Behavioural Economics (Spring 2020) : Prospect Theory and Applications Reference-Point Determination Tutorial

Theory Application 1 of PT Application 2 of PT Application 3 of PT Determination of RP Tutorial Literature
23005 Behavioural Economics

(Spring 2020)
Lecture III
Prospect Theory and Applications
Reference-Point Determination
Tutorial
Andrea Giovannetti
andrea.giovannetti@uts.edu.au
Office Hour: Friday (10:30-11:30) / Zoom appointment:
8712136666 1 / 49
Battleplan:
1. Prospect Theory
2. Applications
3. Theory of Reference-Point Determination1
4. Tutorial with Luz: PT in practice
1
Reference: Economics for Neuroscientists 2010 by Botond Köszegi
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Prospect Theory
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Who got the silver medal? Who got bronze medal?
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How far is the target from the sniper?
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◦ Kahneman and Tversky (1979) challenged EUT by introducing a new evidence-driven

theory called Prospect Theory (PT) which can reconcile the above anomalies
◦ People evaluate their utility of a prospect (outcome 1, P1 ; ...; outcome n, Pn ) by two
distinct phases: an Editing Phase, and the subsequent Evaluation Phase
◦ The Editing Phase has 4 ingredients:

1. Coding: People perceive outcomes as either gains or losses, relative to some
neutral reference position. The reference point usually is current asset position,
but it may be some status quo or expectation of agent.
2. Combination: Prospects can be simplified by combining probabilities for identical
outcomes: (0, .50; 200, .25; 200, .25) will just become (0, .50; 200, .50)
3. Segregation: Riskless components are segregated out from risky components.
For example (300, .80; 200, .20) corresponds to a guaranteed 200 and then a
gamble of (100.80)
4. Cancellation: Components that are shared by two prospects are ignored.
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Evaluation Phase
Ingredients: (1) non-linear outcome-weighting function, (2) Reference-dependent
value-function
Non-Linear Outcome-Weighting Function:
◦ We know that under EUT, the utility of a risky outcome (i.e. a prospect) is linear in
expectation.
◦ Instead, in PT the decision maker does not weigh probabilities linearly but instead
attaches a decision weight w(P ) to each probability.
E [U ] = w(P1 ) · U (s1 ) + w(P2 ) · U (s2 ) + ... + w(Pn ) · U (sn )

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Reference-Dependent Value-Function
◦ The second ingredient of Valuation is the Value Function. Kahneman and Tversky
propose a different approach to the evaluation of outcomes
◦ The value function of PT is defined on changes in wealth or welfare, rather than on final
wealth levels as in EU.
Properties of PT value function:
1. Gains and losses are defined relative to a reference point
Utility from an outcome depends on reddistance from the relevant reference point:
multi-millionaires can dislike a 550 − 500 bet (if the reference point is close to their initial
wealth w0 )
Reference point can be current wealth, a social or psychological status quo, an
expectation about the outcome, etc. (!)
2. Perceptions of both gains and losses are characterized by diminishing marginal
sensitivity in either direction. Successive incremental changes have a smaller and
smaller marginal impact
→ Intuition: we are more sensitive in comparing a loss from 10000$ to 20000$ than from
20000$ to 30000$.
This is deceptively similar to decreasing marginal utility to wealth of EUT. The two
differ in the baseline evaluation. In EUT, the starting value is total wealth. In PT, the
reference point
3. Loss aversion Losses hit larger than gains. The aggravation that one experiences from
losing a sum of money is greater than the pleasure associated with gaining the same
amount
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1. The Value Function is defined upon the variation from a reference point
2. There’s a kink at the origin: losses count always more than gains regardless to initial r.p.
3. Diminishing Sensitivity to further changes from reference points
2 + 3 = determine the shape of of Value Function
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Applications of Prospect Theory
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How we will proceed:

