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PROSPECT THEORY: AN ANALYSIS OF DECISION UNDER RISK
Daniel Kahneman and Amos Tversky
Miguel Morales
Júlia Garcia
Neil de la Fuente
Laia Vilardell
14/ 12/ 2021
Utility function: calculation for how much someone desires something.
Utility theory states that costumers when facing a purchase decision, rank the products in their minds based on the highest degree of satisfaction.
EXAMPLE
Mario: 45 years old, hired by a new company. Enjoys luxurious gadgets and is rich enough to posses those devices.
A new smartphone is presented to the VIP clients (costs $1,100). Mario prefers this new version.
For his satisfaction (utility), owning this new device makes him feel important and appreciated.
Prospect theory: people value certainty over risk, particularly if gains and losses are equal in likelihood
Value function:
S-shaped value curve that is:
concave for gains and convex (and steeper) for losses.
Key concepts:
- Risk aversion for sure gains
- Risk seeking for sure losses
- Fear of losing > joy of gaining
Weighting function:
- Overweight low-probability events.
- Underweight highly certain outcomes.
The Isolation Effect
The Weighting Function
The link below takes us to a video that demonstrates the Weighting Function
https://youtu.be/lhA6ZPwKyUI
We will present a model that tells us if our customers are going to default on their payments when we extend credit to them. We will use this model to decide if we give him the credit or not.
We need to be very conservative doing predictions, because we need to make sure that the customer is going to pay with a very high probability.
Because the majority of people have paid correctly, when we train our model, it will tend to predict that customers will pay correctly. That is because as we have seen in the historical sample we have an unbalanced sample.
So, we have to train our model in a very conservative way. For it we can apply different techniques :
So as we have seen in prospect theory, here in the model we apply techniques related to risk aversion to earn money. Because the bank wants to ensure that they will earn the money from the interest.
Amos and Kahneman were game-changers in terms of understanding the way we make decisions.
This was their masterpiece, where they refuted the utility theory by this more accurate and realistic prospect theory, explaining our way to decide under risk.
THANK YOU!
Prospect Theory:
An analysis of decision under risk