An Individual Has Preferences Consistent with Prospect Theory

question 3

Multiple Choice

An individual has preferences consistent with prospect theory. The person takes their current wealth of $10,000 (plus any certain additions) as their reference point. Gains above this reference point are worth +1 util. Losses below this reference point are worth -2 utils. The person is faced with two choice problems. The first involves a choice between (A) no gamble and (B) a gamble with an equal chance of winning $1,800 and losing $1,000. The second choice problem,the person first has $1,000 taken away (resulting in the adjustment of the reference point) . The choice is then between (C) being given back $1,000 for sure and (D) an equal chance of winning $2,800 or nothing. What choices would the person make?

• A)A and C.
• B)A and D.
• C)B and C.
• D)B and D.

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Definitions:

Income Tax Expense

The amount of income taxes a company expects to pay for the current tax year, accounting for deferred taxes.

Book Income Before Income Tax

The income that a company reports on its financial statements before the deduction of income tax expenses.

Tax Depreciation

The depreciation expense allowed by tax authorities to account for the reduction in value of a tangible asset over its useful life, intended to provide a tax shield for businesses.

Book Depreciation

The portion of an asset's initial cost that is allocated as an expense over its useful life on the financial statements, according to accounting standards.