Behavioural
Economics
A presentation by - Alex Godwin, William Pratt,
Lucy Mace, Jack Bovey, Luke Baker and Elise
Girdler.
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Expected Utility Theory
Originally proposed by Daniel Bernoulli (1798)
Reinterpreted by Neumann and Morgenstern (1944)
Based on expected monetary value except the utility function (u) is
used to show diminishing marginal utility
Expected Monetary Value is the sum of the probabilities multiplied by
the value of the outcome
Expected Utility Theory (Neumann and Morgenstern)
Expected Utility Theory instead uses the utility of the potential monetary
outcome instead of the monetary value itself
Outcome 1
Problem A
Problem B
Outcome 2
£4000 at 80% (20%)
3000 at 100% (80%)
x0.25
x0.25
£4000 at 20% (65%)
3000 at 25%
(35%)
£3000, 0.25
Outcome 2
£3000, 1.00
Problem A
Outcome 2
£0, 0.75
Problem B
£4000, 0.8
Outcome 1
£4000, 0.2
Outcome 1
£0, 0.8
£0, 0.2
20% - Outcome 1
80% - Outcome 2
65% - Outcome 1
35% - Outcome 2
The substitution axiom of utility theory states that if A is preferred to
B then for any probability p, (A,p) should be preferred to (B,p). This
is not the case in the example 1.
Prospect Theory: An analysis of decision under
risk
Kahneman and Tversky 1979
• A critique of expected utility theory as a descriptive model of decision
making under risk, developing an alternative model now known as
prospect theory
• The paper presents situations and proof which violate the axioms of
expected utility theory
• The theory is based on simple prospects, monetary outcomes and
stated probabilities
• But, can be later applied to real life situations
• Evaluates situations involving risk and shows that people respond
differently to a risk depending on whether the outcome is a gain or a loss
1.
Gains
0.25
0.75
2.
£240
84%
£1000
16%
£0
-£750
13%
Text
Losses
0.75
0.25
Non-risk taking
-£1000
87%
Risk Taking
£0
In the first example individuals are less likely to take the risk in
order to win £1000
However when it comes to losses people suddenly become risk
takers and more individuals are willing to take the £1000 gamble.
A hypothetical value function
The curve convex
below the line as
decision makers
are risk seeking
when choosing
between losses.
The curve is
concave above
the line as
decision makers
will be risk averse
when choosing
between gains.
The line at this point is steeper
because decision makers are
extreme risk takers.
Myopic Loss Aversion and the Equity Premium
Puzzle - Benartzi and Thaler
An Application of Prospect Theory
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Mehra and Prescott discovered “the equity premium puzzle”
It leaves us with two questions:
i. Why is the equity premium so large?
ii. Why is anyone willing to hold bonds?
Concepts from the psychology of decision making used:
i. Loss aversion
ii. Mental accounting methods
“I won’t bet because I would feel the $100 loss more than the $200
gain”
Two factors contribute to unwillingness to hold equities:
i. Loss aversion
ii. Short evaluation period
Benartzi and Thaler conclude that a combination of high sensitivity to
losses and high tendancy to frequently monitor ones wealth explain
the equity premium puzzle.