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140-509: Prospect theory is a theory of behavioral economics , judgment and decision making that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics . Based on results from controlled studies , it describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion ). For example, for some individuals,

280-422: A w {\displaystyle K-e^{-aw}} gives exactly the same preferences orderings as does − e − a w {\displaystyle -e^{-aw}} ; thus it is irrelevant that the values of − e − a w {\displaystyle -e^{-aw}} and its expected value are always negative: what matters for preference ordering

420-454: A and b . Then expected utility is given by Thus the risk measure is E ⁡ ( e − a ( w − E ⁡ w ) ) {\displaystyle \operatorname {E} (e^{-a(w-\operatorname {E} w)})} , which differs between two individuals if they have different values of the parameter a , {\displaystyle a,} allowing different people to disagree about

560-401: A bet when they had just won money in the previous round. This behavior is consistent with myopic loss aversion theory, as the participants were placing greater magnitude on their short-term gains and losses instead of their overall earnings over the course of the study. Additionally, the findings revealed that the participants that were provided with a higher amount of money at the beginning of

700-425: A continuous range of values, the expected utility is given by where f ( x ) {\displaystyle f(x)} is the probability density function of x . {\displaystyle x.} The certainty equivalent , the fixed amount amount that would make a person indifferent to it vs. the distribution ⁠ f ( x ) {\displaystyle f(x)} ⁠ ,

840-489: A decision is made. Behavioral economics proposes search heuristics as an aid for evaluating options. It is motivated by the fact that it is costly to gain information about options and it aims to maximise the utility of searching for information. While each heuristic is not wholistic in its explanation of the search process alone, a combination of these heuristics may be used in the decision-making process. There are three primary search heuristics. Satisficing Satisficing

980-627: A factor in limiting the rationality of people's decisions. Sloan first argued this in his paper 'Bounded Rationality' where he stated that our cognitive limitations are somewhat the consequence of our limited ability to foresee the future, hampering the rationality of decision. Daniel Kahneman further expanded upon the effect cognitive ability and processes have on decision making in his book Thinking, Fast and Slow Kahneman delved into two forms of thought, fast thinking which he considered "operates automatically and quickly, with little or no effort and no sense of voluntary control". Conversely, slow thinking

1120-2318: A fixed ratio of probabilities the decision weights are closer to unity when probabilities are low than when they are high. In prospect theory, π {\displaystyle \pi } is never linear . In the case that x > y > 0 {\displaystyle x>y>0} , p > p ′ {\displaystyle p>p'} and p + q = p ′ + q ′ < 1 , {\displaystyle p+q=p'+q'<1,} prospect ( x , p ′ ; y , q ) {\displaystyle (x,p';y,q)} dominates prospect ( x , p ′ ; y , q ′ ) {\displaystyle (x,p';y,q')} , which means that π ( p ) ν ( x ) + π ( q ) ν ( y ) > π ( p ′ ) ν ( x ) + π ( q ′ ) ν ( y ) {\displaystyle \pi (p)\nu (x)+\pi (q)\nu (y)>\pi (p')\nu (x)+\pi (q')\nu (y)} , therefore: π ( p ) − π ( p ′ ) π ( q ′ ) − π ( q ) ≤ ν ( y ) ν ( x ) {\displaystyle {\frac {\pi \left(p\right)-\pi (p')}{\pi \left(q'\right)-\pi \left(q\right)}}\leq {\frac {\nu \left(y\right)}{\nu \left(x\right)}}} As y → x {\displaystyle y\rightarrow x} , π ( p ) − π ( p ′ ) → π ( q ′ ) − π ( q ) {\displaystyle \pi (p)-\pi (p')\rightarrow \pi (q')-\pi (q)} , but since p − p ′ = q ′ − q {\displaystyle p-p'=q'-q} , it would imply that π {\displaystyle \pi } must be linear; however, dominated alternatives are brought to

1260-510: A fully rational process of finding an optimal choice given the information available. Simon used the analogy of a pair of scissors, where one blade represents human cognitive limitations and the other the "structures of the environment", illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment. Bounded rationality implicates the idea that humans take shortcuts that may lead to suboptimal decision-making. Behavioral economists engage in mapping

1400-538: A lecturer in economics at the University of Hohenheim conducted an investigation into the proliferation of behavioral economics. Geiger's research looked at studies that had quantified the frequency of references to terms specific to behavioral economics, and how often influential papers in behavioral economics were cited in journals on economics. The quantitative study found that there was a significant spread in behavioral economics after Kahneman and Tversky's work in

1540-503: A linear combination of the utilities of the outcomes, with the weights being the respective probabilities. Utility functions are also normally continuous functions. Such utility functions are also referred to as von Neumann–Morgenstern (vNM) utility functions. This is a central theme of the expected utility hypothesis in which an individual chooses not the highest expected value, but rather the highest expected utility. The expected utility maximizing individual makes decisions rationally based on

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1680-435: A non-linear monotonic transformation of utility, the expected utility function is ordinal because any monotonic increasing transformation of expected utility gives the same behavior. The utility function u ( w ) = log ⁡ ( w ) {\displaystyle u(w)=\log(w)} was originally suggested by Bernoulli (see above). It has relative risk aversion constant and equal to one, and

1820-481: A normative account of decision making under risk (when probabilities are known) and under uncertainty (when probabilities are not objectively known). Savage concluded that people have neutral attitudes towards uncertainty and that observation is enough to predict the probabilities of uncertain events. A crucial methodological aspect of Savage's framework is its focus on observable choices. Cognitive processes and other psychological aspects of decision making matter only to

1960-431: A nudge. Banning junk food does not. Nudging techniques aim to capitalise on the judgemental heuristics of people. In other words, a nudge alters the environment so that when heuristic, or System 1, decision-making is used, the resulting choice will be the most positive or desired outcome. An example of such a nudge is switching the placement of junk food in a store, so that fruit and other healthy options are located next to

2100-476: A particular outcome and its expected value. Bernoulli further proposed that it was not the goal of the gambler to maximize his expected gain but to instead maximize the logarithm of his gain. Daniel Bernoulli drew attention to psychological and behavioral components behind the individual's decision-making process and proposed that the utility of wealth has a diminishing marginal utility . For example, as someone gets wealthier, an extra dollar or an additional good

