Prospect Theory

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
Food for Thought
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

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

Food for Thought
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

Food for Thought
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.

Food for Thought
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)

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

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

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

Axiom of Expected Utility!

Food for Thought
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

Food for Thought
(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

Food for Thought
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.

Food for Thought
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

Food for Thought

Food for Thought

Food for Thought
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.

Food for Thought
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

Food for Thought
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].

Food for Thought

Food for Thought
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.

Food for Thought
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.

Food for Thought
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.

Food for Thought
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

Food for Thought

Food for Thought

Food for Thought

Food for Thought
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

Food for Thought
A Big Question?
Social Interaction
What is the source of the reference point? e.g. Aspirations

Food for Thought
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).

Food for Thought
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).

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

Food for Thought
Transitivity
≥P satisfies transitivity iff for any L1 , L2 , L3
L1 ≥P L2 ∧ L2 ≥P L3 → L1 ≥P L3

Food for Thought
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

Food for Thought
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

Food for Thought
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().

Prospect Theory

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Prospect Theory

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Tversky and Kahneman 1974: Heuristics and Biases

Tversky and Kahneman 1979: Prospect Theory

14th April 2011

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Adjustment and Anchoring

Francesco Bogliacino Behavioural Economics Reading Group

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

Francesco Bogliacino Behavioural Economics Reading Group

A prospect is a finite list of outcomes and probabilities

We use the simplified notation

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

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

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

Francesco Bogliacino Behavioural Economics Reading Group

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

Francesco Bogliacino Behavioural Economics Reading Group

(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

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

Subjects show experimentally the following preferences U(B) >

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Probabilistic insurance is typically rejected, which implies:

Francesco Bogliacino Behavioural Economics Reading Group

Subjects show experimentally the following preferences U(B) >

Francesco Bogliacino Behavioural Economics Reading Group

They retain two general principles, which are the fundamentals of

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Experimental Evidence of Reference Dependence

Francesco Bogliacino Behavioural Economics Reading Group

Status Quo Bias

Francesco Bogliacino Behavioural Economics Reading Group

Improvement versus trade off

Francesco Bogliacino Behavioural Economics Reading Group

A rationalization: prospect theory

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

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

What a positive theory of choice should account for?

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Some Notes on utility in Economics

General Equilibrium Theory

Francesco Bogliacino Behavioural Economics Reading Group

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

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group

Francesco Bogliacino Behavioural Economics Reading Group