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Prospect Theory and Expected Utility Theory Questions

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

Solution Preview

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 ...

Solution Summary

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

$2.19