Prospect Theory as An Alternative to Expected Utility Theory
- Explain both Prospect theory and the Expected Utility theory
Developed in the year 1979 by Kahneman and Tversky, the prospect theory relates to the nature in which risk involving choices are arrived at (Tversky & Kahneman, 1992). The theory focuses on describing the actual mode of behavior depicted by people. Prospect theory forms one of the founding economic theories that adopted experimental methods. Additionally, this theory attempts to asymmetrically assess people’s experiences with gains and losses. For example, to some people, the feeling of pain experienced when making a loss of 100 dollars stands a compensation possible through joy that is accompanied by making profits of 200 dollars. On the other hand, the expected utility theory refers to the preferred choices of people concerning decisions that possess uncertain outcomes. This theory is adopted by individuals who are in situations where they have to decide without a clear expected outcome originating from the decision (Levy, 1992). Therefore, this leads to the implementation of decisions that contribute to the highest utility expectation. Additionally, this theory dismisses the association of total money value to its utility. The expected theory forms the foundation beneath the taking of insurance covers against various risks by most people. Despite the two theories having their differences, evaluating and explaining some of their differences and similarities would give rise to the reasons as to why prospect theory forms an alternative to expected utility theory.
- Differences and similarities of the Prospect and Expected Utility theories
According to Mongin,(1997) the development of expected utility theory originates from expected value theory. According to expected value theory, to make the best decision on money and risk-related problems, the value of the outcome is multiplied against its probability. This implies that in a situation where one bets 100 dollars for a tossed coin to land on heads, then the value of the outcome is expected to be 50,000 dollars. This is obtained after multiplying the head landing probability which is 50 against 1000 dollars as the value of the outcome. However, weakness and contradiction to this formula are obtained by the prospect theory.
Additionally, in a coin-tossing competition, the head landing of the coin wins 10 dollars. On the other hand, in situations where the coin does not land on the head, the individual continuously tosses the coin until he finds a head landing. Additionally, every proceeding head landing of the coin receives a double dollar such that the second and third head tosses receive $20 and 40 dollars respectively. The first weakness of the theory appears in the game charging fee since the game possesses unending possibility. This implies that the game’s entry fee should similarly be infinite with respect to expected value theory. Nevertheless, there exists a circumstance during the above game where no participant has the urge for payment of more money which depicts that expected value theory possesses selective decision-making application. This is because the majority of people not only prioritize gains but the risks associated with losing as well.
Expected value theory also possesses an error and contrast to prospect theory as demonstrated by the following example illustration. Two options are offered: one relates to a hundred percent probability in obtaining $200 whereas the second involves a probability of fifty percent for obtaining $600. The expected value theory “favors” the second decision as to the most appropriate unlike the usual nature of people who will choose the first option. The representation of favor in quotation marks symbolizes the significant difference between the two theories. Nevertheless, below are some of the evident differences in prospect and expected utility theory
Prospect theory tends to describe how human beings decide on their choices whereas expected utility theory focusses on how the choices should be made. Prospect theory also obtains limited application fractions, unlike the expected theory. Additionally, expected utility theory sets rationality standards under a relevant context of risk decision-making process thus proving to be stronger to prospect theory in offering more accurate predictions.
Prospect and expected utility theories posses a single similarity. This is witnessed through expected utility theory having pu(x) as an assumption for the alternative utility (Hey & Orme, 1994). Similarly, the prospect theory also possesses a related assumption by decision-maker evaluations of p and x as what she or he might obtain and winning chance respectively and finally joins these evaluations.
- From the similarities (How they relate) and differences, How can the Prospect theory be used as an alternative to the expected utility theory
Prospect theory forms a suitable alternative to expected theory through the following example. Two people possess 1000 dollars each. According to expected utility theory, both the participant should enjoy uniform money utility as they possess similar money amounts. Additionally, in a situation whereby one individual had relatively less money amounts the month before whereas the other had more than the 1000 dollars then it implies that the first person is happier than the second. This forms a concept that is not captured by the expected utility theory. This concept demands that the reference point strictly originates from a change in wealth.
Additionally, the prospect theory is associated with three significant aspects:
Level of adaptivity
This refers to changes in points of reference. This can be explained from the concept of inserting left and right hands in hot and cold waters respectively after which you again deep them in a common container of warm water. The eventual result will suggest that the warm water was cold to the left hand whereas the right hand perceived it to be hot despite the water being uniformly warm. This implies that despite the similarity in the outcome, there exists a difference in change due to a difference in points of reference. Similarly, gaining 20 dollars is considered good in the presence of the zero dollars gaining probability. On the other hand, it does not appeal if the outcome had a probability of gaining a hundred dollars. This best describes the adaptive level aspect of prospect theory.
Sensitivity does dimensions
This is described as the prevailing difference in two money sets. With an increase in the money sets, the difference reduces. This concept can be explained through the effects of introducing a tiny source of light into a dark room and a more-lit room. This logically illustrates the resulting difference in the money amounts mentioned above. In the monetary aspect, the existing difference between no money and $20 and 100 and 100 dollars is similar unlike concerning personal worth.
Loss aversion
This forms the third aspect of prospect theory. It implies that losses possess more significant impacts than gains. According to previously conducted research, the aversion of loss stands a chance of being witnessed through traits of evolution. This is as a result of individuals who ran away from risks instead of taking a chance to the opportunity possessed a danger survival probability and finally passing the trait to their next generations through production.
- Conclusion
Through the development of prospect theory, Tversky and Kahneman illustrated the minimal amounts of benefits witnessed through the implementation of decisions based on utility theory. The two researchers applied various aspects such as empirical demonstrations as an explanation for the risk aversion, mathematical model, and psychological principles which focus on how people examine the alternatives that are faced by them. These aspects are jointly utilized by the prospect theory to initiate a process of making risk and uncertainty related decisions.
References
Hey, J. D., & Orme, C. (1994). Investigating generalizations of expected utility theory using experimental data. Econometrica: Journal of the Econometric Society, 1291-1326.
Levy, J. S. (1992). An introduction to prospect theory. Political Psychology, 171-186.
Mongin, P. (1997). Expected utility theory. Handbook of economic methodology, 342350.
Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty, 5(4), 297-323.