Prospect Theory: An Analysis of

Decision under Risk

Source: http://dilbert.com/strips/comic/2000-02-03/

Yangda Di I6034331
Ralitsa Sapunova I6128249
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Agenda
1. Introduction of Expected Utility Theory
2. Critiques of the Expected Utility Theory
a. Certainty, probability, and possibility
b. The reflection effect
c. Probabilistic insurance
d. The isolation effect

3.

Prospect theory
a. Phase of editing
b. Phase of evaluation
c. The value function
d. The weighting function

4. Prospect Theory Applications

5. Prospect Theory Criticism
6. Discussion

Expected utility theory

Expectation:
Asset integration: is acceptable at asset position w if and
only if:
Risk aversion:

u is concave(u<0)

Expected utility theory

An introduction of risk aversion

Problem statement

What are the limitations

of the expected utility
theory?

Critique #1: certainty, probability and

possibility
Example: problem#3
A:( 4000, 80%) , expected utility=3200
B: (3000, 100%), expected utility=3000

N=95
A
B

Critique #1: certainty, probability and

possibility
Example: problem #4
A: (4000,80% *0.25=20%) expected utility=800
B:(3000,100% *0.25=25%) expected utility=750

N=95
A
B

Critique #1: certainty, probability and

possibility
1
0.8
0.6
0.4
0.2
0

B
A
problem 3

problem 4

Reducing the probability of winning from 1.0 to .25( for B ) has

a greater effect than the reduction from .8 to .2( for A ). what
does that imply?
People overweight certain outcomes relative to possible outcomes
Choices change if certainty is reduced, most people choose the
prospect that offers the larger gain

Critique #1: certainty, probability and

possibility
Problem #7
The probabilities of
A:(6000,45%) expected utility=2700
winning are
b:(3000, 90%) expected utility=2700substantial (.90 and .
45), and most people
choose the prospect
N=95
where winning is more
probable.
A
B

Critique #1: certainty, probability and

possibility

In this situation
Problem #8
where winning is
A:(6000,0.1%) expected utility=6possible but not
probable, most
B:(3000,0.2%) expected utility=6
people choose
the prospect that
N=95
offers the larger
A
B gain.

Critique #2:the reflection effect

What happens when the signs of the outcomes are reversed so

that gains are replaced by losses? What does it imply?

Critique #2:the reflection effect

Maximizing gains and minimizing losses

Certainty effect: risk aversion gain domain, and risk seeking
loss domain
People who are usually risk averse in case of gains are ready to
take risk if faced with a probability of incurring a loss

Critique #3: probabilistic insurance

In case of damage, there is a 50% chance that you pay the other half
of the premium and the insurance company covers all the losses; and
there is a 50% chance that you get back your insurance payment and
suffer all the losses.
According to the EUT, the probabilistic insurance is superior to
regular insurance.
However, 80% of the respondents refused to accept the probabilistic
insurance.

YES
NO

Critique #4: the isolation effect

Problem #10: In the first stage, there is a probability of 0 .75 to
end the game without winning anything, and a probability of
0.25 to move into the second stage. If you reach the second
stage you have a choice between A: (4,000,80%) and B:
(3,000,100%).

Critique #4: the isolation effect

Problem 3
problem 10

problem 4

N=141

A
B

According to EUT, the preferences of problem 4 and problem 10 are the

same: (4000,20%) and (3000,25%).
Nevertheless, people ignored the first stage of the game, whose
outcomes are shared by both prospects, and considered Problem 10 as a
choice between (3,000,100%) and (4,000,80%), as in Problem 3.
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Prospect Theory
An alternative model of individual decision making
under risk
unlike expected utility theory which concerns itself with
how decisions under uncertaintyshouldbe made, prospect
theory concerns itself with how decisions areactuallymade.
Montier (2002, p. 20)

Phase of editing
Phase of evaluation

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Phase of editing
Preliminary analysis of the offered prospects
Coding
Combination
Segregation
Cancellation
Simplification
Detection of dominance
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Phase of editing
Preliminary analysis of the offered prospects
Coding - Identifying gains and losses based on
common reference points

Combination - Combining probabilities associated

with identical outcomes

(100$, .2;
100$*, .1)
(100$, .3)
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Phase of editing
Preliminary analysis of the offered prospects
Segregation Separate out guaranteed outcome
component

(100$, .8;
200$, .2)
100$ + (100$, .
2)
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Phase of editing
Preliminary analysis of the offered prospects
Cancellation Discarding the common components

(100$, .2; 50$, .5;

25$, .3)

(100$, .2; 40$, .4;

30$, .4)

Simplification Rounding probabilities or

outcomes
Discarding of extremely unlikely
outcomes

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Phase of editing
Preliminary analysis of the offered prospects
Detection of dominance Rejecting dominated
options without further evaluation

(100$, .6; 50$, .

4)

(60$, .6; 20$, .4)

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Phase of evaluation
Regular

prospect:

If p+q<1, or x0 y or x0 y

Strictly positive or negative prospect:

If p+q=1 and etiehr x>y>0 or x<y<0

Segregat
ion
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Phase of evaluation
When are these formulas equivalent?
V(x, p; y, q) = (p) (x) + (q) (y)
V(x, p; y, q) = (y) + (q) [v(x)-v(y)]

(p)+ (q)
=1

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The Value Function

Valu
e

Loss
es

People think in terms of

gains and losses
Reference point

Gain
s

Concave for gains and

convex for losses
Steeper in losses than
in gains

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The Value Function

diminishing
sensitivity
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The Weighting Function

1.
0

Decision weight
(p)

(p)=p

Small probabilities
Availability bias
Certainty effect

Stated
probability p

1.
0
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Prospect Theory Applications

Finance
Insurance
Endowment effect
Other Applications

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Prospect Theory Criticism

The theory holds for hypothetical choices, but
does it also hold for real life choices?
Relatively little guidance on how the reference
point is determined.
Endowment effect?
Less useful in describing the behavior of
experienced economic actors.

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Discussion
Do you think certain behavior of your can be
explained by prospect theory?
After seeing how your decisions can be
influenced, would you change your decision making
process?

Do you think prospect theory could be essential

to your career?

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References
Barberis, N. C. (2013). Thirty Years of Prospect Theory in Economics: A
Review and Assessment. Journal of Economic Perspectives, 173196.
Daniel Kahneman, A. T. (1979). Prospect theory: An Analysis of Decision
under Risk. Econometrica, 263 292.
Future prospects. (2013, Aug 5th). Retrieved from The Economist:
http://www.economist.com/blogs/freeexchange/2013/08/prospect-theory-andeconomics
List, J. A. (2003). Does Market Experience Eliminate Market Anomalies?
Quarterly Journal of Economics, 4171.
Montier, J. (2002). Darwin's Mind: The Evolutionary Foundations of
Heuristics and Biases. Dresdner Kleinwort Wasserstein - Global Equity
Strategy.
To have and to hold. (2003, Aug 28th). Retrieved from The Economist:
http://www.economist.com/node/2021010
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THANK YOU FOR YOUR

ATTENTION!

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