2240-608: A perceived domain of loss, are more likely to take risks that would otherwise have been avoided, e.g. "gambling on a risky rescue mission", or implementing radical domestic reform to support military efforts. Early applications of prospect theory in International Relations emphasized the potential to explain anomalies in foreign policy decision-making that remained difficult to account for on the basis of rational choice theory. They developed detailed qualitative case studies of specific foreign policy decisions to explore

2380-458: A person might choose (e.g. if someone prioritizes their social life over academic results, they will go out with their friends). Assuming that the decisions of a person are rational , according to this theorem, we should be able to know the beliefs and utilities from a person just by looking at the choices they make (which is wrong). Ramsey defines a proposition as " ethically neutral " when two possible outcomes have an equal value. In other words, if

2520-461: A person's utility takes on one of a set of discrete values , the formula for expected utility, which is assumed to be maximized, is where the left side is the subjective valuation of the gamble as a whole, x i {\displaystyle x_{i}} is the i th possible outcome, u ( x i ) {\displaystyle u(x_{i})} is its valuation, and p i {\displaystyle p_{i}}

2660-413: A poor person. The theory can also more accurately describe more realistic scenarios (where expected values are finite) than expected value alone. He proposed that a nonlinear function of utility of an outcome should be used instead of the expected value of an outcome, accounting for risk aversion , where the risk premium is higher for low-probability events than the difference between the payout level of

2800-414: A potential defendant and plaintiff in discussions of settling a civil suit. Probability distortion is that people generally do not look at the value of probability uniformly between 0 and 1. Lower probability is said to be over-weighted (that is, a person is overly concerned with the outcome of the probability) while medium to high probability is under-weighted (that is, a person is not concerned enough with

2940-404: A probability distribution function has an infinite expected value , a person who only cares about expected values of a gamble would pay an arbitrarily large finite amount to take this gamble. However, this experiment demonstrated that there is no upper bound on the potential rewards from very low probability events. In the hypothetical setup, a person flips a coin repeatedly. The participant's prize

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3080-637: A prospect-utility of π ( 0.01 ) × v ( − 1000 ) + π ( 0.99 ) × v ( 0 ) = π ( 0.01 ) × v ( − 1000 ) {\displaystyle \pi (0.01)\times v(-1000)+\pi (0.99)\times v(0)=\pi (0.01)\times v(-1000)} . According to prospect theory, The comparison between π ( 0.01 ) {\displaystyle \pi (0.01)} and v ( − 15 ) / v ( − 1000 ) {\displaystyle v(-15)/v(-1000)}

3220-506: A radical economic policy as one ensuring 90% employment rather than 10% unemployment, because framing it as the former puts the citizenry in a "domain of gain," which is thereby conducive to greater populace satisfaction. On a broader scale: Consider an administration debating the implementation of a controversial reform, and that such a reform yields a small chance for a widespread revolt. "[T]he disutility induced by loss aversion," even with minute probabilities of said insurrection, will dissuade

3360-499: A recognized field of study. In The Theory of Moral Sentiments , Adam Smith wrote on concepts later popularized by modern Behavioral Economic theory, such as loss aversion . Jeremy Bentham , a Utilitarian philosopher in the 1700s conceptualized utility as a product of psychology. Other economists who incorporated psychological explanations in their works included Francis Edgeworth , Vilfredo Pareto and Irving Fisher . A rejection and elimination of psychology from economics in

3500-404: A second concept, based on the observation that people attribute excessive weight to events with low probabilities and insufficient weight to events with high probability. For example, individuals may unconsciously treat an outcome with a probability of 99% as if its probability were 95%, and an outcome with probability of 1% as if it had a probability of 5%. Under- and over-weighting of probabilities

3640-606: A similar conclusion in their investigation of Italian welfare reforms. Maria Fanis uses prospect theory to show how risk acceptance can help domestic groups overcome collective action problems inherent to coalition building. She suggests that collective action is more likely in a perceive domain of loss because individuals become more willing to accept the risk of free riding by others. In Chile, this process led domestic interest groups to form unlikely political coalitions. Zeynep Somer-Topcu's research suggests that political parties respond more strongly to electoral defeat than to success in

3780-483: A special behavioral economics edition of the Quarterly Journal of Economics ("In Memory of Amos Tversky"), and Kahneman's 2002 Nobel Prize for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." A further argument of Behavioural Economics relates to the impact of the individual's cognitive limitations as

3920-435: A straightforward betting game in which they could either place a bet on a coin landing , or they could choose to not bet at all. The participants were provided with a fixed amount of money, and held the task to maximize their earnings over a series of rounds. The results of the study exhibited that participants were more likely to place a bet when they had just lost money in the previous round, and they were more likely to avoid

4060-461: A strong overweighting of small probabilities is likely to undo the effect of the convexity of v {\displaystyle v} in losses, making the insurance attractive. If we set the frame to -$ 1,000, we have a choice between v ( 985 ) {\displaystyle v(985)} and π ( 0.99 ) × v ( 1000 ) {\displaystyle \pi (0.99)\times v(1000)} . In this case,

4200-404: A subfield of economics is a fairly recent development; the breakthroughs that laid the foundation for it were published through the last three decades of the 20th century. Behavioral economics is still growing as a field, being used increasingly in research and in teaching. Early classical economists included psychological reasoning in much of their writing, though psychology at the time was not

4340-427: Is U ( p ) = ∑ u ( x k ) p k {\displaystyle U(p)=\sum u(x_{k})p_{k}} where p k {\displaystyle p_{k}} is the probability that outcome indexed by k {\displaystyle k} with payoff x k {\displaystyle x_{k}} is realized, and function u expresses

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4480-478: Is $ 15. If we apply prospect theory, we first need to set a reference point. This could be the current wealth or the worst case (losing $ 1,000). If we set the frame to the current wealth, the decision would be to either 1. Pay $ 15 for insurance, which yields a prospect-utility of v ( − 15 ) {\displaystyle v(-15)} , OR 2. Enter a lottery with possible outcomes of $ 0 (probability 99%) or −$ 1,000 (probability 1%), which yields

4620-475: Is a function that assigns a value to an outcome. The value function that passes through the reference point is s-shaped and asymmetrical. Losses hurt more than gains feel good (loss aversion). This differs from expected utility theory , in which a rational agent is indifferent to the reference point. In expected utility theory, the individual does not care how the outcome of losses and gains are framed. The function π {\displaystyle \pi }

