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Prospect Theory (Value Function (Value is defined by gains and losses…
Prospect Theory
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Decision weights
Overweight low prob events: examples easy to recall, recent
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Certainty effect: people overweight certain outcomes vs probable ones. We tend to be less sensitivity to changes in probability in the middle of the range than changes that move us from probability to certainty
Key Aspects
1) People sometimes exhibit risk aversion and sometimes exhibit risk seeking, depending on the nature of the prospect
2) People's valuations of prospects depend on gains and losses relative to a reference point. This reference point is usually the status quo
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Decision makers choose reference point and whether an outcome is perceived as positive or negative will depend on the reference point selected.
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If you segregate, always go back to ref point. if you integrate then you move up or down value function
Break even effect: take more risk after a loss in order to try get back to even. Path dependent behaviour
House money effect: after winning a big profit from house, gamblers increase the stakes and the risk they take. Suggests reduced risk aversion after an initial gain (not seen in prospect theory)
Endowment effect: people often demand much more to give up an item than they would pay to acquire it
