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Lec1 pt1

- Xavier Gabaix teaches Behavioral Economics at MIT. The class meets Monday evenings from 4-6:45/7pm with a 10 minute break. Students must complete 3 problem sets and a term paper due September 15, 2004. - Prospect Theory, developed by Kahneman and Tversky, introduces a probability weighing function that accounts for how people overweight small probabilities and underweight large probabilities compared to expected utility theory. This helps explain risk-seeking behaviors like gambling. - Prospect Theory also uses an S-shaped value function that exhibits loss aversion and diminishing sensitivity to changes in wealth or welfare. This can produce fourfold patterns of risk preferences across domains.

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37 views25 pages

Lec1 pt1

- Xavier Gabaix teaches Behavioral Economics at MIT. The class meets Monday evenings from 4-6:45/7pm with a 10 minute break. Students must complete 3 problem sets and a term paper due September 15, 2004. - Prospect Theory, developed by Kahneman and Tversky, introduces a probability weighing function that accounts for how people overweight small probabilities and underweight large probabilities compared to expected utility theory. This helps explain risk-seeking behaviors like gambling. - Prospect Theory also uses an S-shaped value function that exhibits loss aversion and diminishing sensitivity to changes in wealth or welfare. This can produce fourfold patterns of risk preferences across domains.

Uploaded by

feacas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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14.

127 Behavioral Economics


(Lecture 1)

Xavier Gabaix

February 5, 2003

Overview
Instructor: Xavier Gabaix
Time 4-6:45/7pm, with 10 minute break.
Requirements: 3 problem sets and
Term paper due September 15, 2004 (meet Xavier in May to talk
about it)

2.1

Some Psychology of Decision Making

Prospect Theory (Kahneman-Tversky, Econometrica


79)

Consider gambles with two outcomes: { with probability s, and | with


probability 1 3 s where { D 0 D |.

Expected utility (EU) theory says that if you start with wealth Z then
the (EU) value of the gamble is
Y = sx (Z + {) + (1 3 s) x (Z + |)
Prospect theory (PT) says that the (PT) value of the game is
Y =  (s) x ({) +  (1 3 s) x (|)

where  is a probability weighing function. In standard theory  is linear.

In prospect theory  is concave rst and then convex, e.g.


 (s) =

s
s + (1 3 s)

for some  M (0> 1). The gure gives  (s) for  = =8

0.75

0.5

0.25

0
0

0.25

0.5

0.75

1
p

2.1.1

What does the introduction of the weighing function  mean?

 (s) A s for small s. Small probabilities are overweighted, too salient.


E.g. people play a lottery. Empirically, poor people and less educated
people are more likely to play lottery. Extreme risk aversion.
 (s) ? s for s close to 1. Large probabilities are underweight.

In applications in economics  (s) = s is often used except for lotteries


and insurance

2.1.2

Utility function x

We assume that x ({) is increasing in {, convex for loses, concave for


gains, and rst order concave at 0 that is
3x (3{)
=A1
{<0+ x ({)
lim

A useful parametrization
x ({) = { for { D 0
x ({) = 3 |{| for { $ 0

The graph of x ({) for  = 2 and  = =8 is given below

u
2.5

0
-5

-2.5

2.5

5
x

-2.5

-5

2.1.3

Meaning - Fourfold pattern of risk aversion x

Risk aversion in the domain of likely gains


Risk seeking in the domain of unlikely gains
Risk seeking in the domain of likely losses
Risk aversion in the domain of unlikely losses

2.1.4

How robust are the results?

Very robust: loss aversion at the reference point,  A 1


Robust: convexity of x for { ? 0
Slightly robust: underweighting and overweighting of probabilities  (s) B
s

2.1.5

In applications we often use a simplied PT (prospect theory):

 (s) = s
and
x ({) = { for { D 0
x ({) = { for { $ 0

2.1.6

Second order risk aversion of EU

Consider a gamble { +  and { 3  with 50 : 50 chances.


Question: what risk premium  would people pay to avoid the small
risk ?
We will show that as  < 0 this premium is R
second order risk aversion.

