Question

Explain the following phenomena using properties of Kahneman and Tversky's prospect theory as we’ve discussed it in class. Carefully state what is being evaluated, what is the reference point, what property of prospect theory explains the phenomenon, and why that property explains it. (a) Gamblers tend to bet more recklessly with money they have just won (and more generally, people tend to more easily spend money acquired easily or unexpectedly). This is commonly referred to as the “house money effect.” (b) When some stores started introducing charges for credit-card transactions, credit-card companies lobbied hard to have stores call the credit-card price the regular price and the difference a “cash rebate,” rather than call the cash price the regular price and the difference a “credit-card surcharge.” (c) In many contracts for services (such as cell-phone contracts), different features of the service are separated out in great detail, yet the price of the service is subsumed in a single relatively large payment. (d) The fact we talked about in class on horserace betting (that betting on longshots increases toward the end of the day, especially in the last race). (e) Can you explain the phenomena described under (d) with a second different property of prospect theory?

Answer 1

Ans ) The prospect theory explains the way people choose between probabilistic alternative that involves risk, where the probabilities of outcome are known. The decision of people are based on potential losses or gains rather then final outcome. An important implication of this theory is that the way people subjectively frame an outcome or transaction in their mind affects the utility they expects or receive.

(a) Gambler bet more when they won as their expectations will rise from winning in betting, the consumption will increase from this income as their utility from this money is low( the higher the wealth people have , lower will be the marginal utility they are gaining) as a result the consumption from this winning money will increase as compare to labour income. Because labour income is limited in month/year people will spend accordingly but when unexpectedly income rises the consumption also rises. When income rises unexpectedly the people try to take more risk as they know the probability of outcome. The property here is heuristic. As gambler will set a reference point here and then spend recklessly ( will bet more if the reference point is low or will bet less if there is tendency to loose more).

(b) When the credit card company started to charge interest rate then also using of credit card is not reduced because people see the final outcome not the gain or loss on individual purchase. They measure the expected gain or loss from overall purchase as explained by this theory. Here also the property is heuristic because people will see final outcome not individual outcome and accordingly set a reference point if gain is more then difference between the regular price and credit card surcharge then the use of credit card will not be affected whereas the reference point is less then this difference then the use of credit card will be affected.

(C) Cell phone contracts, different features of services are separated out in great details the price of service are subsumed in single payment as according to this theory the gains which are expected by economic agents are whole amount not as single or separated services. The agents will measure the final outcome relative to the reference point.

And(d) When the agent's expectations seems to be true then the risk lowers by the end and the confidence of agents increase this results in increase in the amount of gambling or as asked in question in the horse race in the last race the longshots increase because of the rise in the expectations. This increase the amount of betting. The reference point is set by agents low , the rise in final outcome or gain is higher then amount spent recklessly.

(E) The second property is subsequent evaluation phase as explained in this theory. This means agents evaluates utility according to the potential probability and respective probability. And then chooses a alternative having higher utility. In above question the last race of horse betting increases because of the potential probability is lower then the respective probability in last race,so the the alternative is higher.