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Prospect Theory in Wild Evidence from the field

Prospect Theory in Wild Evidence from the field. Colin F. Camerer (1998) 20.1.2014 Aku-Ville Lehtimäki, Eija Weck. Expected Utility Theory vs. Prospect Theory. Expected Utility: Prospect Theory: Overweights small probabilities

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Prospect Theory in Wild Evidence from the field

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  1. ProspectTheory in WildEvidence from the field Colin F. Camerer (1998) 20.1.2014 Aku-Ville Lehtimäki, Eija Weck

  2. Expected Utility Theory vs. Prospect Theory • Expected Utility: • Prospect Theory: • Overweights small probabilities • Weights losses more than gains (compared to reference point)

  3. The Equity Premium • Stock pricing: Too high premium for the risk?

  4. The Equity Premium • Expected Utility: Investors are absurdly risk averse • Prospect Theory: Investors are not averse to the variability of return; they are averse to loss!

  5. The Disposition Effect • Investors hold on to stocks that have lost value

  6. The Disposition Effect • Purchase price of a stock should not matter the decision • Prospect Theory: People hate losses!

  7. Labor supply • Tax drivers’ income target: Driver quits working day when day’s income target is reached. • Means long working hours on bad days!

  8. Labor supply • Would be rationale to work long on good days! • Prospect Theory: Aversion of losing (compared to reference salary) on 1-day horizon!

  9. Asymmetric Price Elasticities of Consumer Goods • Consumers dislike price increases more than they like the gain from price cuts and cut back purchases more when prices rise compared with the extra amount they buy when prices fall.

  10. Asymmetric Price Elasticities of Consumer Goods • Prospect Theory: Consumers compare the price to reference price. They get more disutility from raising prices than extra utility from lower prices!

  11. Savings and Consumption: Insensitivity to Bad News • Workers whose wages for the next year are set in advance: Spent more when their future wages expected to rise but did not cut back when their future wages were cut.

  12. Savings and Consumption: Insensitivity to Bad News • Prospect Theory: The pleasure workers get from consuming in the second period depends on how much they consumed in the first period through the effect of previous consumption on the current reference point!

  13. Status Quo Bias • People tend to prefer status quo. If status quo does not exist, people have exaggerated preference for default choice.

  14. Status Quo Bias • Prospect Theory: People averse losses!

  15. Endowment Effects and Buying-Selling Price Gaps • Valuating a thing that a person has got differs from such person’s valuation that does not have it.

  16. Endowment Effects and Buying-Selling Price Gaps • Prospect theory: People move reluctantly away from status quo due aversion of losses.

  17. Racetrack betting: The favourite-longshot bias • Bias toward betting on ”longshots”, horses with relatively small chance of winning.

  18. Racetrack betting: The favourite-longshot bias • Expected Utility: People have convex utility functions • Prospect Theory: overweighting low probabilities! • Gamblers fallacious belief: It’s due for a win for a horse that has not won for a long time!

  19. Racetrack betting: The end-of-the-day effect • Bettors shift their bets from favourites to longshots later in the racing day.

  20. Racetrack betting: The end-of-the-day effect • Prospect Theory: Small longshot bet can generate a large enough profit to cover one’s earlier losses! (Zero daily profit as a reference point)

  21. State lotteries • The popularity of Lotto

  22. State lotteries • Expected utility theory: Extreme risk takers! • Prospect theory: Overweighting of low probabilities of winning!

  23. Telephone wire repair insurance • When offered an insurance of 0,45 $/month vs. a risk of 60 $ at the expected cost of 0.26, people chose to insure.

  24. Telephone wire repair insurance • Expected utility theory: People are extremely risk averse. • Prospect theory: Overweighting the small probability of damage!

  25. Note: Short perspective • In all these examples it’s necessary to assume people are isolating or narrowly bracketing the relevant decisions. With broader bracketing outcomes are mingled with other gains and losses.

  26. Summary • Loss aversion • Extra return of stocks • Longer hours on low-wage days • Asymmetric reactions on price increases and decreases • Insensitivity of consumption to bad news • Status quo and endowment effects • Reflection effect • Holding losing stocks • Insensitivity of consumption to bad news • Shift toward longshot betting at the end of the day • Overweighting low p • Favourite-longshot bias • Lotto lotteries • Purchase of telephone wire repair insurance

  27. THANK YOU!

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