Question

1. Is expected utility theory of any practical relevance? Why or why not? ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________

2. Prospect theory involves introducing several new “parameters” into the expected utility model of choice. Does this constitute “over-fitting”? How might we ensure that we don’t accept Prospect Theory over expected utility simply because introducing new parameters always leads to a better model fit? ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________

3. During the global financial crisis, housing prices in the U.S. and elsewhere plummeted. Sales slowed down, houses stayed on the market for longer than normal, and houses were observed to be much more likely to sell at the same price that they were previously bought for than a slightly lower price. How can prospect theory intuitively explain these events? ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________

4. A common behavior of gamblers, at casinos or at horse tracks for example, is that they make large bets at the end of the day. How can you explain this with prospect theory? ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________

5. The model of Prospect Theory doesn’t specify what the reference point is or even what attributes of utility might be reference dependent. Scientifically speaking, why is this omission a weakness of the Prospect Theory model? What do you think are three things that influence the reference point, depending on the situation? ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________ ________________________________________________________________________________________

Answer 1

1. I think expected utility is of practical relevance if it is defined with some relaxation. It is about what makes an individual or a group of individuals happy. Contemporary economists believe that it is all about preference. An individual might prefer to give up a certain amount of money to the charity while another individual in same condition, might like to enjoy a luxury trip with the money. So a certain product or service has different value to different individuals. It is basically a measure of happiness. But sometimes one has a big family to look after or has to spend some money for taxes which do not make him happy but he has to do as a part of his duty as he has no choice. But those duties can make him happy in the long term. For instance paying taxes will entitle him to some basic amenities as a citizen. Also looking after the family might also give him certain level of fulfilment and dignity in the community. So if we explain expected utility more liberally, it has some practical relevance. But every choice need not directly make the person happy or satisfied or derive utility directly.