Question

Rosa played poker and lost $1000. At the same time, she won $1000 from a scratcher ticket. Assuming that Rosa is loss averse, which of the following is likely true?
(A) Rosa is upset about the loss even though she was compensated by an equal win.
(B) Rosa is happy about the win even though she lost an equal amount.
(C) Rosa is indifferent because she neither won nor lost money in the end.
(D) none of the above

Answer 1

Answer: The Answer to the question is option "A." which is Rosa is upset about the loss even though she was compensated by an equal win."

Explanation:

Loss Aversion

In behavioural economics, loss aversion refers to people’s preferences to avoid losing compared to gaining the equivalent amount.

Therefore,  Loss Aversion, while it sounds like risk aversion, is a complex behavioural bias in which people express both risk aversion and risk-seeking behaviour. Individuals who are loss averse feel the sting of loss twice as great as the joy from an equal size gain – and make investment decisions accordingly.

“Losses loom larger than gains” (Kahneman & Tversky, 1979). For example, if somebody gave us a ₦500 box of candies, we may gain a small amount of happiness (utility). However, if we owned a ₦500 box of candies and it got cracked, we would be more unhappy.

This shows that a ₦1000 gain is less than the ₦1000 loss. Prospect theory also states the importance of how the situation changes from our current reference point. For example, if we have a wealth of ₦100,000 but lose 20% – we will be very unhappy. If we have nothing but gain ₦20, we will

be very happy.

Prospect Theory

Prospect theory is an economic theory which tries to describe the way people will behave when given choices which involve probability.

Prospect theory assumes that individuals make decisions based on expectations of loss or gain from their current relative position.

“An essential feature of Prospect Theory is that carriers of value changes in wealth or welfare – rather than outcomes.”

An important element of prospect theory is the idea that individuals are particularly averse to losing what they already have and less concerned to gain.

“Losses loom larger than gains.”

Given a choice of equal probability, individuals would choose to preserve their existing wealth, rather than risk the chance to increase wealth.

Prospect theory can explain why people exhibit both risk-seeking and risk-averse behaviour.

Answer 2

Answer:

(B) Rosa is happy about the win even though she lost an equal amount.

Explanation:

A risk averse person is one that values protection of capital over gains. He believes that it is better to make small gains and preserve the capital, than to make big gains with the possibility of losing capital.

Risk averse people favour low risk investment where returns are not spectacular and there is a near zero risk of losing capital.

In this case Rosa will be happy that she preserved her capital of $1,000.