◦ We already seen by example that the non-linear probability weighting can explain
important features of human behaviour under risk (e.g. Allais’ paradox!)
◦ We will look at 3 papers focused on empirical phenomena which can be explained with
the second component of PT: the value function
◦ For framing-in the theory, we need to understand:
1. What is the domain subject to reference-dependent evaluation (i.e. the
dimension in the x−axis of the value function)
2. What is the reference point? (i.e. the origin of the value function)
◦ This is a mental exercise which allows us to frame the theory and appreciate its merits
and weaknesses
→ In particular the lack of unique answers
This, as researchers, can make us feel really uncomfortable
and prefer to go for the standard EUT....
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Reference Dependent Preferences and Labor Supply
◦ What do this firms have in common? (apart from consistent tax avoidance and sexist managers)
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Reference Dependent Preferences and Labor Supply
◦ What do this firms have in common? (apart from consistent tax avoidance and sexist managers)
◦ In this business model workers choose how many hours they work every day.
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Lots of people are involved in the Gig Economy

Features: 1) free time allocation 2) Workers can experience frequent temporary
changes in hourly wage
◦ For managers, unions and workers there’s a fundamental set of questions to be
addressed:
I How do workers self organize their working shifts when they are left free to do so?
I What is the relevant dimension considered by workers in solving the problem
above?
◦ In terms of public policies, policy-makers have to understand how (hourly) labor supply
reacts to wage rates and income levels
Innocent HP: Even in the sharing economy, one might expect a positive relationship (or
no relationship) between wages and hours. However, think of the following example:
Example: Suppose a Uber driver in Melbourne nowadays earns $5/hr on Day 1 and
$10/hr on Day 2 (x2 delivery / hour)
(A) 8 hours on both days makes $120.
(B) 9 and 6 makes $105 ( suboptimal!)
(C) 6 and 9 is fewer hours of work, and still makes $120!!.
How do worker pick the optimal number of hours?
This question is important! What if incentives work in unpredictable way?
(e.g. Melbourne municipality raises Uber rates to incentivize drivers to bring more patients to hospital to test for
covid but as a result less drivers are available....)
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Camerer, Babcock, Loewenstein and Thaler (1997) study the labor supply of New York
City cab drivers.
◦ The typical cab driver rents their cab for a 12-hour period for a fixed fee. Within this
12-hour window, a driver can choose hours freely.
◦ Controversal finding: hours are negatively related to wages.
◦ For many random reasons (weather, subway breakdowns, conferences, and so on) a
cab driver’s wage can vary quite a bit.
→ Hence the supply of hours can be affected
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◦ Correlations between log hours and log wages (i.e. the elasticities) in various groups:
between -0.503 and -0.269:
◦ Thus drivers work less on days when the wage is high.
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The explanation they provide: drivers’ evaluation of daily income is

reference-dependent2
◦ Camerer et al. informally proposed a model in which drivers have daily income targets
and work until the target is reached.
Each cab’s driver solves3 :
(
h2

Y − R, if Y ≥ R
max V = U (Y (h)) − θ U (Y ) =
h 2 λ(Y − R), if Y < R
◦ In which h is hours worked per day, w is hourly salary, Y = wh is daily wage

◦ The reference point is some reasonable daily income target R.
◦ Loss aversion λ implies that it might make sense for drivers often stop at the daily
income target.
◦ A driver with a higher wage reaches his target faster, so he works fewer hours.
◦ Notice that with λ = 1 the model collapses to a simple neo-classical maximization
problem
2
A short description of the model is contained in DellaVigna paper available on blackboard (pag. 14)
3
This specification of V is called ”linear-quadratic”. It’s very handy becauses it generates a simple optimum and contains
a neat economic interpretation: utility grows linearly in money and decreases convexly in some ”untangible” θ (e.g. effort)
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◦ First, consider the case: Y = wh ≥ R → w > (R/h)
h2
( )
dV ∗ w
max (wh − R) − θ → = 0 → w − θh → h =
h 2 dh θ
By substituting h∗ in the threshold:

√
w ≥ (R/h) → w > (R/(w/θ)) → w > Rθ
◦ Consider instead the case: Y = wh < R → w < (R/h)
h2
( )
dV ∗ λw
max λ(wh − R) − θ → = 0 → λw − θh → h =
h 2 dh θ
By substituting h∗ in the threshold:

s
Rθ
w < (R/h) → w < (R/(λw/θ)) → w <
λ
◦ Lastly, consider Y = wh = R → w = (R/h)
Here, we can’t rely on standard optimization methods because the value function is not concave (i.e. doesn’t have a
max: Y = R implies U (Y ) = 0 and only the negative component of the value function remains, hence the optimal
solution signals h = 0, which is clearly non-sense. However, when Y = R the optimal rule is simply provided by the
equality:
∗
Y = R → hw = R → h = R/w
q
Rθ
√
◦ Hence, for w in between λ
and Rθ, workers keep Y fixed. If w ↑ they will simply h ↓.
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Simulations of Camerer et al. 1997

◦ Matlab Code: (example: w = 1)
theta = 0.3;
w = 1;
R = 100;
lambda = 4 ;
f o r h = 1:50
i f w.∗ h − R > 0
U( h ) = (w.∗ h − R ) ;
else
U( h ) = lambda . ∗ (w.∗ h − R ) ;
end
c o s t ( h ) = ( 1 / 2 ) . ∗ t h e t a .∗ h ˆ 2 ;
v ( h ) = U( h ) − c o s t ( h ) ;
end
◦ In the next slide I am going to simulate the model of the previous slide for various values
of w : 1, 2, 3, 4, 5, 10
◦ According
p to the theory, we know √ that optimal hours should increase for
w < Rθ/λ = 2.74 and w > Rθ = 5.48. We expect optimal hours to decrease for w
in between.
◦ Graph in next slides: X-axis is hours, Y-axis is costs (yellow line), U (Y (h)) (blue line)
and V (Y (h)) (red line)
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W =1
Max at h ≈ 13
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W =2
Max at h ≈ 27
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W =3
Max at h ≈ 34
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W =4
Max at h ≈ 25
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W =5
Max at h ≈ 20
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W =10
Max at h ≈ 35
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◦ Farber (2005) studied a new set of NYC cabdrivers

◦ To address the measurement errors of Camerer et al. he uses a more sophisticated
model:
I Instead of estimating log(h) = f (log(Y /h)), he estimates the probability of
stopping given the cumulative hours.
I This avoids the so called ”division bias4 ” which would artificially down-bias the
regressor estimates.
◦ Before controlling for driver fixed effects, the probability of stopping work is significantly
related to income realized on a given day
◦ But: driver fixed effects and other controls render this effect statistically insignificant
◦ Farber (2008) estimated a structural model with explicit reference-dependent targets

◦ He estimated driver’ targets as latent variables
◦ He found that his income-targeting model has a better fit than a standard neoclassical
model.
◦ The estimated probability of stopping increases significantly and substantially once the
income target is reached.
4
Camerer uses a log-log regression log(h) = f (log(w)). Problem: they don’t have w. They only have Y and h, so
they actually estimate log(h) = f (log(Y /h)). If h is noisy, estimators are down-biased due to the log specification. To see
it, imagine h = h̃ × in which is noise, then
log(h) = f (log(Y /h)) = f (log(Y /(h̃ × ))) = f (log(Y /(h̃)) − log()) due to log properties. Drop in office hour if
you are interested in a more granular explanation.
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However:
1. The random effects in drivers targets have too high variance: income targets are too
unstable/imprecise for reference-dependent model.
2. The model does not distinguish anticipated, permanent from transitory wage
increases.
This is an important distinction: hard to believe that an anticipated increase reduces
labor supply!
3. Other studies of workers who choose their own hours have found positive relationships
between expected earnings and labor supply.
3.1 stadium vendors go to work on days when their wage can be expected to be
higher (Oettinger)
3.2 bicycle messengers sign up for more shifts when their commissions are
increased (Fehr and Goette)
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Some alternative hypotheses:

