Game theory of Loss Aversion

Abstract

My bachelor thesis is about Loss aversion. In decision theory there are a lot of theories which claim to be a descriptive model of decision making under risk. However, making choices under risk is inconsistent with the basic tenets of utility theory. Nevertheless, expected utility still dominates game-theoretic situations. Kahneman and Tversky’s prospect theory is an alternative theory to expected utility in which outcomes are evaluated with respect to a reference point. With this new investigation about reference-dependent utility functions, a new kind of result is born, Loss aversion. Loss aversion is widely investigated and it refers to people’s tendency to prefer avoiding losses much more than they are motivated to get the equivalent gain. I will extend games to include loss aversion characteristics of the players. In these games, I will show that besides the Nash equilibria, there exists also a loss-aversion equilibrium for any extended game. Besides this, I will also investigate how an increase in loss aversion of a player can effect the payoffs.