4760-719: Is a probability weighting function and captures the idea that people tend to overreact to small probability events, but underreact to large probabilities. Let ( x , p ; y , q ) {\displaystyle (x,p;y,q)} denote a prospect with outcome x {\displaystyle x} with probability p {\displaystyle p} and outcome y {\displaystyle y} with probability q {\displaystyle q} and nothing with probability 1 − p − q {\displaystyle 1-p-q} . If ( x , p ; y , q ) {\displaystyle (x,p;y,q)}

4900-1163: Is a regular prospect (i.e., either p + q < 1 {\displaystyle p+q<1} , or x ≥ 0 ≥ y {\displaystyle x\geq 0\geq y} , or x ≤ 0 ≤ y {\displaystyle x\leq 0\leq y} ), then: V ( x , p ; y , q ) = π ( p ) ν ( x ) + π ( q ) ν ( y ) {\displaystyle V(x,p;y,q)=\pi (p)\nu (x)+\pi (q)\nu (y)} However, if p + q = 1 {\displaystyle p+q=1} and either x > y > 0 {\displaystyle x>y>0} or x < y < 0 {\displaystyle x<y<0} , then: V ( x , p ; y , q ) = ν ( y ) + π ( p ) [ ν ( x ) − ν ( y ) ] {\displaystyle V(x,p;y,q)=\nu (y)+\pi (p)\left[\nu (x)-\nu (y)\right]} It can be deduced from

5040-473: Is a search heuristic in which a person treats each opportunity to research information as their last. Rather than a contingent plan that indicates what will be done based on the results of each search, directed cognition considers only if one more search should be conducted and what alternative should be researched. Elimination by aspects Whereas satisficing and directed cognition compare choices, elimination by aspects compares certain qualities. A person using

5180-442: Is an example of the fourfold pattern of risk attitudes. The first item in each quadrant shows an example prospect (e.g. 95% chance to win $ 10,000 is high probability and a gain). The second item in the quadrant shows the focal emotion that the prospect is likely to evoke. The third item indicates how most people would behave given each of the prospects (either Risk Averse or Risk Seeking). The fourth item states expected attitudes of

5320-504: Is applied, it should come as no surprise that it and other psychological models are applied extensively in the context of political decision-making. Both rational choice and game theoretical models generate significant predictive power in the analysis of politics and international relations (IR). But prospect theory, unlike the alternative models, (1) is "founded on empirical data", (2) allows and accounts for dynamic change, (3) addresses previously-ignored modular elements, (4) emphasizes

5460-419: Is commonly split into people who are aware of their present bias (sophisticated) and those who are not (naive). Expected utility theory The expected utility hypothesis states 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). The summarised formula for expected utility

5600-462: Is constant, and the CARA ( constant absolute risk aversion ) functions, where ARA(w) is constant. They are often used in economics for simplification. A decision that maximizes expected utility also maximizes the probability of the decision's consequences being preferable to some uncertain threshold. In the absence of uncertainty about the threshold, expected utility maximization simplifies to maximizing

5740-411: Is determined by the number of times the coin lands on heads consecutively. For every time the coin comes up heads (1/2 probability), the participant's prize is doubled. The game ends when the participant flips the coin and it comes out tails. A player who only cares about expected value of the payoff should be willing to pay any finite amount of money to play because this entry cost will always be less than

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5880-404: Is directly related to the curvature of the utility function: risk neutral individuals have linear utility functions, while risk seeking individuals have convex utility functions and risk averse individuals have concave utility functions. The degree of risk aversion can be measured by the curvature of the utility function. Since the risk attitudes are unchanged under affine transformations of u ,

6020-415: Is given by C E = u − 1 ( E ⁡ [ u ( x ) ] ) . {\displaystyle \mathrm {CE} =u^{-1}(\operatorname {E} [u(x)])\,.} Often people refer to "risk" in the sense of a potentially quantifiable entity. In the context of mean-variance analysis , variance is used as a risk measure for portfolio return; however, this

6160-421: Is importantly distinct from under- and over-estimating probabilities, a different type of cognitive bias observed for example in the overconfidence effect . The theory describes the decision processes in two stages: The formula that Kahneman and Tversky assume for the evaluation phase is (in its simplest form) given by: where V {\displaystyle V} is the overall or expected utility of

6300-406: Is its probability. There could be either a finite set of possible values x i , {\displaystyle x_{i},} in which case the right side of this equation has a finite number of terms; or there could be an infinite set of discrete values, in which case the right side has an infinite number of terms. When x {\displaystyle x} can take on any of

6440-484: Is not immediately evident. However, for typical value and weighting functions, π ( 0.01 ) > v ( − 15 ) / v ( − 1000 ) {\displaystyle \pi (0.01)>v(-15)/v(-1000)} , and hence π ( 0.01 ) × v ( − 1000 ) < v ( − 15 ) {\displaystyle \pi (0.01)\times v(-1000)<v(-15)} . That is,

6580-1038: Is not preferred to ( y , p q r ) {\displaystyle (y,pqr)} , but from the first equation it follows that π ( p ) ν ( x ) + π ( p q ) ν ( y ) = π ( p q ) ν ( y ) {\displaystyle \pi (p)\nu (x)+\pi (pq)\nu (y)=\pi (pq)\nu (y)} , which leads to π ( p r ) ν ( x ) ≤ π ( p q r ) ν ( y ) {\displaystyle \pi (pr)\nu (x)\leq \pi (pqr)\nu (y)} , therefore: π ( p q ) π ( p ) ≤ π ( p q r ) π ( p r ) {\displaystyle {\frac {\pi \left(pq\right)}{\pi \left(p\right)}}\leq {\frac {\pi \left(pqr\right)}{\pi \left(pr\right)}}} This means that for

6720-403: Is only valid if returns are normally distributed or otherwise jointly elliptically distributed , or in the unlikely case in which the utility function has a quadratic form. However, David E. Bell proposed a measure of risk which follows naturally from a certain class of von Neumann–Morgenstern utility functions. Let utility of wealth be given by for individual-specific positive parameters

6860-454: Is perceived as less valuable. In other words, desirability related with a financial gain depends not only on the gain itself but also on the wealth of the person. Bernoulli suggested that people maximize "moral expectation" rather than expected monetary value. Bernoulli made a clear distinction between expected value and expected utility. Instead of using the weighted outcomes, he used the weighted utility multiplied by probabilities. He proved that