2

. This is called

In fact we will show that for twice continuously digerentiable utilities:



 () ;
= 2>
2
00

where  is the curvature of x at 0 that is  = 3 xx0 .

The risk premium  makes the agent with utility function x indigerent
between
1
1
x ({) and x ({ +  +  ()) + x ({ 3  +  ())
2
2
Assume that x is twice digerentiable and take a look at the Taylor
expansion of the above equality for small . .
h
i

1 0
1 00
2
2
x ({) = x ({) + x ({) 2 () + x ({) 2  +  () + r  2
2
4

or

i

h 2
2
 () =
 +  () + r  2
2

Since  () is much smaller than , so the claimed approximation


is true. Formally, conjecture the approximation, verify it, and use

the implicit function theorem to obtain uniqueness of the function 


dened implicitly be the above approximate equation.

2.1.7

First order risk aversion of PT

Consider same gamble as for EU.


We will show that in PT, as  < 0, the risk premium  is of the order
of  when reference wealth { = 0. This is called the rst order risk
aversion.
Lets compute  for x ({) = { for { D 0 and x ({) = 3 |{| for
{ $ 0.
The premium  at { = 0 satises
1
1

0 = ( +  ()) + (3) |3 +  ()|
2
2

or
 () =

1



31

1


+1

where n is dened appropriately.

 = n

2.1.8

Calibration 1

Take x (f) =
utility

f13 ,
13

i.e. a constant elasticity of substitution, CES,

Gamble 1
$50,000 with probability 1/2
$100,000 with probability 1/2
Gamble 2. ${ for sure.
Typical { that makes people indigerent belongs to (60n> 75n) (though
some people are risk loving and ask for higher {.

Note the relation between { and the elasticity of substitution :


{ 70n 63n 58n 54n 51=9n 51=2n
 1
3
5
10
20
30
Right  seems to be between 1 and 10.
Evidence on nancial markets calls for  bigger than 10. This is the
equity premium puzzle.

2.1.9

Calibration 2

Gamble 1
$10.5 with probability 1/2
$-10 with probability 1/2
Gamble 2. Get $0 for sure.
If someone prefers Gamble 2, she or he satises
1
1
x (z) A x (z +  3 ) + x (z +  + ) =
2
2
Here,  = $=5 and  = $10=25. We know that in EU
 2
W
 ?  () = 
2

And thus with CES utility


2Z 
?
2

forces large  as the wealth Z is larger than 105 easily.

2.1.10

Calibration Conclusions

In PT we have  W = n. For  = 2, and  = $=25 the risk premium


is  W = n = $=5 while in EU  W = $=001.
If we want to t an EU parameter  to a PT agent we get

=

2nZ


and this explodes as  < 0.


If someone is averse to 50-50 lose $100/gain j for all wealth levels
then he or she will turn down 50-50 lose O/gain J in the table

O\j
$101
$105
$110
$125
$400
$400
$420
$550 $1> 250
$800
$800 $1> 050 $2> 090
"
$1000 $1> 010 $1> 570
"
"
$2000 $2> 320
"
"
"
$10> 000
"
"
"
"

2.2

What does it mean?

EU is still good for modelling.


Even behavioral economist stick to it when they are not interested in
risk taking behavior, but in fairness for example.
The reason is that EU is nice, simple, and parsimonious.

2.2.1

Two extensions of PT

Both outcomes, { and |, are positive, 0 ? { ? |. Then,


Y = y (|) +  (s) (y ({) 3 y (|)) =
Why not Y =  (s) y ({) +  (1 3 s) y (|)? Because it becomes selfcontradictory when { = | and we stick to K-T calibration that puts
 (=5) ? =5.
Continuous gambles, distribution i ({)
EU gives:
Y =

Z +"
3"

x ({) i ({) g{

PT gives:
Y =
+

Z +"
0
Z 0
3"

x ({) i ({) 0 (S (j D {)) g{

x ({) i ({)  0 (S (j $ {)) g{

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