Bounded Rationality &

Prospect Theory
Lecture 5
502 February 25 2016

What I want you to learn today

The decisions you make about risk and time are
subject to the influence of System 1 in
predictable ways
Four areas of departure from the standard
model

Risk preferences
Loss aversion
Probability weighting
Time preferences

How do we evaluate worth and wealth?

Bernoulli: The utility of an item (or of money) is
based on our wealth
$20 gift to someone with $200 same as
$40 gift to someone with $400

Solution: Separate the psychological value /

desirability of money and the amount of money:
utility

What about gambles?

Expected value:
EU(x, p; y, 1-p) = p*U(x) + (1- p)*U(y)
1000 vs. 1200 (0.6*2000)
Expected utility (EU):
Average of the utilities of these outcomes (not the
values), weighted by probabilities
Diminishing marginal utility as wealth increases

Problem: Final outcomes vs. changes

Today Shai and Oliver have a wealth of 5 million
Yesterday, Shai had 1 million and Oliver had 9 million
Are they equally satisfied?

The value function of Prospect Theory

(Kahneman & Tversky)

Reference point

Problem: Risk aversion

Get $1000 for sure, or 60% chance of getting $2000

Problem: Risk seeking

Lose $1000 for sure, or 60% chance of losing $2000

Seeking risk, avoiding risk

Risk aversion

Risk seeking

Problem: diminishing sensitivity

Recall Bernoulli: The utility of an item (or of money)
is based on our wealth
$20 gift to someone with $200 same as
$40 gift to someone with $400

Now: Utility is based on reference point

$20 gift to someone with low reference point same as
$40 gift to someone with high reference point

Diminishing sensitivity: increasing a payoff from 10

to 11 is worth more than increasing it from 100 to
101

Diminishing sensitivity

Problem: loss aversion

Endowment effect (Kahneman, Knetsch, Thaler)
The worth of your mug:
To sellers: $7.12
To buyers: $2.87
To choosers: $3.12

Endowment effect emphasizes that the owners

suffer the most
Taste is not fixed: it varies with the reference point

Loss aversion

Implications: Framing
The US is preparing for the outbreak of an unusual
Asian disease, which is expected to kill 600
people. Two alternative programs have been
proposed:
For a group of 600 people.
Version 1:
Program A: 200 people will be saved.
Program B: There is 1/3 P that 600 people will be saved and 2/3
P that no people will be saved

Version 2:
Program A: 400 people will die.
Program B: There is 1/3 P that nobody will die and 2/3 P that
600 people will die.

Your data: Asian disease

Your data: Asian disease

Framing changes the reference point

(positions you for a gain, or a loss)

Which option do you prefer?

economist.com
subscription $59

economist.com
subscription $59

Print subscription
$125

Print subscription
$125

Print & web

subscription $125

Print & web

subscription $125

Which option do you prefer?

Which option do you prefer?

Goals can be reference points

Missing a goal is a loss, exceeding it is a gain
Golf: reference is the Par
One stroke under: birdie
One stroke over: bogey

Consider 2.5 million professional golfing putts that

are trying to avoid a bogey or achieve a birdie
More successful when putting for par (avoid
bogey) than achieving birdie
Tiger Woods: average score would have improved
by 1 stroke, increased earnings of 1 million
Pope & Schweitzer

Other applications of loss aversion

Status quo bias:
weight disadvantages of change more heavily than
advantages

Negotiation obstacles:
My concessions are losses to methey hurt
Your concessions are gains to methey mean little

Market rigidities:
Reluctance to sell at loss

How do we judge probability?

Consider P (winning $10,000)

Change from 0 to 5%
Change from 5% to 10%
Change from 60% to 65%
Change from 95% to 100%

Are the improvements equally good?

Our decisions do not follow linear function of probability
Move from 0% chance to .5% chance
Move from 100% chance to 95.5% chance

Humans vs. econs probability weighting

How much
humans
weight the
probability

Psychophysics of chance
Certainty
effect
How much
humans
weight the
probability

Possibility
effect

Your data: Subjective probabilities are not

linear

Prospect theory: Key points

Diminishing sensitivity
Reference points
Loss aversion
Probability weighting: Possibility and certainty
effects

Temporal discounting

The discount function

Temporal discounting
Loss of subjective value of gains over time
Important for policy: delayed outcomes are not
valued as highly as immediate ones.
Implications for saving, investment in health,
education
Intertemporal choice exhibits decreasing impatience

Decreasing impatience
Do you want $100 today, or $110 1 year from
now?
$100 in 10 years, or $110 in 11 years?