1. Liquidity constraints: maybe drivers have some fixed daily expenses that they have to
meet from their income that day.
I But drivers who own a medallion exhibit the same pattern of behavior.
2. Fatigue: if its more tiring to drive on high-wage days, its natural for drivers for drivers to
stop early.
I But drivers say its easier to drive when there are more passengers.
3. Endogeneity:
There’s one thing that this paper couldn’t rule out completely: that w increases due
to labor supply shocks, not due demand shock!
Suppose it’s Christmas (or alternatively, that one day all cab drivers catch the flu).
Then, fewer drivers will work, and those who do will work fewer hours.
→ And those who work get higher wages!
If the above is true: h determines w (and not the other way around) therefore Farber’s
(and Camerer’s) model fails.
Farber’s failure prompts out a central question: how are reference points (if exist)
determined?
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◦ What is the reference-dependence domain in Camerer’s paper?
◦ What’s the reference point?
◦ What ingredient of the value function is relevant for this story and how?
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◦ What is the reference-dependence domain in Camerer’s paper?

◦ Daily income.
◦ What’s the reference point?
◦ A total daily earning built upon an expectation
◦ Loss aversion keeps drivers pushing up (and not above) their reference daily income
Taxi drivers decide to stop working after reaching the target because after comparing
the cost of renting the taxi against the gains generated by booking an additional slot, they
find out that potential profits are not worth the costs. If we assume a risky framework in
which gains are uncertain and costs instead are certain, we can speculate that taxi
drivers prefer a sure (yet limited) gain against a risky bet provided they secured their
reference target. On the other hand, Reference-dependent preferences imply that if taxi
drivers don’t get to the reference point, they will do whatever is possible (i.e. take the
bet of booking an additional slot) in order to get to their reference point.
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Wage Determination and Productivity

Motivation: We know that (M PL ≈ wage) is key in multiple dimensions (e.g. economic
growth, international trade).
Standard story: demand = supply, workers earn more if they are more productive with
respect to other production inputs
Reality shows the relation goes also the other way around: if workers receive less
than what they consider a fair amount, they adjust productivity:
”... I am working with the feeling

That the company is stealing
Fifty pennies from my pocket every day;
But for every single penny
They will lose ten times as many
By the speed that I’m producing, I dare say.”
(from Akerlof and Yellen, 1990)
◦ In market economy $ is a proxy for status

◦ In non-market economies (i.e. no wage bargaining) status is obtained with targeted
propaganda.
◦ The comprehension of the relation productivity / wages has explosive policy implications:
we can booster productivity with the right set of psychological incentives
◦ In order to do so we need to understand the mechanics of wage negotiation
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◦ Mas (2006) study the wage bargaining between New Jersey police (the employee) and
N.J. municipalities (the employer)
◦ In the 9 percent of cases in which the police and the municipality do not reach an
agreement, the contract is determined by final offer arbitration. The police and the
municipality submit their offers to the arbitrator, who has to choose one of the two offers.
◦ Mas looks at how police pay affects performance for 383 arbitration cases from 1978 to
1995.
◦ Each arbitration is a big thing: it affects several hundreds of (organized) workers.
Generates local media debate, involves unions, etc.
◦ Main result: in the cases in which the employer’s offer is chosen, the share of crimes
solved by the police (i.e. ”the clearance rate”) decreases by 12 percent compared to the
cases in which the police offer is chosen. The author also reports a smaller increase in
crime (!)
◦ Lower than expected pay therefore induces the police to devote less effort to fighting
crime.
◦ Second result: Mas shows that the clearance rate responds differently depending on
whether the police gains or loose from bargaining with municipality
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◦ What is the reference-dependance domain?
◦ Whats the reference point?
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◦ What is the reference-dependance domain?

