Digital Assignment – 01

Behavioral Economics

Name: J Sridhar Shubham

Reg. No: 19BEI0039

LOSS AVERSION

Prospect theory was introduced in the year 1979 by Amos Tversky, which was later developed by
Daniel Kahneman in 1992, and it is said to more accurately describe how decisions are made, as
compared to the existing expected utility theory that was prevalent at that period of time. According
to the expected utility theory, an agent chooses between risky prospects by comparing expected
utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by
their probabilities).

However, Prospect theory claims that agents put more weight on expected gains than potential
losses, as the emotional pain caused by losses of an equivalent magnitude is greater than gains, thus
people tend to shy away from high risk, high stake gambles. So when we take an example of the
lottery, according to expected utility theory, the total expected utility (EU) will be calculated via the
formula:

Where U is the utility function. In this paper, U is assumed to be strictly increasing and continuous
with U(0) = 0. In contrast to the traditional interpretation we assume that U is defined on gains and
losses and not on final wealth positions.

Whereas in prospect theory, there exists a weighting function w (which represents the emotional bias
against losses, i.e., w : [0, 1] → [0, 1], strictly increasing with w(0) = 0 and w(1) = 1), such that
lotteries are evaluated by the formula:

According to the modern cumulative prospect theory, called cumulative prospect theory (CPT),
differs from OPT by involving two weighting functions w+ ,w−, and moreover, the weights used in
the evaluation of lotteries are differences in decumulative, respectively, cumulative probabilities. All
lotteries are evaluated by the formula:
Loss aversion can be defined by various different propositions, one of them being one proposed by
Kahneman and Tversky, which states that individuals dislike symmetric 50-50 bets with high stakes,
preferring to have better odds with lower stakes instead. This can be formally defined as:

The second proposition for this theory is:

Assuming OPT, one can equivalently define loss aversion as aversion to symmetric bets, where the
aversion becomes more pronounced if the size of the stakes increases. That is, (p, x; 1−2p, 0; p,−x) ≺
(p, y; 1−2p, 0; p,−y) for all x > y ≥ 0 and any p ∈ (0, 1/2). The middle payoff in these lotteries does
not need to be equal to the status quo, and could be any common outcome.

The condition says that all that matters for the preference in Definition 3 is that the absolute size of
the payoffs with likelihood α are smaller in the second lottery. This condition demands that among
two lotteries, for which one can win or lose a given amount with equal probability, that lottery will
be preferred for which this amount is smaller.

Conclusion:

The paper dealt with various different definitions of loss aversion, while also dealing with how
perception of probabilities play an important role alongside taking into the consideration the concept
of strong loss aversion, with each of the three different definitions explaining these different
concepts.

References:

Schmidt, U., & Zank, H. (2005). What is loss aversion?. Journal of risk and uncertainty, 30(2), 157-
167.