Prospect Theory Study Guide

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Brigham Young University, Idaho *

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Economics

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Feb 20, 2024

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Prospect Theory Study Guide Instructions This is an open-book, open-note assignment. However, your work should be your own – copying and pasting from other sources is plagiarism. If you aren’t sure of the answers, try your very best, and then go back to the readings and check your work. 1. In your own words, described expected utility theory, and the concept of diminishing marginal utility. Or, put differently, why might the beggar go out of his way to pick up a $10 bill, while the millionaire barely notices it? According to the utility hypothesis, people make decisions based on a possible outcome they feel would be the best and the most beneficial. To the beggar, the $10 is the best possible outcome. The millionaire sees the money as small and not a great enough outcome because they already have more than that. 2. In your own words, what is “theory-induced blindness”? How is expected utility theory an example? The theory-induced blindness explains that once someone had understood and used a theory, going forward they will not necessarily see the flaws in it. In expected utility theory, people make choices based on an outcome they think is the best. They do not take the time to see that this could be a flawed way to choose something. 3. In your own words, what is prospect theory ? What are examples the demonstrate the conclusions of prospect theory? Prospect theory is a theory that states that people would prefer to avoid a potential loss than risk a potential gain. For example, if someone has a choice between being given $100 and a 50%chance of winning $200, most people would take the $100 even though the other option is more. 4. In your own words, what does Kahneman mean by loss aversion ? I think that Kahneman explains that Loss aversion refers to a person wanting to avoid losses and it affects them earning gains. For example a person deciding to keep an old car due to the fear of losing the money they have already invested in it, even though the cost of maintaining it may be greater than the cost of the new car.

5. In your own words, what is the endowment effect and the status quo bias ? What experiences have you had that illustrate either of these? Endowment effect is when ownership increases the value an item holds. Status quo bias is when someone sees going away from the status quo as negative, or a loss. One time I decided to change gears and do an assignment a little differently then others in my class. The whole time I was second guessing myself and thinking that it was a bad choice. 6. In your own words, what is the framing effect? What are some examples? Framing effect is when a persons decisions are influenced by the way information is presented. For example, when given a choice between two yogurts, one may lean towards one of them because it is shown as having less fat.

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