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Applications of Prospect Theory, Neuroscience, and Uncertainty


Vlad Mitroi

on 27 November 2011

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Transcript of Applications of Prospect Theory, Neuroscience, and Uncertainty

2. wrong assigned values to "Likely to recommend primary provider to someone I know" =58 and to "Overall satisfaction with primary provider"=44
3. in Q10 there is no value assigned to "Female" it should be Female=2
4. To all the subsections of Q6 (Q6a, ....Q6m) the value "N/A" is not missing so the subquestions should not have any missing values
5. Q11 should have value 4 assigned for "separated", not 8
6. "Primary last" variable has no purpose so it should be excluded
7. Q14, should not have 4 as a missing value. It should be "none"
8. Wrong label for Q6m. It should be "Quality of service" Break time! Because... flies! Applications of Prospect Theory, Neuroscience, Emotions, and Uncertainty Agenda I. Loss Aversion & Prospect Theory (12.3-12.4 & Camerer)
II. New Findings on Judgment and Dec. Making (Ch.13)
III. Uncertainty (Ch.14)
IV. Applications of Prospect Theory (Camerer)

I. Loss Aversion
Prospect Theory
(12.3-12.4 & Camerer) Who watched the video? Towards the end of the video, the neuroschentist uses dots to describe how the brain codes movement. What were the dots doing? According to the neuroscientist, what theory can be used to understand how the brain deals with uncertainy? Whoever knows the answer will receive a piece of candy! Whoever knows the answer will take candy from the individuals who don't know the answer!
If all of you know the answer I will give you another piece of candy
If no one knows I will take the candy from Q1 back.
What are the factors underlying loss aversion? Endowment effect Query theory Emotional Appraisal theory Incidental emotional state
"Misery is not miserly" Practical examples from the field of finance:

A. "Get-evenitis" and the disposition effect

B. "Myopic loss aversion" and the equity premium puzzle

C. Status quo bias (see lecture)

D. Throwing good money after bad in project termination A. "Get-evenitis" and the disposition effect Hersh Shefrin and Meir Statman (1985) III. Research approach IV. Findings I. Observe the behavior V. Conclusion II. Possible explanations They consider a wider theoretical framework concerning a general disposition to sell winners too early and hold losers too long.

More specifically, the authors argue that the tendency to concentrate loss realizations in December is not normatively based; however, it is consistent with a
descriptive theory. Mental accounting,
Regret aversion,
Tax considerations,
Loss aversion. The authors discuss evidence which suggests that this disposition shows up in real-world financial markets, not just in contrived laboratory experiments. The authors find that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and a disposition to sell winners and ride losers. Normative assumptions don't explain sufficiently the disposition effect
Aversion to loss realization represents a good behavioral predictor for this effect B. "Myopic loss aversion" and the equity premium puzzle Benartzi and Thaler (1995) The facts are:
Stocks have outperformed bonds over the last century (7% return vs. 1% return)
High equity premium, low risk-free rate, and smooth consumption have difficulty in explaining this because of a reasonable high risk aversion Loss aversion & short evaluation period
Preference over returns vs. consumption
Utility is defined over gains & losses
Horizon vs. Examination D. Throwing good money after bad in project termination Managers commit themselves to projects by taking responsability for sunk costs
They find it difficult to realize losses
Throw good money after bad in an attempt to break even Statman and Sepe (1989) Do group (individual) decisions have a differential impact on escaladating commitment to a failing project? II. New Findings on Judgment and Dec. Making (Ch.13) 13.1 The neuroscience of decisions
(neuroeconomics) Research tools and techniques are becoming more and more advanced

The goal is to localize where different types of decisions are made in the human brain 1. Deliberate consideration of gambles
=> dorsolateral prefrontal cortex 2. Valuation processes for own consumption, painful experiences, money
=> limbic system: the striatum, the amygdala, and the insula 3. Integration of cognitive situation info. and emotional valuations
=> orbitofrontal cortex An interesting finding is that brains are responsive to the relative -not absolute- amounts to be gained or lost
=> support for prospect theory The finding was that the brain reaction, in the amygdala, to receiving $ 0 was either positive or negative depending on "what else might have happened" 13.2 Emotions in decision making "Although humans have a remarkable capacity for self-control, we all exhibit lapses and act contrary to our declared intentions to abstain, adhere, or save." (Rachlin, 1989) Immediate gratification vs. long-term welfare <=>
immediate vs. delayed rewards Time preferences Consider the following choices:

