10.1 Prospect theory and loss aversion

Prospect theory and loss aversion challenge traditional economic models by incorporating psychological factors into decision-making under uncertainty. These concepts explain why people often make choices that seem irrational, like overvaluing losses compared to equivalent gains.

Understanding prospect theory helps us grasp real-world economic behaviors, from consumer choices to financial markets. It's crucial for designing effective policies, marketing strategies, and incentives that account for how people actually make decisions, not just how they "should" in theory.

Prospect Theory vs Expected Utility

Key Principles and Differences

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• Prospect theory describes decision-making under uncertainty incorporating psychological factors
• Evaluates outcomes relative to a reference point rather than in absolute terms like expected utility theory
• Introduces a value function concave for gains and convex for losses reflecting diminishing sensitivity
• Uses decision weights instead of probabilities accounting for overweighting low probabilities and underweighting high probabilities
• Accounts for framing effects where choice presentation influences decisions unlike expected utility theory
• Explains the certainty effect overvaluing certain outcomes compared to probable ones contradicting expected utility assumptions

Value Function and Decision Weights

• Value function shape reflects risk aversion in gains and risk-seeking behavior in losses
• Decision weights capture tendency to overweight unlikely events and underweight likely ones
• Probability weighting function typically inverse S-shaped (overweight small probabilities, underweight large ones)
• Value function steeper for losses than gains illustrating loss aversion
• Examples:
  • Lottery tickets (overweighting small chance of winning)
  • Insurance (overweighting small chance of large loss)

Loss Aversion and Decision-Making

Psychological Impact and Behavioral Effects

• Loss aversion psychological impact of loss typically twice as strong as equivalent gain
• Leads to endowment effect valuing owned items higher than identical unowned items
• Results in disposition effect in investing holding losing stocks too long and selling winners too quickly
• Contributes to status quo bias preferring current state to avoid potential losses from change
• Examples:
  • Reluctance to sell house below purchase price even if market value declined
  • Holding onto underperforming investments hoping for recovery

Implications for Marketing and Policy

• Influences marketing strategies framing offers as avoiding losses rather than acquiring gains
• Crucial for policymakers designing incentives or implementing changes perceived as potential losses
• Affects pricing strategies emphasizing savings or loss prevention
• Impacts public policy communication focusing on preventing negative outcomes
• Examples:
  • "Don't miss out on this limited-time offer" (loss framing in marketing)
  • Emphasizing potential tax savings rather than refunds in tax policy

Reference Points and Gains vs Losses

Influence on Decision-Making

• Reference points basis for evaluating outcomes as gains or losses
• Often current state or status quo but influenced by expectations aspirations or social comparisons
• Changes in reference points alter outcome perception from gain to loss or vice versa
• Adaptation shifts reference points over time (hedonic treadmill effect)
• Examples:
  • Salary expectations based on industry averages
  • Judging investment performance against market indices

Framing and Manipulation

• Reference points manipulated through framing effects influencing chosen reference point
• Crucial for predicting behavior in various economic contexts
• Impacts financial markets with purchase prices or historical highs influencing investor behavior
• Affects consumer choices and policy responses
• Examples:
  • Framing a $1000 bonus as$500 twice a year vs $1000 once (different reference points)
  • Anchoring effect in negotiations setting initial offer as reference point

Prospect Theory in Economic Applications

Consumer Behavior and Financial Markets

• Explains sunk cost fallacy continuing investment in losing propositions to avoid realizing losses
• Informs insurance product design as people pay premiums to avoid potential losses even with negative expected value
• Provides insights into investor behavior market anomalies and effectiveness of investment strategies
• Examples:
  • Continuing to attend concerts after purchasing season tickets despite not enjoying them
  • Preference for low-deductible insurance plans despite higher overall costs

Labor Markets and Policy Design

• Explains worker resistance to nominal wage cuts more than demand for raises influencing wage rigidity
• Informs tax policy design explaining preference for tax refunds over lower withholding
• Guides incentive structure design in employee compensation and public health initiatives
• Helps frame policy choices like presenting energy conservation as avoiding losses rather than achieving gains
• Examples:
  • Framing pay cuts as "temporary salary adjustments" to reduce resistance
  • Presenting health initiatives as avoiding future illness rather than gaining better health