Professor : Soe-Tsyr, YuanPresenter : Sherry

Endogenizing Prospect Theory’sReference Pointby Ulrich Schmidt and Horst Zank

Outline

• Abstract• Introduction • Prospect Theory Function• Endogenous Prospect Theory• What is “Preference”• Main condition in paper• Conclusion

• Prospect theory is a behavioral economic theory that describes the way people chose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known.

• The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.

Review Prospect Theory

Abstract

• In previous models of (cumulative) prospect theory reference-dependence of preferences is imposed beforehand and the location of the reference point is exogenously determined.

• This note provides a foundation of prospect theory, where reference-dependence is derived from preference conditions and a unique reference point arises endogenously.

Introduction

• Prospect theory is currently one of the most influential models of decision making under uncertainty and has been applied in various fields like finance, consumer choice, and political decision making.

• Reference-dependence means that people do not evaluate final outcomes but instead they base decisions on gains and losses relative to a reference point.

Prospect Theory Function

• current axioms of PT assume the existence of a preference relation defined on gains and losses relative to an exogenously fixed reference point and then impose behavioral conditions on this (reference-dependent) preference relation.

• As a consequence, PT can neither be tested nor applied to concrete choice problems without making prior assumptions about the location of the reference point.

• This is sometimes interpreted as a major shortcoming of prospect theory.

Endogenous Prospect Theory

• The goal of the present note is to derive a new foundation for the model.

• We call the new approach endogenous prospect theory (EPT) because reference-dependence is not assumed beforehand but derived from a behavioral foundation.

Endogenous Prospect Theory

• As mentioned above, according to previous models of prospect theory two criteria can be used to identify the reference point, diminishing sensitivity and loss aversion.

• In EPT we focus on diminishing sensitivity.• By imposing our central axiom —termed consistent

diminishing sensitivity— reference dependence arises endogenously in our model and the reference point is located at the position at which sensitivity towards changes in outcomes is maximal.

Preference

Preference

Transitive : whenever A > B and B > C, then also A > Cwhenever A ≥ B and B ≥ C, then also A ≥ Cwhenever A = B and B = C, then also A = C.

Complete :

Prospect Theory Function

𝐔=𝐰 (𝒑𝟏 ) 𝐯 (𝒙𝟏 )+𝐰 (𝒑𝟏 ) 𝐯 ( 𝒙𝟐 )+…

… represent all of possible results; represent the probability of all of the results; is value function, and it means the relatively value in the decision-maker’s mind; is probability weighting function, and it means the reaction of most people face probability.

Prospect Theory Function• Prospect theory generalizes CEU by introducing a reference-

point , which may impact on utility and capacity. In all axiomatic work we are aware of, the existence and location of this reference-point is assumed exogenously.

Prospect Theory Function

Main condition in paper

Main condition in paper

Such a finding is in agreement with risk aversion in the sense of diminishing marginal utility for increments in outcomes.

This latter finding is in agreement with risk seeking in the sense of diminishing marginal utility for decrements in outcomes.

Conclusion

• theory build on existing tools that were used to derive PT with exogenous reference points.

• How to detect the reference point is a shortcoming in earlier derivations of PT, which has often been criticized, and our note proposes a solution that overcomes this hurdle.

Value

• For PT to become a valuable tool for economic analyses the model needs a theoretical foundation of how to detect the reference point from preferences.

How to apply_1

• In my research, I trend to evaluate the utilize value of making decision. In advance, I must to detect the current reference point that user hold.

• The tool is proposed by this paper can help us base on user’s preference to gain their reference point.

How to apply_2

• Paper said “reference-dependence is derived from preference conditions and a unique reference point arises endogenously”

• Regard “endogenously” as personal behavior.• It means someone’s reference point can be changed by their

behavior.

In our platform ?

Apply Media Industry to illustrate

View of ECONOMYIn Macroeconomics

NO. 1 Media Platform

Individual access news on demand

exogenously

This way can’t aim the individual’s behavior to design the contents.

View of ECONOMYIn Microeconomics

Detect every user’s current reference point, and evaluate the utilize value to move it to the best one.

When every user have good behavior in media domain, then the media industry will be great.

endogenously

Q&A

• Can we find more factors that impact the location of reference point ?

• And, how to move the location of reference point ?