◦ Wages.
◦ Whats the reference point?
◦ An expectation over fair wages
◦ Loss aversion explains the dual response of police efficiency. Losses implied by a
wage downturn produce a greater psychological effect than unions succeeding in getting
better conditions.
◦ Being a cop is a risky job. We could speculate a reinforcing effect between loss aversion
and salary
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The Disposition Effect

◦ Odean (1998) acquired data on 10.000 customer accounts at a nationwide discount
brokerage house.
◦ He constructs a measure of how often investors realize losses and gains relative to their
opportunities to do so.
◦ On any sale date, he counts the number of losers and winners.
◦ Among these, he counts the realized losses and the realized gains.
◦ He defines the proportion of losses realized and the proportion of gains realized (PGR)
as:
realized losses realized gains

P LR = P LG =
realized losses + unsold losses realized gains + unsold gains
Definition: The disposition effect is the tendency to sell winners and hold on to losers
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Key Findings:
Entire Year December Jan-Nov
PLR 0.098 0.128 0.094
PGR 0.148 0.108 0.152
Difference -0.050 0.020 -0.058
t-stat -35 4.3 -38
◦ A similar mechanism has been observed in the housing market (Genesove and Mayer 2001).
◦ Investors’ evaluation of the stock’s sale price is reference-dependent.
◦ What is the reference point here?
◦ What features of the value function are relevant for this application?
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Key Findings:
Entire Year December Jan-Nov
PLR 0.098 0.128 0.094
PGR 0.148 0.108 0.152
Difference -0.050 0.020 -0.058
t-stat -35 4.3 -38
◦ A similar mechanism has been observed in the housing market (Genesove and Mayer 2001).
◦ Investors’ evaluation of the stock’s sale price is reference-dependent.
◦ What is the reference point here?

The reference point is the purchase price.
◦ What features of the value function are relevant for this application?
Loss Aversion: We enjoy to realize a profit and suffer in selling a loser, yet the latter effect dominates the former.
Diminishing Sensitivity: individuals are willing to take more risks with losing stocks than with winning stocks. (See
Figure 2)
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◦ Indeed traders have a different explanation for such tendency

◦ A standard alternative route: traders (inefficiently) try to ”buy fear, sell greed”. Strong
belief in mean reversion and consequent use of horrible martingale strategies (i.e. try
to ”buy the depth” of market, in floors lingo ) which partially account for the observation
on long VIX trading discussed in previous class.
◦ Also tax incentives should be considered: Losses are tax deductible. From Figure 2:
traders hold sub performing stocks too long (in fact the ratio PGR/PLR drops below 1,
meaning they keep winners longer than losers, only in the proximity of the end of fiscal
year)
◦ But how about Liquidity constraints? Transaction fees? Margins?
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Disposition effect in lab

◦ To address the above criticism Weber and Camerer experimentally test mean-reversion
v.s. prospect theory as an explanation for disposition effect. They set up an
experimental stock market, and have subjects buy and sell stocks.
◦ As expected, subjects exhibit symptoms of disposition effect as in Odean’s data.
◦ However, Weber and Camerer include a twist: sometimes, a subject’s holding of a stock
is randomly liquidated.
◦ If subjects believed in mean-reversion (i.e a loser is more likely to go up than other
stocks), they should repurchase a losing stock that’s randomly liquidated.
◦ Subjects do not repurchase, indicating that the disposition effect is more likely due to
prospect theory.
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Theories on the determination of the Reference Point
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◦ The reference-dependent machinery introduced so far hinges upon the determination

of the reference point.
◦ In many contexts we can identify easily the reference point.
◦ Unfortunately, this is not always the case. Example: dynamic contexts such as in the taxi
cab case
◦ Five candidate theories has been advanced to help the identification of the reference
point in a more general and less ad-hoc way.
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1) Status Quo: The original assumption in PT was that the reference point is the status
quo or the endowment.
I Definition: Status quo implies a preference for the current state (the status) and
any change is perceived as a loss. It is a static theory
I Advantage 1: Straightforward implementation: grounded on descriptive narrative
of current reality.
I Advantage 2: Has power in isolated contexts (i.e. lab experiments)
I However, it looks artificial for most economic interactions:

