- WTP: willing to pay
- Disparity: higher valuation under WTA than under WTP
Scale compatibility: importance of one aspect of option is enhanced by compatibility with the
decision a person is asked to make