7000-417: Is still sometimes assumed in economic analyses. The utility function exhibits constant absolute risk aversion, and for this reason is often avoided, although it has the advantage of offering substantial mathematical tractability when asset returns are normally distributed. Note that, as per the affine transformation property alluded to above, the utility function K − e −

7140-449: Is the allocation of cognitive ability, choice and concentration. Fast thinking utilises heuristics, which is a decision-making process that undertakes shortcuts, and rules of thumb to provide an immediate but often irrational and imperfect solution. Kahneman proposed that the result of the shortcuts is the occurrence of a number of biases such as hindsight bias, confirmation bias and outcome bias among others. A key example of fast thinking and

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7280-434: Is the idea that there is some minimum requirement from the search and once that has been met, stop searching. After satisficing, a person may not have the most optimal option (i.e. the one with the highest utility), but would have a "good enough" one. This heuristic may be problematic if the aspiration level is set at such a level that no products exist that could meet the requirements. Directed cognition Directed cognition

7420-392: Is thus defined on deviations from the reference point, generally concave for gains and commonly convex for losses and steeper for losses than for gains. If ( x , p ) {\displaystyle (x,p)} is equivalent to ( y , p q ) {\displaystyle (y,pq)} then ( x , p r ) {\displaystyle (x,pr)}

7560-439: Is used extensively in mental accounting . The digital age has brought the implementation of prospect theory in software. Framing and prospect theory has been applied to a diverse range of situations which appear inconsistent with standard economic rationality: the equity premium puzzle , the excess returns puzzle and long swings/PPP puzzle of exchange rates through the endogenous prospect theory of Imperfect Knowledge Economics,

7700-573: Is which of two gambles gives the higher expected utility, not the numerical values of those expected utilities. The class of constant relative risk aversion utility functions contains three categories. Bernoulli's utility function has relative risk aversion equal to 1. The functions for α ∈ ( 0 , 1 ) {\displaystyle \alpha \in (0,1)} have relative risk aversion equal to 1 − α ∈ ( 0 , 1 ) {\displaystyle 1-\alpha \in (0,1)} . And

7840-483: The Expected utility hypothesis and discounted utility models began to gain acceptance. In challenging the accuracy of generic utility, these concepts established a practice foundational in behavioral economics: Building on standard models by applying psychological knowledge. Mathematical psychology reflects a long-standing interest in preference transitivity and the measurement of utility. In 2017, Niels Geiger,

7980-580: The Monty Hall problem where it was demonstrated that people do not revise their degrees on belief in line with experimented probabilities and also that probabilities cannot be applied to single cases. On the other hand, in updating probability distributions using evidence, a standard method uses conditional probability , namely the rule of Bayes . An experiment on belief revision has suggested that humans change their beliefs faster when using Bayesian methods than when using informal judgment. According to

8120-557: The Penn Medicine Nudge Unit is the world's first behavioral design team embedded within a health system. Nudge theory has also been applied to business management and corporate culture , such as in relation to health, safety and environment (HSE) and human resources. Regarding its application to HSE, one of the primary goals of nudge is to achieve a "zero accident culture". Cass Sunstein has responded to critiques at length in his The Ethics of Influence making

8260-505: The St. Petersburg paradox (involving infinite expected values) in 1713, prompting two Swiss mathematicians to develop expected utility theory as a solution. Bernoulli's paper was the first formalization of marginal utility , which has broad application in economics in addition to expected utility theory. He used this concept to formalize the idea that the same amount of additional money was less useful to an already-wealthy person than it would be to

8400-452: The bounds of rationality of economic agents . Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory . Behavioral economics began as a distinct field of study in the 1970s and 1980s, but can be traced back to 18th-century economists, such as Adam Smith , who deliberated how the economic behavior of individuals could be influenced by their desires. The status of behavioral economics as

8540-616: The disposition effect or the reversing of risk aversion / risk seeking in case of gains or losses (termed the reflection effect ), can also be explained by referring to the prospect theory. An important implication of prospect theory is that the way economic agents subjectively frame an outcome or transaction in their mind affects the utility they expect or receive. Narrow framing is a derivative result which has been documented in experimental settings by Tversky and Kahneman, whereby people evaluate new gambles in isolation, ignoring other relevant risks. This phenomenon can be seen in practice in

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8680-431: The natural tendency of humans to focus on short-term losses and gains and to weigh them more heavily than long-term losses and gains. This bias can lead to seemingly poorer decision making, as individuals may focus towards avoiding immediate losses instead of achieving long-term gains. A prolific study that examined myopic loss aversion was conducted by Gneezy and Potters in 1997.[9] In this study, participants engaged in

8820-588: The status quo bias , various gambling and betting puzzles, intertemporal consumption , and the endowment effect . It has also been argued that prospect theory can explain several empirical regularities observed in the context of auctions (such as secret reserve prices) which are difficult to reconcile with standard economic theory. Online pay-per bid auction sites are a classic example of decision making under risk. Previous attempts at predicting consumer behavior have shown that utility theory does not sufficiently describe decision making under risk. When prospect theory

8960-435: The 1990s and into the 2000s. Bounded rationality is the idea that when individuals make decisions, their rationality is limited by the tractability of the decision problem, their cognitive limitations and the time available. Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of decision-making . It complements "rationality as optimization", which views decision-making as

9100-511: The Firm , was to view firms as coalitions of groups whose targets were based on satisficing rather than optimizing behaviour. Another treatment of this idea comes from Cass Sunstein and Richard Thaler 's Nudge . Sunstein and Thaler recommend that choice architectures are modified in light of human agents' bounded rationality. A widely cited proposal from Sunstein and Thaler urges that healthier food be placed at sight level in order to increase

9240-537: The Great Recession had a "decade-long expansion in US housing market activity peaked in 2006," which came to a halt in 2007. As the trends prior to 2008 hinted at the fall of mortgage pricing, real-estate investors reacted promptly. The mass sell-offs of mortgaged-backed investments led to a similar instability in other markets, including credit markets, and the stock market. Some behaviors observed in economics, like

9380-489: The ability for researchers and policymakers to create interventions that help people make more informed choices and attain their long-term goals. When referring to investment decisions, myopic loss aversion has the ability to lead to investment decisions that can be of a more conservative approach. For instance, investors potentially overreact to dips in stock prices in their stock portfolio, which causes feelings of fear and anxiety of profit loss. This reaction from investors has

