Quiz: Cognitive psych prospect theory and decisions

What is Prospect Theory?

A behavioral economic theory that describes how people make decisions under risk, emphasizing the value of potential losses and gains.

True or False: Prospect Theory assumes people are always rational.

False. Prospect Theory shows that people often behave irrationally when faced with uncertainty.

Define Loss Aversion.

The principle that losses weigh heavier on decision-making than equivalent gains, often represented as a ratio, typically around 2:1.

What are the two phases of decision-making in Prospect Theory?

1. Editing Phase: Organizing choices. 2. Evaluation Phase: Assessing potential outcomes.

Fill in the blank: In Prospect Theory, __________ is more impactful than gains.

Losses.

How does the value function in Prospect Theory differ?

It is concave for gains (risk-averse) and convex for losses (risk-seeking) with a steeper slope for losses.

Question: What is the reference point in Prospect Theory?

The baseline or status quo from which gains and losses are evaluated.

Comparison: Certainty Effect vs. Probability Weighting.

Certainty Effect: Overvaluing certain outcomes. Probability Weighting: Misjudging probabilities, leading to irrational decisions.

What is the endowment effect?

The tendency for people to value items they own more than equivalent items they do not own.

True or False: People prefer a sure gain over a gamble with higher potential gains.

True. People often prefer a guaranteed outcome due to risk aversion.

Describe diminishing sensitivity in Prospect Theory.

As gains or losses increase, the additional impact of further gains or losses decreases.

What is framing effect?

The way choices are presented can significantly affect decisions; e.g., '90% lean' vs. '10% fat.'

How is the value function mathematically represented?

\displaystyle v(x) = \begin{cases} x^\alpha & \text{if } x > 0 \ -\lambda(-x)^\\beta & \text{if } x < 0 \end{cases}

Example: If a bet offers a 50% chance to win $\displaystyle 100 or lose$50, which do you choose?

Many may avoid the gamble due to loss aversion despite the positive expected value.

What role do heuristics play in Prospect Theory?

Heuristics simplify decision-making, often leading to cognitive biases and deviations from rationality.

Fill in the blank: The __________ prevents individuals from recognizing the true probabilities of outcomes.

Probability weighting function.

What does prospect theory suggest about losses?

Losses loom larger than gains. This means people are more sensitive to losses than to equivalent gains, often leading to risk-averse behavior.

True or False: Prospect theory predicts people will gamble to avoid losses.

True. People may take risks to avoid a loss rather than accept a sure loss, demonstrating loss aversion.

Fill in the blank: In prospect theory, __________ is the tendency to prefer avoiding losses over acquiring equivalent gains.

loss aversion

Compare risk-seeking vs. risk-averse behavior in gains.

Risk-averse: Prefer sure gains (e.g., $\displaystyle 50 guaranteed). Risk-seeking: Prefer gambles for higher gains (e.g., 50$100).

What is the certainty effect in decision-making?

The tendency to overweight outcomes that are certain compared to those that are probable, leading to irrational decisions.

Cause → Effect: Why do people often underweight small probabilities?

Cause: Small probabilities are perceived as negligible. Effect: This leads to neglecting potential gains or losses, such as buying lottery tickets.

What role does framing play in decisions?

Framing affects choices based on how options are presented, such as emphasizing potential gains vs. losses.

True or False: People always make rational decisions according to prospect theory.

False. Prospect theory shows that people often make irrational decisions influenced by cognitive biases.

What is the impact of mental accounting on decision-making?

Mental accounting leads individuals to categorize money into different accounts, influencing spending and saving behaviors based on perceived gains or losses.

Example: How does prospect theory explain overpaying for low-probability outcomes?

People may overvalue a lottery ticket ($\displaystyle 1 ticket for a chance at$1 million) due to the potential for a life-changing gain, despite low probability.

Define the concept of diminishing sensitivity in prospect theory.

Diminishing sensitivity means that as the magnitude of outcomes increases, the additional impact of each incremental change decreases (e.g., $\displaystyle 50 gains vs.$500).

What is the isolation effect?

The isolation effect occurs when individuals disregard certain aspects of a decision, focusing instead on a single outcome that seems more attractive.

True or False: People are more likely to take risks when faced with potential losses.

True. Under loss conditions, individuals often become risk-seeking, preferring to gamble rather than accept losses.

What is a common everyday example of loss aversion?

People are likely to avoid a $\displaystyle 50 loss more eagerly than they seek a$50 gain, showing their greater sensitivity to losses.

How does prospect theory apply to investing?

Investors may hold losing stocks too long due to loss aversion, hoping to avoid locking in a loss, which can lead to poor financial decisions.

Cause → Effect: What happens when choices are presented as gains vs. losses?

Cause: Choices framed as gains lead to risk-averse decisions. Effect: Choices framed as losses tend to result in risk-seeking behavior.

How does prospect theory apply to insurance decisions?

Individuals often overvalue small probabilities, leading to excessive insurance purchases. - Risk aversion - Loss aversion

True or False: Loss aversion means losses weigh heavier than gains.

True. Losses are perceived as more impactful than equivalent gains, affecting decisions.

Fill in the blank: In investing, prospect theory suggests ____ leads to poor choices.

Loss aversion. Investors may hold losing stocks too long, fearing loss.

Compare risk-seeking behavior in gains vs. losses.

Gains: Risk-averse; prefer guaranteed outcomes. Losses: Risk-seeking; gamble to avoid loss.

How is prospect theory relevant to marketing?

Marketers can frame products to highlight gains or minimize perceived losses. - Discounts - Warranties

What role does framing play in health decisions?

Framing options as potential losses rather than gains increases the likelihood of preventive measures.

Cause → Effect: Why do people avoid risky health treatments?

Cause: Fear of loss. Effect: Preference for safe, less effective alternatives.

True or False: Prospect theory solely explains individual choices.

False. It also explains group behaviors like market trends and collective risk-taking.

How can prospect theory influence political decisions?

Voters may be swayed more by potential losses than by potential gains in policies.

What is the endowment effect?

The tendency to value owned items more than equivalent items not owned, impacting sales.

Give an example of prospect theory in sports.

Coaches may prefer conservative plays to avoid loss over risky plays that could win games.

Fill in the blank: Prospect theory suggests people perceive ____ differently during economic downturns.

Risk. They become more risk-averse to avoid potential losses.