Your data: Decreasing impatience

Decreasing impatience
Intertemporal choices often exhibit decreasing
impatience: more patient in the long run than in
the short run
Other names: present bias; myopia; hyperbolic
discounting

The standard model: exponential

discounting

A behavioral model: quasi-hyperbolic

discounting (Laibson, 1997)

Exponential vs. quasi-hyperbolic

Exponential vs. quasi-hyperbolic

Implications of decreasing impatience

Dynamic inconsistency: Dont carry out plans you make today
New years resolutions:
Study more watch Youtube
Save more go out
Lose weight eat dessert

Two limits on willingness to invest in long-term outcomes

Loss of value over time
Knowledge that one may not follow through

Dynamic inconsistency and policy

Farmers and fertilizer (Duflo et al.)
Commitment savings accounts (Ashraf et al.)
Save More Tomorrow (Thaler & Benartzi)
stikk.com

Behavioral design for dynamic

inconsistency

SnuzNLuz Alarm Clock:

Connects via WiFi to your
online bank account, and don
ates YOUR real money to an
organization you HATE when
you decide to snooze!

But how does it really work? ....it's quite simple actually. The SnzNLz uses the very
complex psychological phenomemon known as 'HATRED'. Basically it's human nature
to wish harm upon your enemies. Similarly, it's human nature not to give your enemies
gobs of cash so that they can grow big and dominate the world with their totally wrong,
stupid and invalid point of view... That's why every time you hit the snooze button, the
SnzNLz will donate a specified amount of your real money to a non-profit you hate.
The problem of sleeping in is solved.

Common Usage Suggestions!

Are you a butcher? Set your SnzNLz to donate to PETA

Are you a republican? Set your SnzNLz to donate to the ACLU!
Are you a land developer? Set your SnzNLz to donate to the Wilderness
Society!
Enjoy your freedom? (Blue state version) Set your SnzNLz to donate to
the GOP. Or
Enjoy your freedom? (Red state version) Set your SnzNLz to donate to
MoveOn.Org
Are you a hippie? Set your SnzNLz to donate to the American Coal
Foundation.
Are you a Ninja? Set your SnzNLz to donate to, hrrrm, we can't find a
Pirate Charity at the moment. But there must be one...somewhere...anyways,
the point is it's easy to setup once you identify your enemy!

Implications for life in the policy world

Choose frames wisely: Framing for decisions
matters a great deal (gain vs. loss)
Choose choice sets: Set of alternatives matters for
revealed preferences
Choose probabilities: Small probabilities
overweighted, large probabilities underweighted
Choose timing: Address interventions to the
immediate self

EXTRA SLIDES

Four-fold pattern of risk preferences

Low P
(Possibility effect)

Gains

Losses

Hi P
(Certainty effect)

Four-fold pattern of risk preferences

Low P
(Possibility effect)

Hi P
(Certainty effect)

Gains

Hope of large gain

Risk seeking
LIKE LONG SHOTS
($1,000, .01 > $10)
Reject favorable settlement

Fear of disappointment
Risk aversion
LIKE SURE GAINS
($900) > ($1,000, .9)
Accept unfavorable settlement

Losses

Fear of large loss

Risk aversion
BUY INSURANCE
(-$10) > (-$1000, .01)
Accept unfavorable settlement

Hope to avoid loss

Risk seeking
GO FOR BROKE
(-$1000, .90) > (-$900)
Reject favorable settlement

Why do losses loom large?

Negativity dominance: Emotional reactions to
change and loss (System 1)
Brains designed to give priority to bad news (although
careful with evolutionary arguments like this)
Bad is stronger than good quick to form bad
impressions and they are more resistant to change

Humans vs. Econs

Inconsistent rather than consistent (preference
reversals)
Narrow as opposed to aggregate (gains and
losses relative to a reference point, rather than
overall wealth)
Myopic rather than far-sighted (temporal
discounting and decreasing sensitivity)

How do we choose?
Choice conflict
Proliferation of alternatives

A US supermarket

6 jams on
display:
24 jams on
display:

40% stop to try

60% stop to try

30% bought
one
3% bought one

(Iyengar / Lepper, 2000; Schwartz, 2000)

6 jams on
display:
24 jams on
display:

40% stop to try

60% stop to try

30% bought
one
3% bought one

(Iyengar / Lepper, 2000; Schwartz, 2000)

6 jams on
display:
24 jams on
display:

40% stop to try

60% stop to try

30% bought
one
3% bought one

(Iyengar / Lepper, 2000; Schwartz, 2000)

401 K options: for every 10-option increase,

probability of participation declines by 2%
(Iyengar / Jiang, 2005)

Effect of conflict on choices

When conflicted, even among good options, we
keep searching
When there is choice proliferation, we avoid
choosing (Jam)
When conflicted between new options, default
is likely to benefit

Temporal discounting
Choosing 100 today over 110 next month is
discounting the future (declines sharply with time)
Discounting declines with magnitude of choice:
$10 today* vs. $15 in one year
$1000 today vs. $1500 in one year*

Your data: Magnitude effect