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Tversky and Kahneman 1974: Heuristics and Biases

Tversky and Kahneman 1979: Prospect Theory


Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Prospect Theory

Francesco Bogliacino1

14th April 2011

1
European Commission JRC-IPTS, Seville, Universidad EAFIT and RISE
Group, Calle Inca Garcilaso, 3, 41092, Sevilla, Spain. Email:
francesco.bogliacino@gmail.com.
Francesco Bogliacino Behavioural Economics Reading Group
Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Representativeness
Definition: A judgement of probability on event A given event B is
done based on similarity between A and B.
Associated Biases:
Insensitivity to prior probability (unless similarity is
uninformative)
Insensitivity to sample size: assessment of the likelihood of the
sample result is done regardless of the dimension of the sample
Misconception of chance: gambling fallacy
Insensitivity to predictability: good presentation of a firm
affects the predicted profitability even though no information
is given that is relevant to profits
Misconception of regression: e.g. the case of landing

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Availability
Definition: Assessing the frequency by the ease with which things
come to mind
Associated Biases:
effectiveness of the search set
imaginability

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Adjustment and Anchoring


Definition: estimation adjusting from an initial value
Associated Biases:
insufficient adjustment: if you provide different starting value,
subject make systematic mistakes
conjunctive and disjunctive events: see example

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experiment

Subjects were asked to bet on two events of the following three types

1 simple events: drawing a red marble from an urn with 50%


red marble
2 conjunctive events: drawing seven red marble in succession
with replacement (90% red marble in the urn)
3 disjunctive events: drawing at least one red marble from 7
successive draws with replacement (10% red marbles in the
population)
People tend to bet on (2) against (1) and on (1) against (3). Heuris-
tic: anchoring. The simple event is the reference point, so overesti-
mate conjunctive and underestimate disjunctive.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Notation

A prospect is a finite list of outcomes and probabilities

(x1 , p1 , ..., xn , pn )

We use the simplified notation

(x, p) = (x, p, 0, 1 − p) (x) = (x, 1)

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experiment
Choose between A = (4000, .80) and B = (3000)

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experiment
Choose between C = (4000, .20) and D = (3000, .25)

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

People tend to choose B and C, but this is inconsistent with the


Axiom of Expected Utility!

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Expected Utility

According to expected utility theory, choice is based on three tenets.


(1) Given a prospect (x1 , p1 , ..., xn , pn ) expected utility
n
X
U(x1 , p1 , ..., xn , pn ) = pi u(xi )
i=1

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

(2) A prospect (x1 , p1 , ..., xn , pn ) is acceptable at asset w iff

U(x1 + w , p1 , ..., xn + w , pn ) > u(w )

(3) Risk aversion: u(·) is concave

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

If an agent has preferences such that (Experiment 1):

u(4000).8 < u(3000)

then by multiplying for a constant:

u(4000).8/4 < u(3000)/4 → U(C ) < U(D)

which is violated experimentally.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experiment
Choose between A = (4000, .80) and B = (3000)

Experiment
Choose between C = (−4000, .80) and D = (−3000)

Subjects show experimentally the following preferences U(B) >


U(A) and U(C ) > U(D), this implies an inversion of risk attitudes
between gains and losses

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Probabilistic insurance is typically rejected, which implies:


risk aversion is not enough:
pu(w − x) + (1 − p)u(w ) = u(w − y ) implies
(1 − r )pu(w − x) + rpu(w − y ) + (1 − p)u(w − ry ) > u(w − y )
by simple concavity
any insurance is probabilistic. Omitting some information can
spur the decision to insure.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experiment
Step 1: You receive 1000
Step 2: Choose between A = (1000, .50) and B = (500)

Experiment
Step 1: You receive 2000
Step 2: Choose between C = (−1000, .50) and D = (−500)

Subjects show experimentally the following preferences U(B) >


U(A) and U(C ) > U(D), this implies a complete failure of ex-
pectation principles

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

They retain two general principles, which are the fundamentals of


Prospect Theory:
In the first step a reference point is chosen (coding): the
choice includes the use of heuristics (segregation, cancellation
etc)
gains and losses from the reference point are valued
according to a value function whose concavity changes around
the reference point and which is steeper for losses than for
gains [and probability are replaced by weight].