$20 immediately vs. receive $25 in one week

$20 in 35 days vs. $25 in 42 days Dynamic inconsistency
The general DU model Frederick, Loewenstein, and O'Donoghue (2002) Assumptions of the DU model:
1. Integration of new alternatives with existing plans
2. Utility independence
3. Consumption independence
4. Stationary instantaneous utility
5. Independence of discounting from consumption
6. Constant discounting and Time consistency
7. Diminishing marginal utility and positive time prefernce Models that enrich the Instantaneous Utility function A. Habit-formation models
B. Reference point models
C. Models incorporating Utility from anticipation
D. Visceral influences (Loewenstein, 1996) Frederick, Loewenstein, and O'Donoghue (2002) Affect heuristic Slovic (1987) Emotion-modified decision weighting function Rottenstreich and Hsee (2001) III. Uncertainty (Ch. 14) 14.1 Uncertainty as negative Either ignore uncertainty or invent some "higher rationale"
Superstitions are likely to occur when outcomes involve both skill and chance (easier to confuse one with the other)
"win-stay / lose-switch" strategy
Probability matching Two consequences:
impossible to evaluate chance in success vs. failure
distinction between adaptive and superstitious behavior =>meaningless When there is a chance component in the outcomes of own behavior, people treat it as skill (stock picking)
The tendency to reject uncertainty is a strong bias (aversion to ambiguity=>video) 14.2 The illusion of hedonic certainty Premises concerning the capacity to predict post-decision experienced utility:

1. We are (at best) moderately accurate predictors of evaluations and emotional reactions to future outcomes;
2. The outcomes are often hard to predict;
3. Even if we could predict our reactions, the impact of the outcomes on our long-term global well-being is much smaller than we think it is
Two sources of this overestimation error:
Insensitivity to regression towards the mean when predicting based on partly valid info;
Individuals do not appreciate their own resiliency and adaptability Immune neglect: we recover faster than we expect from harm and loss, but then we also become accustomed to good faster than we think. (Dan Gilber, 2007) What does this mean for decision making?

People have erroneous, self-aggrandizing beliefs that they can predict and control how happy they will be. 14.3 The price of denying uncertainty Heuristic driven biases:
Illusion of validity
Illusion of control
Self-attribution bias
Cognitive dissonance IV. Applications of Prospect Theory ( return to Camerer) A. Labor supply and framing effects Main findings:
Cab drivers set a daily income target
Drivers will work long hours on bad days (low wage/hour) and quity earlier on good days (high wage/hour)

Standard theory of labor supply predicts the oposite: Drivers will work the hours that are most profitable (quit early on bad days and compensate by working more on good days) Possible explanation:
Mental accounting
Framing effects ( eg. annuity puzzle)
Loss aversion Camerer, Babcock, Loewenstein, & Thaler (1997) B. Assimetric price elasticities and consumer goods Main findings (Putler, 1992):
Loss averse consumers dislike price increases more than they like the windfall gain from price cuts
Price elasticities are asymmetric => larger in magnitude after price increases than after price decreases

Hardie, Johnson, & Fader (1993) found that consumers use reference points to compare current prices => implies choice bracketing (not include in the general utility of the shopping basket)

C. Insensitivity to bad income news Standard theory: if next year's wage is surprisingly good =>teachers should spend more now (reverse=>cut back on spending now).

Shea (1995) found that teacher spend more now when wages are expected to rise but don't cut back when wages are expected to fall.

Bowman, Minehart, & Rabin (1999) demonstrate that teachers exhibit loss aversion because of reference point setting (the pleasure experienced next period depends on the pleasure experienced this period)
=> violates the independence of consumption assumption of the general DU model. D. Racetrack betting: Favorite-longshot bias and end-of-day effect Longshot horses with 2% of the total money bet on them win just 1% of the time (Thaler and Ziemba, 1988) => overbetting on longshots.

Possible explanations:
gamblers fallacy (negative-recenty effect)
overweighting low probabilities ( also state lotteries)
End-of-day effect: bet more on longshots later in the day.

