CHAPTER 23 PROSPECT THEORY
CHAPTER 23 PROSPECT THEORY
Modeling decisions under uncertainty Pervasiveness of uncertainty Cards and gambling:raise?or fold? Career decisions:which major?which career? Insurance choices:buy insurance or go uninsured? How does eating this donut affect the likelihood of heart attack? Which disease treatment to pursue:the cheaper but higher risk one?Or the certain but more expensive option? Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Modeling decisions under uncertainty Pervasiveness of uncertainty Cards and gambling: raise? or fold? Career decisions: which major? which career? Insurance choices: buy insurance or go uninsured? How does eating this donut affect the likelihood of heart attack? Which disease treatment to pursue: the cheaper but higher risk one? Or the certain but more expensive option?
Modeling decisions under uncertainty Consider a"lottery"with uncertain prospects: Option Probability P Option x2 Probability P2 Option X3 Probability P3 … Option XN Probability Pn How should such a lottery be valued? Valuation Function: V(A)=V(x1,Pi x2,p2i...;XN,Pn) Preferred lotteries yield higher values Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Modeling decisions under uncertainty Consider a “lottery” with uncertain prospects: Option x1 Probability p1 Option x2 Probability p2 Option x3 Probability p3 … … Option xN Probability pn How should such a lottery be valued? Valuation Function: V(A) = V(x1 , p1 ; x2 , p2 ; … ; xN , pn ) Preferred lotteries yield higher values
Modeling rationality Economists assume that people are rational,even under uncertainty But what does "rational"imply? Three Properties: 1.Completeness 2.Transitivity 3.Independence Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Modeling rationality Economists assume that people are rational, even under uncertainty But what does “rational” imply? Three Properties: 1. Completeness 2. Transitivity 3. Independence
Modeling rationality:three properties 1.Completeness Between any two options,a decision can always be made. i.e.Either V(A)>V(B) V(A)<V(B) V(A)=V(B) Completeness rules out indecision(but not indifference) 2.Transitivity 3.Independence Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Modeling rationality: three properties 1. Completeness Between any two options, a decision can always be made. i.e. Either V(A) > V(B) V(A) < V(B) V(A) = V(B) Completeness rules out indecision (but not indifference) 2. Transitivity 3. Independence