I Suppose you decide to post an adv on gumtree for selling your mug. Do you
see the foregoing of the mug as a loss (and price as a compensation)?
I Suppose you repeatedly trade the mug: would the psychological effect
wash out as you learn trading?
I For markets in which intangible and perfectly fungible goods are exchanged
(e.g. stock market) the hp. does not make much sense.
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2) Lagged Consumption: Attempts to introduce adaptation in the above theory.

◦ Adaptation captures a common trait of our internal decision machinery:
1. We react to shocks when shocks realize
2. The effect of any shock fades in time (i.e. we get used to it)
◦ Example: Imagine you win the Tuesday Jackpot.
I How do you feel one week after the lucky draw? Your reference point is a function
of your lagged consumption (pizza? Netflix?). Anything above that level makes
you happy
I How do you feel one year after the lucky draw? Now your reference point is likely
to be a function of a Jaquet-Droz Bird Repeater (> $850.000). Unlikely you will
experience positive shocks given your recent consumption.
◦ On a macro scale, the theory is useful to give account of two regularities: (1) The time
path of happiness changes along our life (2) The relation between happiness and GDP
in nations across the world is non-univocal
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That is to say we compare ourselves with our previous self and with others
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3) Social Preferences:
◦ People compare their outcomes to those of others around them
◦ Controlling for their own income, hours of work, etc., peoples happiness is decreasing
in the income of those working in similar jobs.
◦ Increases in a country’s income do not lead to significant increases in life satisfaction
levels, while within a country those who make more are happier.
◦ Neumark and Postlewaite (1998) provide evidence suggesting that social comparisons
affect the labor-supply decisions of women.
→ Controlling for economic circumstances, a woman is more likely to work if her
sister’s husband makes more than her own husband.
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4) Goals and Aspirations:

◦ Self-Discrepancy theory (Higgins, 1987)
◦ Originates from psychological research in the field of belief-incongruity
Definition: Internal disagreement causes emotional and psychological turmoil

Ideal self and ought self act as self guides with which the actual self aspires to be
aligned.
◦ The Ideal self represents hopes and wishes

I Falling short of ”ideal self” results in dejection-related emotions → reaction.
◦ The Ought self is determined through obligation and sense of duty

I Falling short of ”ought self” results in anxiety-related emotions → reaction.
◦ Shortfall of this approach: Psychological Hp. Difficult to metricize and gives rise to
incoherent literature
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5) Recent Expectations:
◦ In this approach, the reference point for evaluating an outcome is recent expectations on
the outcome (Köszegi and Rabin (2006,2007,2009) )
◦ The expectations-based theory can produce the same predictions of alternative theories
1. vs. status-quo / recent consumption: if expectations remain stable → recent
expectations = status quo / lagged consumption.
2. vs. Aspirations We only set goals we may be aware of
3. vs. Social Theory Individuals’ expectations are built upon others’ outcomes
However: Recent Expectation theory can encompass facts which other theories fail to
explain
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The Endowment Effect Revisited

◦ In the mugs experiment we observed a large gap between WTP and WTA
◦ The endowment effect contradicts widespread evidence of fluid / tight markets
◦ List (2003) studied the effect of endowment effect with experienced traders.
◦ He assigned to a group of sports-card traders one of two sports cards in exchange for
their participation in a survey.
◦ He then offered an exchange for the other card.
◦ Albeit the endowment effect predicts that very few traders should switch, ≈ 50% of the
traders switched.
◦ Recent Expectation theory can explain this: experienced traders don’t attach personal
value on items they expect to trade precisely because they expect to trade the cards
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Tutorial
Prospect Theory in Practice
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Example I
◦ Max has reference dependent preferences on money. We call the realized outcome in
money m and his reference point rm . Max’s utility is given by:

x for x ≥ 0
V (m − rm ) in which V (x) =
2x for x < 0
◦ Assume Max holds no money.