9520-408: The ability to lead in a loss in profit due to selling off their stock. Studies in behavioral finance analyzed this pattern, observing that there is a tendency to avoid high-reward options in the market, as the risk of short-term loss potentially influences the broker. Acclaimed behavioral economists Benartzi and Thaler analyzed this concept, calling it the "equity premium puzzle." This puzzle refers to

9660-409: The agent and therefore must be chosen. The main problem with the expected value theory is that there might not be a unique correct way to quantify utility or to identify the best trade-offs. For example, some of the trade-offs may be intangible or qualitative. Rather than monetary incentives , other desirable ends can also be included in utility such as pleasure, knowledge, friendship, etc. Originally

9800-669: The axioms are satisfied one can use the information to reduce the uncertainty about the events that are out of their control. Additionally the theorem ranks the outcome according to a utility function that reflects the personal preferences. The key ingredients in Savage's theory are: There are four axioms of the expected utility theory that define a rational decision maker: completeness; transitivity; independence of irrelevant alternatives; and continuity. Completeness assumes that an individual has well defined preferences and can always decide between any two alternatives. This means that

9940-453: The axioms of the theory. The von Neumann–Morgenstern formulation is important in the application of set theory to economics because it was developed shortly after the Hicks–Allen " ordinal revolution" of the 1930s, and it revived the idea of cardinal utility in economic theory. However, while in this context the utility function is cardinal, in that implied behavior would be altered by

10080-599: The case in favor of nudging against charges that nudges diminish autonomy, threaten dignity, violate liberties, or reduce welfare. Ethicists have debated this rigorously. These charges have been made by various participants in the debate from Bovens to Goodwin. Wilkinson for example charges nudges for being manipulative, while others such as Yeung question their scientific credibility. Some, such as Hausman & Welch have inquired whether nudging should be permissible on grounds of ( distributive ) justice; Lepenies & Malecka have questioned whether nudges are compatible with

10220-736: The cash register, while junk food is relocated to another part of the store. In 2008, the United States appointed Sunstein, who helped develop the theory, as administrator of the Office of Information and Regulatory Affairs . Notable applications of nudge theory include the formation of the British Behavioural Insights Team in 2010. It is often called the "Nudge Unit", at the British Cabinet Office , headed by David Halpern . In addition,

10360-518: The company. For that reason, no state can rule out the performance of an act. Only when the state and the act are evaluated simultaneously, it becomes possible to determine an outcome with certainty. The Savage representation theorem (Savage, 1954) A preference < satisfies P1–P7 if and only if there is a finitely additive probability measure P and a function u : C → R such that for every pair of acts f and g . f < g ⇐⇒ Z Ω u ( f ( ω )) dP ≥ Z Ω u ( g ( ω )) dP *If and only if all

10500-558: The completeness axiom, the individual also decides consistently. Independence of irrelevant alternatives pertains to well-defined preferences as well. It assumes that two gambles mixed with an irrelevant third one will maintain the same order of preference as when the two are presented independently of the third one. The independence axiom is the most controversial axiom. . Continuity assumes that when there are three lotteries ( A , B {\displaystyle A,B} and C {\displaystyle C} ) and

10640-509: The concavity of the value function in gains and the underweighting of high probabilities can also lead to a preference for buying the insurance. The interplay of overweighting of small probabilities and concavity-convexity of the value function leads to the so-called fourfold pattern of risk attitudes : risk-averse behavior when gains have moderate probabilities or losses have small probabilities; risk-seeking behavior when losses have moderate probabilities or gains have small probabilities. Below

10780-526: The decision shortcuts that agents use in order to help increase the effectiveness of human decision-making. Bounded rationality finds that actors do not assess all available options appropriately, in order to save on search and deliberation costs. As such decisions are not always made in the sense of greatest self-reward as limited information is available. Instead agents shall choose to settle for an acceptable solution. One approach, adopted by Richard M. Cyert and March in their 1963 book A Behavioral Theory of

10920-411: The degree of risk associated with any given portfolio. Individuals sharing a given risk measure (based on given value of a ) may choose different portfolios because they may have different values of b . See also Entropic risk measure . For general utility functions, however, expected utility analysis does not permit the expression of preferences to be separated into two parameters with one representing

11060-450: The dilemma regarding an actor's perceived position on the gain-loss domain spectrum, and the discordance between ideological and pragmatic (i.e. 'in the lab' versus 'in the field') assessments of an actor's propensity toward seeking or avoiding risk. That said, political scientists have applied prospect theory to a wide range of issues in domestic and comparative politics. For example, they have found that politicians are more likely to phrase

11200-427: The early 1900s brought on a period defined by a reliance on empiricism. There was a lack of confidence in hedonic theories, which saw pursuance of maximum benefit as an essential aspect in understanding human economic behavior. Hedonic analysis had shown little success in predicting human behavior, leading many to question its viability as a reliable source for prediction. There was also a fear among economists that

11340-490: The editing stage, risky situations are simplified using various heuristics . In the evaluation phase, risky alternatives are evaluated using various psychological principles that include: In 1992, in the Journal of Risk and Uncertainty , Kahneman and Tversky gave a revised account of prospect theory that they called cumulative prospect theory . The new theory eliminated the editing phase in prospect theory and focused just on

11480-613: The elimination by aspects heuristic first chooses the quality that they value most in what they are searching for and sets an aspiration level. This may be repeated to refine the search. i.e. identify the second most valued quality and set an aspiration level. Using this heuristic, options will be eliminated as they fail to meet the minimum requirements of the chosen qualities. Besides searching, behavioral economists and psychologists have identified other heuristics and other cognitive effects that affect people's decision making. These include: Mental accounting Mental accounting refers to

11620-637: The empirical results there has been almost no recognition in decision theory of the distinction between the problem of justifying its theoretical claims regarding the properties of rational belief and desire. One of the main reasons is because people's basic tastes and preferences for losses cannot be represented with utility as they change under different scenarios. Behavioral finance has produced several generalized expected utility theories to account for instances where people's choices deviate from those predicted by expected utility theory. These deviations are described as " irrational " because they can depend on

11760-400: The evaluation phase since they are eliminated in the editing phase. Although direct violations of dominance never happen in prospect theory, it is possible that a prospect A dominates B, B dominates C but C dominates A. To see how prospect theory can be applied, consider the decision to buy insurance. Assume the probability of the insured risk is 1%, the potential loss is $ 1,000 and the premium

11900-463: The evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggin 's rank-dependent utility theory. Psychological traits such as overconfidence , projection bias and the effects of limited attention are now part of the theory. Other developments include a conference at the University of Chicago ,