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Experimental Evidence of Reference Dependence

Endowment Effect
A group of subject received a mug and was ask to indicate at
which price they were ready to sell it. Another group of people was
asked the same question, but they were told that they would have
received either a mug or a sum of money at the end of the game.
The median price is statistically higher for the first group.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Status Quo Bias


A group of subject was given a mug while a separate group
received a large bar of chocolate. They were told what the other
group received and offered the possibility to trade. 90% retained
the first gift.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Improvement versus trade off


Experimentally, if given the initial endowment, the subject is
offered an improvement on one dimension or an option of a larger
improvement in one dimension and a loss on the other, the former
is more likely to be accepted.

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

A rationalization: prospect theory

Indifference curve change according to the reference point, i.e. utility


is reference dependent.
Loss aversion: utility is steeper for losses than for gain.
Diminishing sensitivity: the sensitivity on one dimension is lower the
larger the distance from the reference point

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

What a positive theory of choice should account for?

1 Framing Effect
2 Non linear preferences
3 Source Dependence
4 Risk Seeking
5 Loss Aversion

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

A Big Question?

Social Interaction
What is the source of the reference point? e.g. Aspirations

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Some Notes on utility in Economics

General Equilibrium Theory


Game Theory
The distinction per se is arbitrary, methodologically and mathemat-
ically the treatment is the same. However, for our purpose it is im-
portant to trace the line. The former use as primitive (in the most
general case) a preference relation which is not necessarily transi-
tive [thus no utility function] and it is fully ordinal. By Assumption
biases are omitted (competition is deemed to select smarter be-
haviour). Moreover, it is not restrictive in terms of predictions and
thus it is able to rationalize (almost) anything (the anything goes
theorems, Sonnescheim-Debreu-Mantel and Boldrin-Montrucchio).

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

At the opposite, Game Theory is founded on VNM utility function


which are cardinal utilities (defined up to an affine transformation)
and require the following assumptions:
1 completeness
2 transitivity
3 independence
4 continuity
It is much more restrictive (but with endemic multiplicity of equilib-
ria).

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Completeness
≥P satisfies completeness iff for any L1 , L2 , exactly one of the
three holds
L1 >P L2 L2 >P L1 L1 =P L2

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Transitivity
≥P satisfies transitivity iff for any L1 , L2 , L3

L1 ≥P L2 ∧ L2 ≥P L3 → L1 ≥P L3

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Continuity
≥P satisfies continuity iff for any L1 , L2 , L3 , with L1 ≥P L2 ≥P L3 ,
∃ q ∈ [0, 1]
q L1 + (1 − q) L3 =P L2

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Independence
≥P satisfies independence iff for L1 ≥P L2 , for any L3 , q ∈ [0, 1]

q L1 + (1 − q) L3 ≥P q L2 + (1 − q) L3

Francesco Bogliacino Behavioural Economics Reading Group


Tversky and Kahneman 1974: Heuristics and Biases
Tversky and Kahneman 1979: Prospect Theory
Tversky and Kahneman 1991: Reference Dependence
Food for Thought
Utility in Economics

Ordinal utility is defined up to a monotonic transformation. But if


we want to same something on risk attitudes we should be stricter,
as in VNM utility. In fact VNM utility is defined only up to an affine
transformation, because a more general transformation can affect
risk propensity representation.
e.g. T : R+ , T 0 (), T 00 () > 0, u 00 () < 0, now consider the second
derivative of T ◦ u.

T 00 ()[u 0 ()]2 + T 0 ()u 00 ()


it can be greater than zero if the elasticity of the first derivative of
T is larger than that of u().

Francesco Bogliacino Behavioural Economics Reading Group