Advanced Search
MyIDEAS: Login

Prospect Theory or Skill Signaling?

Contents:

Author Info

  • 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.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.bus.indiana.edu/riharbau/RePEc/iuk/wpaper/bepp2005-06-harbaugh.pdf
Download Restriction: no

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.

as in new window
Length:
Date of creation: 2005
Date of revision:
Handle: RePEc:iuk:wpaper:2005-06

Contact details of provider:
Postal: 1309 East Tenth Street, Room 451, Bloomington, IN 47405-1701
Phone: 812-855-9219
Fax: 812-855-3354
Email:
Web page: http://www.bus.indiana.edu/bepp/
More information through EDIRC

Related research

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

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. William Harbaugh & Kate Krause & Lise Vesterlund, 2002. "Risk attitudes of children and adults: Choices over small and large probability gains and losses," Artefactual Field Experiments 00055, The Field Experiments Website.
  2. Judith Chevalier & Glenn Ellison, 1999. "Career Concerns Of Mutual Fund Managers," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 389-432, May.
  3. Antoni Bosch-Domènech & Joaquim Silvestre, 2002. "Reflections on gains and losses: A 2x2x7 experiment," Economics Working Papers 640, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2005.
  4. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
  5. William T. Harbaugh & Kate Krause & Lise Vesterlund, 1999. "Risk attitudes of children and adults: choices over small and large probability gains and losses," University of Oregon Economics Department Working Papers 1999-2, University of Oregon Economics Department.
  6. Uri Gneezy & John List & George Wu, 2006. "The uncertainty effect: When a risky prospect is valued less than its worst possible outcome," Framed Field Experiments 00152, The Field Experiments Website.
  7. Loomes, Graham & Sugden, Robert, 1982. "Regret Theory: An Alternative Theory of Rational Choice under Uncertainty," Economic Journal, Royal Economic Society, vol. 92(368), pages 805-24, December.
  8. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
  9. Rick Harbaugh & Tatiana Kornienko, 2000. "Local Status and Prospect Theory," Claremont Colleges Working Papers 2000-38, Claremont Colleges.
  10. Cowen, Tyler & Glazer, Amihai, 2007. "Esteem and ignorance," Journal of Economic Behavior & Organization, Elsevier, vol. 63(3), pages 373-383, July.
  11. Stephen Morris, 2001. "Political Correctness," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 231-265, April.
  12. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  13. Roland Benabou and Jean Tirole, 2004. "Willpower and Personal Rules," Journal of Political Economy, University of Chicago Press, vol. 112(4), pages 848-886, August.
  14. Yoram Halevy & Vincent Feltkamp, 2005. "A Bayesian Approach to Uncertainty Aversion," Review of Economic Studies, Oxford University Press, vol. 72(2), pages 449-466.
  15. Avery, Christopher N. & Chevalier, Judith A., 1999. "Herding over the career," Economics Letters, Elsevier, vol. 63(3), pages 327-333, June.
  16. Catherine C. Eckel & Philip J. Grossman, 2008. "Sex and Risk: Experimental Evidence," Development Research Unit Working Paper Series archive-09, Monash University, Department of Economics.
  17. Rabin, Matthew, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Department of Economics, Working Paper Series qt731230f8, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  18. Susan K. Laury & Charles A. Holt, 2005. "Further Reflections on Prospect Theory," Experimental Economics Center Working Paper Series 2006-23, Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University.
  19. Milbourn, Todd T & Shockley, Richard L & Thakor, Anjan V, 2001. "Managerial Career Concerns and Investments in Information," RAND Journal of Economics, The RAND Corporation, vol. 32(2), pages 334-51, Summer.
  20. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, vol. 80(3), pages 465-79, June.
  21. Jianakoplos, Nancy Ammon & Bernasek, Alexandra, 1998. "Are Women More Risk Averse?," Economic Inquiry, Western Economic Association International, vol. 36(4), pages 620-30, October.
  22. Mathias Dewatripont & Ian Jewitt & Jean Tirole, 1999. "The economics of career concerns: part 1 :comparing information structures," ULB Institutional Repository 2013/9617, ULB -- Universite Libre de Bruxelles.
  23. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
  24. Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, vol. 36(6), pages 643-660, June.
  25. Michael T. Rauh & Giulio Seccia, 2005. "Anxiety and Performance: An Endogenous Learning-by-doing Model," Working Papers 2005-01, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
  26. Botond Köszegi, 2006. "Ego Utility, Overconfidence, and Task Choice," Journal of the European Economic Association, MIT Press, vol. 4(4), pages 673-707, 06.
  27. Holmstrom, Bengt & Ricart i Costa, Joan, 1986. "Managerial Incentives and Capital Management," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 835-60, November.
  28. Whitmore, G A, 1970. "Third-Degree Stochastic Dominance," American Economic Review, American Economic Association, vol. 60(3), pages 457-59, June.
  29. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
  30. Fishburn, Peter C, 1978. "On Handa's "New Theory of Cardinal Utility" and the Maximization of Expected Return," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages 321-24, April.
  31. Nick Feltovich & Richmond Harbaugh & Ted To, 2002. "Too Cool for School? Signalling and Countersignalling," RAND Journal of Economics, The RAND Corporation, vol. 33(4), pages 630-649, Winter.
  32. Menezes, C & Geiss, C & Tressler, J, 1980. "Increasing Downside Risk," American Economic Review, American Economic Association, vol. 70(5), pages 921-32, December.
  33. Nicholas Barberis & Richard Thaler, 2002. "A Survey of Behavioral Finance," NBER Working Papers 9222, National Bureau of Economic Research, Inc.
  34. Prendergast, Canice & Stole, Lars, 1996. "Impetuous Youngsters and Jaded Old-Timers: Acquiring a Reputation for Learning," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1105-34, December.
  35. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
  36. Banks, Jeffrey S & Sobel, Joel, 1987. "Equilibrium Selection in Signaling Games," Econometrica, Econometric Society, vol. 55(3), pages 647-61, May.
  37. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  38. Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 871-915, August.
  39. Shefrin, Hersh & Statman, Meir, 1985. " The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence," Journal of Finance, American Finance Association, vol. 40(3), pages 777-90, July.
  40. David E. Bell, 1983. "Risk Premiums for Decision Regret," Management Science, INFORMS, vol. 29(10), pages 1156-1166, October.
  41. George Wu & Richard Gonzalez, 1996. "Curvature of the Probability Weighting Function," Management Science, INFORMS, vol. 42(12), pages 1676-1690, December.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Cowen, Tyler & Glazer, Amihai, 2007. "Esteem and ignorance," Journal of Economic Behavior & Organization, Elsevier, vol. 63(3), pages 373-383, July.
  2. 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.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:iuk:wpaper:2005-06. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Rick Harbaugh).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.