You may be asked to do any of the following on your third and final exam Define what an argument is An argument is a connected series of statements called premises that are intended to give reasons to believe some further statement called the conclusion is true Milan is north of Rome rome is north of naples So milan is north of naples We can put arguments into standard form 1 milan is north of rome 2 rome is north of naples 3 So milan is north of naples Define what it is for an argument to be valid and for an argument to be sound Valid Argument If the premises are true the conclusion must be true If the conclusion is false then at least one of the premises must be false Sound Argument All of the premises are true and it is valid Explain the difference between deductive arguments and inductive arguments and be able to identify whether an argument is inductive or deductive Deductive Arguments attempts to be valid 1 All Italians play soccer 2 Michele is Italian 3 Michele plays soccer 1 Most Italians play soccer 2 Michele is Italian 3 Michele probably plays soccer Inductive Arguments Designed to be strong and show that the conclusion is probable given the truth of the premises Explain the difference between a descriptive theory and a prescriptive theory and classify expected utility theory and prospect theory accordingly A prescriptive theory tells you what you ideally should do Expected utility Econs The agent of economic theory is rational selfish and his tastes do not change Bruno Frey Expected Utility Theory the utility of gain is assessed by comparing the utilities of two states According to expected utility theory we must weight the utility of some outcome according to its probability o But we don t Allais s Paradox A descriptive theory describes you what you in fact do Prospect theory Humans neither fully rational nor completely selfish and that their tastes are anything but stable Daniel Kahneman To a psychologist it is self evident that people are Prospect Theory 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 o Prospect theory focuses on 1 Gains and loses 2 Requires an evaluation relative to a reference point 3 Holds that people are loss averse Explain the differences between expected theory and prospect theory What sets prospect theory apart from utility theory 7 pts 1 Prospect theory focuses on gains and losses rather than final states e g one s state of wealth 2 Prospect theory requires an evaluation relative to a reference point 3 Prospect theory holds that people are loss averse 4 A principle of diminishing sensitivity in a variety of dimensions o According to Kahneman what can prospect theory not account for 7 pts Disappointment and regret In utility theory the utility of gain is assessed by comparing the utilities of two states According to expected utility theory we must weight the utility of some outcome according to its probability o But we don t Allais s Paradox Be able to identify prospect theory s graph and explain how it displays the main features of prospect theory 1 The graph shows the psychological value of gains and losses which are the carriers of value in prospect theory unlike Bernoulli s model in which states of wealth are the carriers of value Gain and loss satiation The values of the outcomes for both positive and negative consequences of the choice have the diminishing returns characteristic 2 The graph has two distinct parts to the right and to the left of a neutral reference point A salient feature is that it is S shaped which represents diminishing sensitivity for both gains and losses Reference level dependence An individual views consequences monetary or other in terms of changes from the reference level which is usually that individual sstatus quo 3 Finally the two curves of the S are not symmetrical The slope of the function changes abruptly at the reference point the response to losses is stronger than the response to corresponding gains This is loss aversion Loss aversion The resulting value function is steeper for losses than for gains losing 100 produces more pain than gaining 100 produces pleasure Be able to identify and explain the fourfold pattern table Losses Gains High Probability Certainty Effect Low Probability Possibility Effect 95 chance to win 10 000 Fear of disappointment RISK AVERSE 5 chance to win 10 000 95 chance to lose 10 000 Hope to avoid loss RISK SEEKING 5 chance to lose 10 000 Fear of large loss RISK AVERSE The decisions we are inclined to make in the fourfold pattern are irrational but Hope of large gain RISK SEEKING they are enticing because we take a narrow view of decisions On a broad view we bundle all these gambles together and see them as part of a To avoid large long term costs and inferior outcomes in your life adopt a broad larger outcome in life view of decisions Why is accepting the sure loss the most rational thing to do In the long run taking risky gambles to avoid losses costs more than the sure losses Explain what loss aversion is and identify it at work in explaining why we make certain decisions In prospect theory loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains Loss aversion also explains 1 Why we tend to maintain the status quo 2 Why bargaining and negotiations are difficult Define and explain the endowment effect including why it takes place and why it interferes in rational decision making endowment effect People tend to place more value on what they own The willingness to buy or sell X depends on the reference point whether you own X now The endowment effect doesn t apply to Things held for exchange o Much of this overweighting and underweighting is explained by our aversion to loss o Loss aversion is an automatic response of System 1 Explain how to combat the endowment effect We can combat the endowment effect by thinking like a trader o Ask yourself How much do I want to have X compared with other things I could o The asymmetry between the pleasure of getting and the pain of giving up is have instead irrelevant Define and explain the possibility effect certainty effect and identify it taking place in various decisions The possibility effect Highly unlikely outcomes are overweighted The certainty effect Highly likely outcomes are underweighted Explain why and how we are influenced by the possibility effect and