A simplified prospect theory value function with x representing changes in wealth can be written as follows:

V(x) = x^1/2 x0

V(x) = -2(-x)^1/2 x <0

1. What is loss aversion? Explain how the above function takes loss aversion into account.

2. An investor is considering prospects P1 and P2:

P1(0.5, 0, 100) P2(1, 25) (0.5) = 0.44, (1) = 1

Using the above value function and the given decision weights, which prospect would she choose? Comment on your answer.

3. i) Now an investor is considering P3 and P4:

P3(0.001, 9000) P4(1, 9) (0.001) = 0.011, (1) = 1

Using the above value function and the given decision weights, which prospect would she choose? Comment on your answer.

ii) Now she is considering P5 versus P6:

P5(0.001, -9000) P6(1, -9) (0.001) = 0.011, (1) = 1

Using the above value function and the given decision weights, which prospect would she choose? Comment on your answer.