In this paper it is shown that the combination of mental accounting and loss aversion can fundamentally changes people's way of evaluating risky alternatives. The observation is applied in a market setting: Parimutuel betting markets. In parimutuel betting markets it has been found that for horses with lowest odds (favorites), market estimates of winning probabilities are smaller than objective winning probabilities; for horses with highest odds (longshot) the opposite is observed (the favorite-longshot bias). I build a game theoretical model and show that the favorite-longshot bias is the equilibrium play of the players with loss aversion, and that the degree of the favorite-longshot bias depends on the mental accounting process the players use.
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Paper provided by Faculty of Economics and Statistics, University of Innsbruck in its series Working Papers with number
2009-15.
Find related papers by JEL classification: C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games D40 - Microeconomics - - Market Structure and Pricing - - - General D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
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