12040-435: The event. Additionally, he believed that outcomes must have the same utility regardless of state. For that reason, it is essential to correctly identify which statement is considered an outcome. For example, if someone says "I got the job" this affirmation is not considered an outcome, since the utility of the statement will be different for each person depending on intrinsic factors such as financial necessity or judgment about

12180-585: The expansion of behavioral economics, has been linked to the cognitive revolution . In the 1960s, cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards, Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. These developments spurred economists to reconsider how psychology could be applied to economic models and theories. Concurrently,

12320-405: The expected utility theory, which only considers choices with the maximum utility. Also, the concavity for gains and convexity for losses implies diminishing marginal utility with increasing gains/losses. In other words, someone who has more money has a lower desire for a fixed amount of gain (and lower aversion to a fixed amount of loss) than someone who has less money. The theory continues with

12460-403: The expected value of the variable in question and the other representing its risk. The expected utility theory takes into account that individuals may be risk-averse , meaning that the individual would refuse a fair gamble (a fair gamble has an expected value of zero). Risk aversion implies that their utility functions are concave and show diminishing marginal wealth utility. The risk attitude

12600-456: The expected, infinite, value of the game. However, in reality, people do not do this. "Only a few of the participants were willing to pay a maximum of $ 25 to enter the game because many of them were risk averse and unwilling to bet on a very small possibility at a very high price. In the early days of the calculus of probability, classic utilitarians believed that the option which has the greatest utility will produce more pleasure or happiness for

12740-473: The extent that they have directly measurable implications on choice. The theory of subjective expected utility combines two concepts: first, a personal utility function, and second, a personal probability distribution (usually based on Bayesian probability theory). This theoretical model has been known for its clear and elegant structure and its considered by some researchers to be "the most brilliant axiomatic theory of utility ever developed". Instead of assuming

12880-423: The fact that stocks, in terms of historical statistics, exceed profits in comparison to bonds over extended periods of time. More interestingly, they observed that newer investors tend not to emphasize stocks over bonds. This phenomenon has been linked by Benartzi and Thaler to myopic loss aversion due to the lack of emphasis on stocks by young investors, as young investors tended to abandon stocks due to minor dips in

13020-527: The field of behavioral finance , which has produced deviations from expected utility theory to account for the empirical facts. Other critics argue applying expected utility to economic and policy decisions, has engendered inappropriate valuations, particularly in scenarios in which monetary units are used to scale the utility of nonmonetary outcomes, such as deaths. Psychologists have discovered systematic violations of probability calculations and behavior by humans. This have been evidenced with examples such as

13160-525: The first equation that ν ( y ) + ν ( − y ) > ν ( x ) + ν ( − x ) {\displaystyle \nu (y)+\nu (-y)>\nu (x)+\nu (-x)} and ν ( − y ) + ν ( − x ) > ν ( x ) + ν ( − x ) {\displaystyle \nu (-y)+\nu (-x)>\nu (x)+\nu (-x)} . The value function

13300-479: The functions for α < 0 {\displaystyle \alpha <0} have relative risk aversion equal to 1 − α > 1. {\displaystyle 1-\alpha >1.} See also the discussion of utility functions having hyperbolic absolute risk aversion (HARA). When the entity x {\displaystyle x} whose value x i {\displaystyle x_{i}} affects

13440-485: The genesis of the Montreal Protocol, a landmark environmental agreement. Behavioral economics Behavioral economics is the study of the psychological (e.g. cognitive, behavioral, affective, social) factors involved in the decisions of individuals or institutions, and how these decisions deviate from those implied by traditional economic theory. Behavioral economics is primarily concerned with

13580-753: The government from moving forward with the reform. Scholars have employed prospect theory to shed light on a number of issue areas in politics. For example, Kurt Weyland finds that political leaders do not always undertake bold and politically risky domestic initiatives when they are at the pinnacle of their power. Instead, such policies often appear to be risky gambits initiated by politically vulnerable regimes. He suggests that in Latin America, politically weakened governments were more likely to implement fundamental and economically painful market-oriented reforms, even though they were more vulnerable to political backlash. Barbara Vis and Kees van Kersbergen have reached

13720-413: The human tendency to want rewards sooner. It describes people who are more likely to forego a greater payoff in the future in favour of receiving a smaller benefit sooner. An example of this is a smoker who is trying to quit. Although they know that in the future they will suffer health consequences, the immediate gain from the nicotine hit is more favourable to a person affected by present bias. Present bias

13860-493: The idea that people conclude their utility from "gains" and "losses" relative to a certain reference point. This "reference point" is different for each person and relative to their individual situation. Thus, rather than making decisions like a rational agent (i.e using expected utility theory and choosing the maximum value), decisions are made in relativity not in absolutes. Consider two scenarios; Prospect theory suggests that; These two examples are thus in contradiction with

14000-425: The individual prefers A {\displaystyle A} to B {\displaystyle B} and B {\displaystyle B} to C {\displaystyle C} , then there should be a possible combination of A {\displaystyle A} and C {\displaystyle C} in which the individual is then indifferent between this mix and

14140-408: The individual prefers A {\displaystyle A} to B {\displaystyle B} , B {\displaystyle B} to A {\displaystyle A} , or is indifferent between A {\displaystyle A} and B {\displaystyle B} . Transitivity assumes that, as an individual decides according to

14280-437: The influencers as choice architects. Thaler and Sunstein defined their concept as: A nudge, as we will use the term, is any aspect of the choice architecture that alters people's behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as

14420-450: The involvement of psychology in shaping economic models was inordinate and a departure from accepted principles. They feared that an increased emphasis on psychology would undermine the mathematic components of the field. To boost the ability of economics to predict accurately, economists started looking to tangible phenomena rather than theories based on human psychology. Psychology was seen as unreliable to many of these economists as it

14560-644: The likelihood that a person will opt for that choice instead of less healthy option. Some critics of Nudge have lodged attacks that modifying choice architectures will lead to people becoming worse decision-makers. In 1979, Kahneman and Tversky published Prospect Theory : An Analysis of Decision Under Risk , that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory. Kahneman and Tversky utilising prospect theory determined three generalisations; gains are treated differently than losses, outcomes received with certainty are overweighed relative to uncertain outcomes and

