(a) One of the core elements of Prospect Theory is the observation that people in general...

 

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(a) One of the core elements of Prospect Theory is the observation that people in general seem to treat probabilities non-linearly. Why do economists think that people should treat probabilities linearly, and how do people treat them in fact (according to Prospect Theory)? Support your answer with a sketch. [8 marks] (b) The non-linear treatment of probabilities, in combination with the value function from Prospect Theory, gives rise to inconsistencies (from the perspective of the traditional expected utility framework) in people's risk preferences. Use (an) example(s) to explain what these inconsistencies are and how the combination of the value function with non-linear probability weights can give rise to it. [12 marks] (a) One of the core elements of Prospect Theory is the observation that people in general seem to treat probabilities non-linearly. Why do economists think that people should treat probabilities linearly, and how do people treat them in fact (according to Prospect Theory)? Support your answer with a sketch. [8 marks] (b) The non-linear treatment of probabilities, in combination with the value function from Prospect Theory, gives rise to inconsistencies (from the perspective of the traditional expected utility framework) in people's risk preferences. Use (an) example(s) to explain what these inconsistencies are and how the combination of the value function with non-linear probability weights can give rise to it. [12 marks]