You may be asked to do any of the following on your third and final exam Define what an argument is Argument A connected series of statements premises intended to give reasons to believe a further statement conclusion is true Define what it is for an argument to be valid and for an argument to be sound Valid IF the premises are true the conclusion MUST be true However if the premises are false and the conclusion is true the argument may still be valid Sound All premises are true and the argument is valid Explain the difference between deductive arguments and inductive arguments and be able to identify whether an argument is inductive or deductive Deductive Argument intended to be valid an argument is either valid or not Inductive Argument intended to be strong strength can come in degrees Explain the difference between a descriptive theory and a prescriptive theory and classify expected utility theory and prospect theory accordingly Descriptive Theory explains the way in which humans in fact behave sometimes irrational PROSPECT THEORY Prescriptive Theory describes the ideal way for people to behave most rational EXPECTED UTILITY THEORY Explain the differences between expected utility theory and prospect theory Expected Utility Theory It is most rational to maximize the expected utility or amount of happiness that an option will produce Gain is assessed by comparing the utilities of two states the state of wealth before the outcome and the state of wealth after the outcome Prospect Theory Because people are loss averse they don t always maximize utility and are therefore making irrational decisions An outcome is evaluated solely on the gains and losses associated with it The evaluation of an outcome is relative to a neutral reference point Be able to identify prospect theory s graph and explain how it displays the main features of prospect theory Features of Prospect Theory Neutral Reference Point and y axis meet There is no monetary or psychological value assigned to this reference point the point on the graph where the x Diminishing Sensitivity the rate at which psychological value increases begins to slow down As the costs or payoffs become larger Loss Aversion The psychological value associated with a loss is much more strongly affected than it is for a gain of the same monetary value In other words it s much more painful to lose than it is pleasurable to gain Be able to identify and explain the fourfold pattern table Explain what loss aversion is and identify it at work in explaining why we make certain decisions Loss Aversion the human tendency to prefer avoiding a loss over acquiring a gain This causes people to take irrational gambles in order to avoid a loss When given the choice to either take a 95 chance of losing 10 000 OR a 100 chance to lose 9 500 people will often choose the first option because they overweight the probability 5 of avoiding the loss altogether Define and explain the endowment effect including why it takes place and why it interferes in rational decision making Endowment Effect the fact that one owns something causes them to place a higher value on it It takes place because of loss aversion People would rather avoid losing what they already own over gaining something else of equal or greater value Explain how to combat the endowment effect The endowment effect doesn t apply to things held for exchange So one can combat it by thinking like a trader Ask How much do I want to keep X over other things I could have instead Define and explain the possibility effect and identify it taking place in various decisions Possibility Effect The tendency to overweight the probability of unlikely events Define and explain the certainty effect and identify it taking place in various decisions Certainty Effect The tendency to underweight the probability of likely events Explain why and how we are influenced by the possibility effect and certainty effect Focused Attention Confirmation Bias and Cognitive Ease If a claim is most likely false we try to make it true by coming up with many scenarios that will make it true Possibility Effect If a claim is most likely true we try to make it false by coming up with many scenarios that will make it false Certainty Effect Coming up with all of these scenarios in either case gives us a sense of cognitive ease Explain why and how the possibility effect and certainty effect lead us to make irrational decisions They lead us to make decisions that will yield a lower expected utility According to expected utility theory outcomes should be weighted according to their Possibility Effect leads us to buy lottery tickets The small probability of winning is overweighted Certainty Effect Option 1 95 chance to win 10 000 Option 2 100 chance to win 9 000 One who falls prey to the certainty effect will chose Option 2 because they underweighted the 95 chance and would rather go for the sure thing Explain denominator neglect and identify when it takes place Denominator Neglect tendency to ignore the denominator of a probability and only focus on the numerator or frequency Explain the impact of presenting information as frequency or abstract probability on denominator neglect Frequency leads to denominator neglect because it leads to a more vivd representation of each individual case in our mind likelihood is overweighted Abstract Probability less of an impact on probability judgment Explain what mental accounting is and give some examples of mental accounts Mental Accounting the tendency to place a higher or lower value on a sum of money because of the source that it comes from Ex Undervalued Money Credit Cards Gambling winnings tax refunds bonuses money spent on extras or accessories to a large purchase Overvalued Money Inheritance money that should be spent on retirement Explain how to avoid mental accounting Imagine always paying in cash Wait a little bit before spending found money Imagine all money as hard earned Assess each component of a big purchase Define sunk costs and explain the sunk cost fallacy giving your own examples Sunk Cost A cost that has already been paid and cannot be returned Sunk Cost Fallacy Instead of only taking future costs and benefits into consideration sunk costs are also given weight when making a decision Ex Sheryll has just finished her first year of Philosophy graduate school and is absolutely miserable She wants to quit but doesn t want all of the time and energy spent on her first year to go to waste Be able