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Prospect Theory and Expected Utility Theory Questions

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According to prospect theory, which is preferred?
1. Prospect A or B
Decision (i) Choose between
A. (.80, $50, $0)
B. (.4, $100, $0)

2. Prospect C or D?
Decision (ii) Choose between:
C. (.00002, $500,000, $0) and
D. (.00001, $1,000,000, $0)

3. Are these choices consistent with expected utility theory? Why or why not?

5-3: Rex is a smart fellow. He gets an A in a course 80% of the time. Still, he likes his leisure, only studying for the final exam in half of the courses he takes. Nevertheless, when he does study, he is almost sure (95% likely) to get an A. Assuming he got an A, how likely is it he studied? If someone estimates the above to be 75%, what error are they committing? Explain

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Solution Summary

The solution uses prospect theory to make these three choices 442 with a reference included and all probability calculation displayed.

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The key difference between prospect theory and expected utility theory is the way they assign utility to possible outcomes. In expected utility theory, the utility of an outcome is a linear function of the outcome itself. But in prospect theory, there is an S-shaped curve giving the utility of each outcome -- small gains or losses result in outsize positive or negative utilities, and larger gains or losses result in only marginally-increasing positive or negative utilities. See this graph as an example: http://upload.wikimedia.org/wikipedia/commons/4/4e/Valuefun.jpg

1. We interpret (.80, $50, $0) as meaning we have an 80% chance of receiving $50 and ...

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