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# Topic2d - Topic IID Applications of Prospect Theory For...

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Topic IID: Applications of Prospect Theory For many years, expected utility has been used by economists to capture risk preferences — indeed, it is still used in almost all applications. BUT economists are starting to recognize that some behaviors many such behaviors, prospect theory provides a natural interpretation. To illustrate, we’ll consider 7 examples. 1

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Application #1: The Samuelson Bet Example due to Samuelson (1963) Consider the following bet: win \$200 with prob 1 / 2 lose \$100 with prob 1 / 2 Samuelson’s colleague turned down this bet, but announced that he would accept 100 plays of the same bet. Samuelson proved that his colleague was “irrational” — by proving that it is inconsistent with expected ­ utility theory to turn down the single bet but accept 100 such bets. But WAS his colleague “irrational”? 2
Consider an alternative “model”: Suppose that a person evaluates bets according to the value function v ( x )= ( x if x 0 2 . 5 x if x 0 Consider the single bet y =[200 ,. 5; 100 ,. 5] . Consider taking two such bets, which means you face aggregate gamble z =[400 ,. 25; 100 ,. 5; 200 ,. 25] . Point: Unlike EU, loss aversion can lead a person to reject one play of the bet but to accept multiple plays of the bet. 3

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An important issue: Mental Accounting Mental accounting is the process that a person uses to interpret a choice situation. Any application of prospect theory requires a mental ­ accounting assumption. Sometimes, what’s required is an assumption about how people decide what are the objects for evaluation. as people ignoring seemingly extraneous parts of the problem. E.g., to explain the behavior of Samuelson’s colleague, we
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Topic2d - Topic IID Applications of Prospect Theory For...

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