14700-416: The lottery B {\displaystyle B} . If all these axioms are satisfied, then the individual is said to be rational and the preferences can be represented by a utility function, i.e. one can assign numbers (utilities) to each outcome of the lottery such that choosing the best lottery according to the preference ⪰ {\displaystyle \succeq } amounts to choosing

14840-430: The lottery with the highest expected utility. This result is called the von Neumann–Morgenstern utility representation theorem . In other words, if an individual's behavior always satisfies the above axioms, then there is a utility function such that the individual will choose one gamble over another if and only if the expected utility of one exceeds that of the other. The expected utility of any gamble may be expressed as

14980-487: The market. This behavior can lead to a decreases market predictability, as investors act on short-term losses by selling their stocks, there can be a ripple effect that intensifies dips in the economy. As investors that are heavily influenced by the market decline sell their stocks, the now increased amount of shares due to mass sell-offs further lower prices. This hypothetical community of investors react along with falling stock prices, causing them to sell, potentially causing

15120-443: The new model having the ability to correct for two behavioral irrationalities: The sunk cost fallacy and average auctioneer revenues above current retail price. These findings would also imply that the using prospect theory as a descriptive theory of decision making under risk is also accurate in situations where risk arises through the interactions of different people. Given the necessary degree of uncertainty for which prospect theory

15260-493: The next election cycle. As prospect theory predicts, parties are more likely to shift their policies in response to a vote loss in the previous election cycle compared to a vote gain. Lawrence Kuznar and James Lutz find that loss frames can increase support of individuals for terrorist groups. International relations theorists have applied prospect theory to a wide range of issues in world politics, especially security-related matters. For example, in war-time , policy-makers, when in

15400-482: The nudge is a microtargeted design geared towards a specific group of people, irrespective of the scale of intended intervention. In 2008, Richard Thaler and Cass Sunstein 's book Nudge: Improving Decisions About Health, Wealth, and Happiness brought nudge theory to prominence. It also gained a following among US and UK politicians, in the private sector and in public health. The authors refer to influencing behavior without coercion as libertarian paternalism and

15540-565: The nudge theory in works of Hungarian social psychologists who emphasize the active participation in the nudge of its target (Ferenc Merei and Laszlo Garai ). Behavioral economics aims to improve or overhaul traditional economic theory by studying failures in its assumptions that people are rational and selfish. Specifically, it studies the biases, tendencies and heuristics of people's economic decisions. It aids in determining whether people make good choices and whether they could be helped to make better choices. It can be applied both before and after

15680-483: The options are presented to them. People tend to have little control over their susceptibility to the framing effect, as often their choice-making process is based on intuition. While heuristics are tactics or mental shortcuts to aid in the decision-making process, people are also affected by a number of biases and fallacies . Behavioral economics identifies a number of these biases that negatively affect decision making such as: Present bias Present bias reflects

15820-461: The outcome of the probability). The exact point in which probability goes from over-weighted to under-weighted is arbitrary, but a good point to consider is probability = 0.33. A person values probability = 0.01 much more than the value of probability = 0 (probability = 0.01 is said to be over-weighted). However, a person has about the same value for probability = 0.4 and probability = 0.5. Also,

15960-448: The outcomes to the individual making the decision, x 1 , x 2 , … , x n {\displaystyle x_{1},x_{2},\ldots ,x_{n}} are the potential outcomes and p 1 , p 2 , … , p n {\displaystyle p_{1},p_{2},\dots ,p_{n}} their respective probabilities and v {\displaystyle v}

16100-440: The pain from losing $ 1,000 could only be compensated by the pleasure of earning $ 2,000. Thus, contrary to the expected utility theory (which models the decision that perfectly rational agents would make), prospect theory aims to describe the actual behavior of people. In the original formulation of the theory, the term prospect referred to the predictable results of a lottery . However, prospect theory can also be applied to

16240-440: The prediction of other forms of behaviors and decisions. Prospect theory challenges the expected utility theory developed by John von Neumann and Oskar Morgenstern in 1944 and constitutes one of the first economic theories built using experimental methods . Prospect theory stems from loss aversion , where the observation is that agents asymmetrically feel losses greater than that of an equivalent gain. It centralises around

16380-496: The priorities and personal preferences of an individual we can anticipate what choices they are going to take. In this model, he defined numerical utilities for each option to exploit the richness of the space of prices. The outcome of each preference is exclusive of each other. For example, if you study, then you can not see your friends, however you will get a good grade in your course. In this scenario, we analyze personal preferences and beliefs and will be able to predict which option

16520-608: The probability can be defined in terms of a preference, each proposition should have ⁠ 1 / 2 ⁠ in order to be indifferent between both options. Ramsey shows that In the 1950s, Leonard Jimmie Savage , an American statistician, derived a framework for comprehending expected utility. At that point, it was considered the first and most thorough foundation to understanding the concept. Savage's framework involved proving that expected utility could be used to make an optimal choice among several acts through seven axioms. In his book, The Foundations of Statistics, Savage integrated

16660-472: The probability of achieving some fixed target. If the uncertainty is uniformly distributed, then expected utility maximization becomes expected value maximization. Intermediate cases lead to increasing risk aversion above some fixed threshold and increasing risk seeking below a fixed threshold. The St. Petersburg paradox presented by Nicolas Bernoulli illustrates that decision making based on expected value of monetary payoffs lead to absurd conclusions. When

16800-470: The probability of an event, Savage defines it in terms of preferences over acts. Savage used the states (something a person doesn't control) to calculate the probability of an event. On the other hand, he used utility and intrinsic preferences to predict the outcome of the event. Savage assumed that each act and state are sufficient to uniquely determine an outcome. However, this assumption breaks in cases where an individual does not have enough information about

16940-401: The propensity to allocate resources for specific purposes. Mental accounting is a behavioral bias that causes one to separate money into different categories known as mental accounts either based on the source or the intention of the money. Anchoring Anchoring describes when people have a mental reference point with which they compare results to. For example, a person who anticipates that

17080-423: The reaction of people to stock market fluctuations in comparison with other aspects of their overall wealth; people are more sensitive to spikes in the stock market as opposed to their labor income or the housing market. It has also been shown that narrow framing causes loss aversion among stock market investors. And the work of Tversky and Kahneman is largely responsible for the advent of behavioral economics , and

17220-424: The resultant irrational decisions is the 2008 financial crisis. Nudge is a concept in behavioral science , political theory and economics which proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals—in other words, it's "a way to manipulate people's choices to lead them to make specific decisions". The first formulation of