◦ A closer look into the psychological features captured with V (x): we expect Max to be
loss averse (why?) but with no decreased sensitivity over variations (why?)
Problem
◦ Assume Max signed up for an economics experiment after his friend Alvin told him
participants will receive $10
◦ Consider two alternative mind-frames: (m.1) Max is skeptical (r1 = m1 = 0), (m.2)
Max is enthusiast (r1 = $10).
◦ Max arrives at the experiment and it turns out that a $8 show-up fee is paid by the
experimenters.
Q.1 Compute Max’s utility under mind frames (1), (2) and state which mind frame yields
higher utility.
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Example I
◦ Max has reference dependent preferences on money. We call the realized outcome in
money m and his reference point rm . Max’s utility is given by:

x for x ≥ 0
V (m − rm ) in which V (x) =
2x for x < 0
◦ Assume Max holds no money.

◦ A closer look into the psychological features captured with V (x): we expect Max to be
loss averse (why?) but with no decreased sensitivity over variations (why?)
Problem
◦ Assume Max signed up for an economics experiment after his friend Alvin told him
participants will receive $10
◦ Consider two alternative mind-frames: (m.1) Max is skeptical (r1 = m1 = 0), (m.2)
Max is enthusiast (r1 = $10).
◦ Max arrives at the experiment and it turns out that a $8 show-up fee is paid by the
experimenters.
Q.1 Compute Max’s utility under mind frames (1), (2) and state which mind frame yields
higher utility.
Solution Q.1
(m.1) V (x) = V (8 − 0) = 8 (m.2)V (8 − 10) = 2 · (−2) = −4
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◦ Assume Max enters the experiment’s room and he is given a mug. Max’s value function
over money and mugs is given by:
V (m − rm ) + V (5 · c − 5 · rc )
◦ Q.2 For (m.1): (i) write down Max’s (2-dimension) new reference point; and (ii) solve for
the price pc that makes him indifferent between keeping his mug and receiving nothing
and giving up his mug and getting pS c.
◦ Q.3 (i) Assume instead Max gets no mug. For (m.1): solve for the price pB
c that makes
him indifferent between not having a mug and purchasing one (ii) Draw your conclusion
about the gap.
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V (m − rm ) + V (5 · c − 5 · rc )
Solution Q.2
V (8−0+pS S S
c )+V (5·0−5·1) = V (8−0)+V (5c−5c) → (8+pc )−10 = 8 → pc = 10
c that makes
about the gap.
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V (m − rm ) + V (5 · c − 5 · rc )
Solution Q.2
V (8−0+pS S S
c )+V (5·0−5·1) = V (8−0)+V (5c−5c) → (8+pc )−10 = 8 → pc = 10
c that makes
about the gap.
Solution Q.3
V (8 − 0 − pB B B
c ) + V (5 − 0) = V (8 − 0) + V (0 − 0) → 8 − pc + 5 = 8 → pc = 5
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Q.2: proof
◦ Solution to Q.2: Skeptical Max’s reference point is bi-dimensional, that is r = (rm , rc ) = (0, 1). We now want to
compare two different prospects:
(1) Max keeps the mug he received. (2) Max sells the mug. We want that the price he receives for the mug in prospect
(2) equalizes the utilities of the two prospects, that is we are after the pS
c such that (1) = (2).
◦ Hence, we first characterize (1) and (2) and then find the price which equalizes (1) and (2).
◦ Determination of (1):
U (keep) = U (m = 8, c = 1) given r = (0, 1)

