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Prospect Theory or Skill Signaling?

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  • Rick Harbaugh

    (Department of Business Economics and Public Policy, Indiana University Kelley School of Business)

Abstract

Failure is embarrassing. In gambles involving both skill and chance, we show that a strategic desire to avoid appearing unskilled generates behavioral anomalies that are typically explained by prospect theory’s concepts of loss aversion, probability weighting, and framing effects. Loss aversion arises because losing any gamble, even a friendly bet with little or no money at stake, reflects poorly on the decision maker’s skill. Probability weighting emerges because winning a gamble with a low probability of success is a strong signal of skill, while losing a gamble with a high probability of success is a strong signal of incompetence. Framing matters when there are multiple equilibria and the framing of a gamble affects beliefs, e.g., when someone takes a “dare” rather than admit a lack of skill. The analysis is based on models from the career concerns literature and is closely related to early social psychology models of risk taking. The results provide an alternative perspective on the existence of prospect theory behavior in economic, financial, and managerial decisions where both skill and chance are important. We identify specific situations where skill signaling makes opposite predictions than prospect theory, allowing for tests between the strategic and behavioral approaches to understanding risk.

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File URL: http://www.bus.indiana.edu/riharbau/RePEc/iuk/wpaper/bepp2005-06-harbaugh.pdf
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Bibliographic Info

Paper provided by Indiana University, Kelley School of Business, Department of Business Economics and Public Policy in its series Working Papers with number 2005-06.

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Date of creation: 2005
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Handle: RePEc:iuk:wpaper:2005-06

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Keywords: prospect theory; career concerns; probability weighting; loss aversion; framing effects; dare taking; embarrassment aversion;

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References

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Cited by:
  1. Severin Borenstein & Meghan Busse & Ryan Kellogg, 2007. "Principal-agent Incentives, Excess Caution, and Market Inefficiency: Evidence From Utility Regulation," NBER Working Papers 13679, National Bureau of Economic Research, Inc.
  2. Cowen, Tyler & Glazer, Amihai, 2007. "Esteem and ignorance," Journal of Economic Behavior & Organization, Elsevier, vol. 63(3), pages 373-383, July.

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