Possible explanations:
Mental accounting
Reference point setting (get-evenitis) That was it for today! Any questions? Thank you for your attention and participation! Reference list: Benartzi, Shlomo, and Richard Thaler. 1995. “Myopic Loss Aversion and the Equity Premium Puzzle.” Quarterly Journal of Economics, 110: 73–92.
Bowman, David, Debby Minehart, and Matthew Rabin. 1997. “Loss Aversion in a Savings Model.” Working paper, University of California, Berkeley.
Camerer, Colin F. 1995. “Individual Decision Making.” In Handbook of Experimental Economics, edited by A. E. Roth and J. Kagel. Princeton: Princeton University Press.
Hardie, Bruce G. S., Eric J. Johnson, and Peter S. Fader. 1993. “Modeling Loss Aversion and Reference Dependence Effects on Brand Choice.” Marketing Science.
Putler, Daniel S. 1992. “Incorporating Reference Price Effects into a Theory of Consumer Choice.” Marketing Science, 11(3): 287–309.
Read, Daniel, George Loewenstein, and Matthew Rabin. 1998. “Choice bracketing.” Working paper, Department of Social and Decision Sciences, Carnegie-Mellon University.
Shea, John. 1995. “Union Contracts and the Life-Cycle/Permanent-Income Hypothesis.” American Economic Review, 85: 186–200.
Shefrin, Hersh, and Meier Statman. 1985. “The Disposition to Sell Winners too Early and Ride Losers too Long.” Journal of Finance, 40: 777–90.
Thaler, Richard, and William T. Ziemba. 1988. “Parimutuel Betting Markets: Racetracksand Lotteries.” Journal of Economic Perspectives, 2: 161–74.
A complete version will be available on demand from the authors. ? Gamblers fallacy: Longshots are horses that lost many races in a row. Now it's gambler's fallacious belief that such horses are due for a win.

But wouldn't one expect such a outcome due to the concept of regression to the mean?
Chris According to behavioral economics the proper response to phenomena such as the obesity epidemic is information. More information is supposed to influence consumer behavior. Calorie labeling, however, has not produced the desired outcome. Aren't the tools of conventional economics (tax on unhealthy processed foods) still the more efficient remedy to most of the challenges to society?
Georgi ? On page 324 the authors state, that our ability to cope with the world is based on three beliefs:
1. We are superior
2. We are invulnerable
3. The world is just

What do you think about these beliefs? Can you give example situations in which each belief is important? And what would happen if these beliefs would not exist?
Sebastian ? Out of Chapter 13 I get the expression that "classic" behavioral decision theory like we learned it in the sessions before has only very limited explanatory and predictive power.

I would like to discuss the relative importance and goodness to study human decision making with the methods of laboratory/field and natural experiments of simply observing or asking (survey) about human behavior.
Frauke ? Empirical research suggests that the presence of the status quo bias influences peoples decisions. When designing new policies or new pansion plans does it then make sense to offer people a choice at all? Discuss.
Fabian ? The last page of chapter 12 talks about the limitations of prospect theory. The example they give is that is does not explain preference reversals.

1. Could you think of prospect theory in a way that it would explain preference reversals? (maybe smtg like changing reference points)
2. What could explain preference reversals ? (other than prospect theory)
3. What other examples could you think of of things that are not explained by prospect theory?
Andreea ? Does the belief that we cannot predict the outcome of a coin tossing treaten our ability to cope with the world? Or is it that cognition itself is so inextricably bound with our attempts to predict that our judgement about events in the world implicitly assume predictability? The book doesn't answer this question, but what do you think? Are their solutions to these problems?
Veronne ? First of all thanks for the video which is very interesting and I did not know him.
During the minute 12:56 he says that the brain makes precise predictions. Could be an evidence that EXPERTS predictions are better than the models in your opinion?
Pierangela ? On page 320 they introduce a believe in some higher rationale which would help people dealing with uncertainties. In my view a believe in a higher rationale underestimates/decreases the skill component in an uncertain task or event. How does that fit with the fact that people usually overestimate their ability/skill to influence an uncertain outcome as again described on pages 321-324?
Arno ? On page 290, the authors say that the endowment effect is "part of the explanation of the malfunction of some markets". This means that the endowment effect would lead to irrational or non-optimal behavior.
But few words later, they say that "Obviously it is strategically wise" to, let's say, make a conscious use of the endowment effet.
So are we consciously using the endowment effet or are we just victims of it coping with the consequences?
Audrey ? From pages 329 to 330, there is a discussion of the benefits of the beleif in control. The point emphasizes that though much of our life is out of our own control, the belief in control can be a positive motivator in developing human values, motivating effort in the workplace, etc. "Some control theorists, neverless, claim that belief in control, illusionary or real, is a mentally healthy motivator?" Do you agree with the this "noble lie"? Discuss!
Dustin ?
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