U (8, 1) = V (8 − 0) + V (1 · 5 − 1 · 5)
| {z } | {z }
utility from unexpected show up fee utility from holding the mug
U (8, 1) = 8
◦ Now we determine (2)
S
U (sell) = U (m = (8 + pc ), c = 0) given r = (0, 1)
S S
U (8 + pc , 0) = V ((8 − 0) + pc ) + V (0 · 5 − 1 · 5)
| {z } | {z }
utility from unexpected show up prize + pS pain from giving away the mug
c
S
U (8, 0) = (8 + pc ) −2×5
◦ Price which achieves equalization of (1) and (2) is obtained by comparing the two prospects:
U (keeping the mug) = U (selling the mug)

S
8 = 8 + pc − 10
S
pc = 10
47 / 49
Q.3: proof
◦ Solution to Q.3: This time we assumed Max received no mug in first place. Therefore, the reference point now is:
r = (rm , rc ) = (0, 0). Now want to compare two different prospects:
(1) Max stays with no mug. (2) Max buys the mug. We want that the price he pays for the mug in prospect (2)
equalizes the utilities of the two prospects, that is we are after the pB
c such that (1) = (2).
◦ Hence, we first characterize (1) and (2) and then find the price which equalizes (1) and (2).
◦ Determination of (1):
U (no mug) = U (m = 8, c = 0) given r = (0, 0)
U (8, 0) = V (8 − 0) + V (0 · 5 − 0 · 5)
| {z } | {z }
utility from unexpected show up prize utility from no mug
U (8, 0) = 8
◦ Notice that the above prospect brings the same utility of prospect (1) in Q.2. This comes from the combination of two
effects: a) with reference dependent utilities any initial difference in endowments washes out as long as endowments
are not affected by unexpected changes. b) in the two cases, agents experience a communal source of surprise (i.e.
the show up fee against their $0 expectation).
◦ Now we determine (2)
B
U (buy) = U (m = (8 − pc ), c = 1) given r = (0, 0)
B B
U (8 − pc , 1) = V ((8 − 0) − pc ) + V (1 · 5 − 0 · 5)
| {z } | {z }
utility from unexpected show up prize - pB gain from getting the mug
c
S
U (8, 0) = (8 − pc ) + 5
◦ Price which achieves equalization of (1) and (2) is obtained by comparing the two prospects:
U (no mug) = U (buy the mug)
S S
8 = 8 − pc + 5 ⇒ pc = 5
48 / 49
Literature cited:
Camerer, Colin, et al. ”Labor supply of New York City cabdrivers: One day at a time.”
The Quarterly Journal of Economics 112.2 (1997): 407-441.
DellaVigna, S. (2007). Psychology and economics: Evidence from the field. National
Bureau of Economic Research.
Farber, H. S. (2005). Is tomorrow another day? The labor supply of New York City
cabdrivers. Journal of political Economy, 113(1), 46-82.
Farber, H. S. (2008). Reference-dependent preferences and labor supply: The case of
New York City taxi drivers. American Economic Review, 98(3), 1069-82.
Goette, Lorenz, David Huffman, and Ernst Fehr. ”Loss aversion and labor supply.”
Journal of the European Economic Association 2.23 (2004): 216-228.
Higgins, E. Tory. ”Self-discrepancy: a theory relating self and affect.” Psychological
review 94.3 (1987): 319.
List, J. A. (2003). Does market experience eliminate market anomalies?. The Quarterly
Journal of Economics, 118(1), 41-71.
Mas, Alexandre. ”Pay, reference points, and police performance.” The Quarterly Journal
of Economics 121.3 (2006): 783-821.
Odean, Terrance. ”Are investors reluctant to realize their losses?.” The Journal of
finance 53.5 (1998): 1775-1798.
Oettinger, Gerald S. ”An empirical analysis of the daily labor supply of stadium venors.”
Journal of political Economy 107.2 (1999): 360-392.
49 / 49

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Theory Application 1 of PT Application 2 of PT Application 3 of PT Determination of RP Tutorial Literature

23005 Behavioural Economics

4. Tutorial with Luz: PT in practice

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