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14.127 Behavioral Economics
(Lecture 1)
Xavier Gabaix
February 5, 2003
1 Overview
• Instructor: Xavier Gabaix
• Time 4-6:45/7pm, with 10 minute break.
• Requirements: 3 problem sets and
Term paper due September 15, 2004 (meet Xavier in May to talk
about it)
2 Some Psychology of Decision Making
2.1 Prospect Theory (Kahneman-Tversky, Econometrica
79)
Consider gambles with two outcomes: with probability , and with
probability 1 where 0 .
• Expected utility (EU) theory says that if you start with wealth then
the (EU) value of the gamble is
= ( + ) + (1 ) ( + )
• Prospect theory (PT) says that the (PT) value of the game is
= () () + (1 ) ()
where is a probability weighing function. In standard theory is linear.
• In prospect theory is concave first and then convex, e.g.
() =
+ (1 )
for some (01). The figure gives () for = 8
1
0.75
0.5
0.25
0
0 0.25 0.5 0.75 1
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