17360-643: The role of framing effects in choice selection. For example, Rose McDermott applied prospect theory to a series of case studies in American foreign policy, including the Suez Crisis in 1956, the U-2 Crisis in 1960, the U.S. decision to admit the Iranian shah to the United States in 1979, and the U.S. decision to carry out a hostage rescue mission in 1980. Jeffrey Berejikian employed prospect theory to analyze

17500-483: The rule of law. Similarly, legal scholars have discussed the role of nudges and the law. Behavioral economists such as Bob Sugden have pointed out that the underlying normative benchmark of nudging is still homo economicus , despite the proponents' claim to the contrary. It has been remarked that nudging is also a euphemism for psychological manipulation as practiced in social engineering . There exists an anticipation and, simultaneously, implicit criticism of

17640-577: The same choices, depending on the framing of the choices, i.e. how they are presented. Like any mathematical model , expected utility theory is a simplification of reality. The mathematical correctness of expected utility theory and the salience of its primitive concepts do not guarantee that expected utility theory is a reliable guide to human behavior or optimal practice. The mathematical clarity of expected utility theory has helped scientists design experiments to test its adequacy, and to distinguish systematic departures from its predictions. This has led to

17780-558: The second derivative u'' is not an adequate measure of the risk aversion of a utility function. Instead, it needs to be normalized. This leads to the definition of the Arrow–Pratt measure of absolute risk aversion: where w {\displaystyle w} is wealth. The Arrow–Pratt measure of relative risk aversion is: Special classes of utility functions are the CRRA ( constant relative risk aversion ) functions, where RRA(w)

17920-449: The situation in the decision-making process, (5) "provides a micro-foundational basis for the explanation of larger phenomena", and (6) stresses the importance of loss in utility and value calculations. Moreover, again unlike other models, prospect theory "asks different sorts of questions, seeks different evidence, and reaches different conclusions." However, there exist shortcomings inherent in prospect theory's political application, such as

18060-442: The stock price to lower as a whole. This concept, investor anxiety, can potentially emphasize the want to sell of investments for security reasons, regardless of long-term profit potential. This constant market fluctuation is directly related to market stability. An example of this effect was seen during economic crises such as the 2008 financial crash, when panic induced sell-offs heavily impacted market stability. The period prior to

18200-483: The structure of the problem may affect choices. These arguments were supported in part by altering a survey question so that it was no longer a case of achieving gains but averting losses and the majority of respondents altered their answers accordingly. In essence proving that emotions such as fear of loss, or greed can alter decisions, indicating the presence of an irrational decision-making process. Prospect theory has two stages: an editing stage and an evaluation stage. In

18340-461: The study tended to be more risk-averse than those who were given a lower starting amount. This observation supports the concept of diminishing sensitivity to changes in wealth predicted by prospect theory. Overall, the study by Gneezy and Potters emphasizes the existence of myopic loss aversion, demonstrating how this bias can result in non-optimal decisions. By analyzing how prospect theory and myopic loss aversion influence decision-making, it provides

18480-444: The term and associated principles was developed in cybernetics by James Wilk before 1995 and described by Brunel University academic D. J. Stewart as "the art of the nudge" (sometimes referred to as micronudges ). It also drew on methodological influences from clinical psychotherapy tracing back to Gregory Bateson , including contributions from Milton Erickson , Watzlawick , Weakland and Fisch, and Bill O'Hanlon. In this variant,

18620-680: The total utility of the consumer was the sum of independent utilities of the goods. However, the expected value theory was dropped as it was considered too static and deterministic. The classical counter example to the expected value theory (where everyone makes the same "correct" choice) is the St. Petersburg Paradox . In empirical applications, a number of violations of expected utility theory have been shown to be systematic and these falsifications have deepened understanding of how people actually decide. Daniel Kahneman and Amos Tversky in 1979 presented their prospect theory which showed empirically, how preferences of individuals are inconsistent among

18760-539: The utility function used in real life is finite, even when its expected value is infinite. In 1926, Frank Ramsey introduced the Ramsey's Representation Theorem. This representation theorem for expected utility assumed that preferences are defined over a set of bets where each option has a different yield. Ramsey believed that we always choose decisions to receive the best expected outcome according to our personal preferences. This implies that if we are able to understand

18900-757: The utility of each respective payoff. Graphically the curvature of the u function captures the agent's risk attitude. Standard utility functions represent ordinal preferences. The expected utility hypothesis imposes limitations on the utility function and makes utility cardinal (though still not comparable across individuals). Although the expected utility hypothesis is standard in economic modelling, it has been found to be violated in psychological experiments. For many years, psychologists and economic theorists have been developing new theories to explain these deficiencies. These include prospect theory , rank-dependent expected utility and cumulative prospect theory , and bounded rationality . Nicolaus Bernoulli described

19040-425: The value of probability = 0.99 is much less than the value of probability = 1, a sure thing (probability = 0.99 is under-weighted). A little more in depth when looking at probability distortion is that π ( p ) +  π (1 −  p ) < 1 (where π ( p ) is probability in prospect theory). Myopic loss aversion (MLA), a concept derived from prospect theory, refers to

19180-432: The way the problem is presented, not on the actual costs, rewards, or probabilities involved. Particular theories include prospect theory , rank-dependent expected utility and cumulative prospect theory are considered insufficient to predict preferences and the expected utility. Additionally, experiments have shown systematic violations and generalizations based on the results of Savage and von Neumann–Morgenstern. This

19320-440: The weather on a particular day would be raining, but finds that on the day it is actually clear blue skies, would gain more utility from the pleasant weather because they anticipated that it would be bad. Herd behavior This is a relatively simple bias that reflects the tendency of people to mimic what everyone else is doing and follow the general consensus. Framing effects People tend to choose differently depending on how

19460-429: Was a new field, not regarded as sufficiently scientific. Though a number of scholars expressed concern towards the positivism within economics, models of study dependent on psychological insights became rare. Economists instead conceptualized humans as purely rational and self-interested decision makers, illustrated in the concept of homo economicus . The resurgence of psychology within economics, which facilitated

19600-448: Was added to a previously existing model that was attempting to explain consumer behavior during auctions, out-of-sample predictions were shown to be more accurate than a corresponding expected utility model. Specifically, prospect theory was boiled down to certain elements: preference, loss aversion and probability weighting. These elements were then used to find a backward solution on 537,045 auctions. The greater accuracy may be explained by

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