Prospect Theory

Two Worlds

• Economist:“The agent of economic theory is rational, selfish, and his tastes do not change”

“To a psychologist, it is evident that people are neither fully rational, nor completely selfish, and their tastes are anything but stable.”

• Expected Utility Theory: If you prefer and apple to a banana, then you also prefer a 10% chance to win an apple to 10% chance to win a banana

Then comes Bernoulli

80% chance to win $100 and 20% chance to win $10

OR A $80 note??

Depends on peoples relative wealth, so comes the concept of utility

Consider the following:

Equal chances to have 1 million or 7 million

OR 4 million with certainty??

Wealth 1 2 3 4 5 6 7 8 9 10Utility 10 30 48 60 70 78 84 90 96 100

Problem with Utilities

Today, Jack and Jill each have a wealth of 5 milYesterday, Jack had 1 mil and Jill had 9 milDo they have the same utility?

Another one:The gamble: equal chances to end up owning 1 million or 4 millionOR The sure thing: own 2 million for sureLets say 2 players – A with current wealth of 1 million, and B with current wealth of 4 million

So where was Bernoulli wrong?

Outcomes as Gains and Losses• Problem 1: Get $900 for sure OR 90% chance to get

$1000?• Problem 2: Lose $900 for sure or 90% chance to

lose $1000• Problem 3: In addition to your wealth, you are

given $1000. Now choose:• 50% chance to win $1000 OR get $500 for sure

• Problem 4: In addition to you wealth, you are given $2000. Now choose:• 50% chance to win $1000 OR get $500 for sure

To SUM UP

• Expected value theory focuses on the expected value of the outcome• Utility theory only focused on a utility of the outcome• Bernoulli’s correction was that utility depends also on

the present state of wealth• Finally, PROSPECT THEORY shows errors in Bernoulli’s

corrections. It suggests:• There is a reference point for every decision (not only todays

wealth, but also what was yesterday) – A before and after effect

• From this point, we consider gains and losses• In general people are more loss averse

Is prospect theory the end?

Consider the following:A. One chance in a million to win 1 milB. 90% chance to win 12 and 10% chance to win

nothingC. 90% chance to win 1 mil and 10% to win nothing