Problem Set #8 Prospect Theory and Anomalies

• Consider the following lottery choices.
• R1 a 0.80 chance of winning 4,000 vs. S1 a sure payment of 3,000,
• R2 a 0.20 chance of winning 4000            S2 a 0.25 chance of winning 3,000.

In each case the alternative payoff is 0.

1. Show that a risk neutral person would choose both R1 and R2.
2. As a behavioral matter, what choices to people make?
3. How can choices be explained by prospect theory?
• In non-mechanical ‘directed search’ models, the workers see the wages posted by employers and have to decide simultaneously which employer to approach for employment. If an employer has more applicants than positions, then the limited positions are allocated at random among the applicants.  Suppose that there are two employers, each with one position posted, and one of the wage postings is five times higher than the other. Would you expect to see more workers apply to the high-wage position or to the low-wage position.  Why?
• Consider the following lottery choices
 1 R1 9 in 10 chance of 664 1 in 10 chance of 25 S1 9 in 10 chance of 547 1 in 10 chance of 275 2 R2 9 in 10 chance of 389 1 in 10 chance of 2500 S2 9 in 10 chance of 511 1 in 10 chance of 600

1. Which gamble would a risk neutral person select in each case?
2. What difference in behavior might you expect to see in going from lotter choice 1 to lottery choice 2. Why?
3. Richard Thaler conducted a famous experiment in which they gave half the students in a room a lottery ticket. The ticket was worth \$5 with probability .2 and \$0 otherwise. They asked people with the lottery to state a minimum sales price. Then they asked the other students to indicate the maximum amount they would pay to buy the lottery. They found that the people who owned the lottery stated far higher minimum sales prices than the maximum offer price of those without lotteries
4. How might these results be consistent with prospect theory.
5. This well known ‘reluctance to sell’ has important applications in environmental economics. Why?

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