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Topic2c - Topic IIC An Alternative Model Prospect Theory...

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Topic IIC: An Alternative Model: Prospect Theory Prospect Theory (an alternative to EU Theory) Two Phases of Choice Process: Editing Evaluation ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Editing Stage : organize & reformulate the problem What’s going on? A choice problem is described to you, and then you transform it into the lotteries that you will evaluate. For instance: Coding: code outcomes as gains & losses relative to some reference point. Cancellation: discard shared components. Simpli fi cation: rounding off probabilities. 1
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Evaluation Stage : A person evaluates a prospect ( x, p ; y, q ) according to: V ( x, p ; y, q ) = π ( p ) v ( x ) + π ( q ) v ( y ) . Reminder: Expected utility says evaluate according to: U ( x, p ; y, q ) = pu ( w + x ) + qu ( w + y ) + (1 p q ) u ( w ) π ( · ) is the probability-weighting function. v ( · ) is the value function. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Value Function v ( · ) : Three Key Features: The carriers of value are changes in wealth (
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