Reference Dependent Utility
Prospect Theory, Loss Aversion
Willa Friedman
University of Houston
September 3, 2019
Willa Friedman
(UH)
Lecture 5  Reference Dependent Utility 3
September 3, 2019
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Outline
1
Announcements and Review
2
More endowment effect examples
3
Prospect Theory Applications
4
NonLinear Probability Weighting
The simultaneous purchase of lotteries and insurance
5
Summary of prospect theory
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(UH)
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September 3, 2019
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More endowment effect examples
Assignment 2 due today.
Assignment 3 due next Tuesday.
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Lecture 5  Reference Dependent Utility 3
September 3, 2019
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More endowment effect examples
If your birthday is in the first half of the year, close your eyes, until I tell you to
open them.
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Lecture 5  Reference Dependent Utility 3
September 3, 2019
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More endowment effect examples
How much would someone need to pay you to cut off your left foot? Please close
your eyes for the next slide.
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Lecture 5  Reference Dependent Utility 3
September 3, 2019
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More endowment effect examples
If your birthday is in the first half of the year, please open your eyes now.
Imagine you had lost your left foot in an accident. How much would you need to
be compensated to be “made whole” again?
Think about this.
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More endowment effect examples
Everybody open your eyes.
First half of the year birthdays, give me some numbers.
Second half of the year birthdays, give me some numbers.
First half of the year, what were you asked?
Second half of the year, what were you asked?
Why might these be different?
We’ll come back to this.
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(UH)
Lecture 5  Reference Dependent Utility 3
September 3, 2019
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More endowment effect examples
Buying and selling prices
As last time, let
c
1
and
c
2
be consumption in mugs and money; and
r
1
and
r
2
be the reference point in mugs and money.
The value/utility function is
v
(4
c
1

4
r
1
) +
v
(
c
2

r
2
)
,
where
v
satisfies
v
(
x
) =
x
for
x
≥
0 and
v
(
x
) = 2
x
for
x
≤
0.
Normalize the decisionmaker’s current wealth to zero, and suppose she starts
off with zero mugs.
We found the buying price was $2 and the selling price was $8.
Now we’ll consider the buying price for the “seller” or a person with one mug.
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(UH)
Lecture 5  Reference Dependent Utility 3
September 3, 2019
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More endowment effect examples
What is this owner’s buying price for another mug?
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