Prospect Theory

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Outline
Review of expected utility
Prospect theory
Value function
Experimental Evidence
Expected utility vs Prospect theory

Probability weighting function

Experimental Evidence
Expected utility vs Prospect theory

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St. Petersburg Paradox

and Expected Utility
How to define the utility/value of a lottery
mean?

St. Petersburg paradox: You are faced with a

sequence of tosses of a fair coin. The game
will end for the first time the coin comes up
Head. If this happens on the th trial, you get
2 dollars.
What is your willingness to pay to participate in
this game?
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St. Petersburg Paradox

and Expected Utility
1
2

1
4

Mean: U=
2+
4+
1 + 1 + 1 + = +

1
8

8+=

But you will not pay a large amount for the game
Mean is not a good measure of utility

Expected utility: () = , U=
1
4

1
8

1
2

ln2 +

ln4 +
ln8 + =
+
[ =1( )] 2 = 22
2

The utility is finite with a concave

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Expected Utility
A lottery specifies the probability for each prize.
= (, ; , 1 ), occurs with probability
and occurs with probability 1 .
The expected utility that represents the decision
maker - DMs preference would be U =
+ 1 , where () and () is
utility for and .
Note that is the utility function over lottery,
while is the utility over outcome/money. Thus,
the preference over lottery solely depends on
function
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Risk Aversion
DM is risk averse if she prefers the mean of
the gamble over the gamble.
DM is risk averse if u is concave.
( + (1 )) () + (1 )() for
any , , and [0,1]; OR (x)0

DM is risk neutral if she is indifferent between

the mean of the gamble and the gamble.
DM is risk seeking if she prefers the gamble
over the mean of the gamble.
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An Example
= ($100, 0.5; 0, 0.5)
The mean of the lottery is $50

If u() = 0.5 ,
The expected utility of the lottery is U() =
0.5(1000.5 )+0.5(00.5 )=5
The expected utility of $50 is
50 = 50 = 500.5
50 > U , so DM prefers $50 over the lottery
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Axioms of Expected Utility

Completeness and transitivity
Continuity
Independence: For every lottery , , , and
every 0,1 ,
iff + (1 ) + (1 )

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An Example
If 50 100, 0.5; 0, 0.5 , independence implies
50, 0.02; 0, 0.98 100, 0.01; 0, 0.99 .
Why? = 50, = 100, 0.5; 0, 0.5 , R = 0, and
= 0.02
+ (1 ) = 50, 0.02; 0, 0.98
+ 1 = 100, 0.01; 0, 0.99 .

Is your choice consistent with independence?

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Three Tenets of Expected Utility

Asset Integration: ( , ; ; , ) is
acceptable at asset w iff
( + , ; ; + , ) ()
Risk Aversion: is concave
1

Expectation: ( , ; ; , )
= ( ) + + ( )
1

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Asset Integration
In addition to whatever you own, you have
been given 1,000. You are now asked to choose
between A1: (1,000, 0.5), and B1: (500)
Most people would choose: 1 1

In addition to whatever you own, you have

been given 2,000. You are now asked to choose
between A2: (-1,000, 0.5), and B2: (-500)
Most people would choose: 2 2
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Asset Integration
(1) = 0.5( + 1000 + 1000) + 0.5( + 1000)
= 0.5 + 2000 + 0.5 + 1000
1 = + 1000 + 500 = + 1500
(2) = 0.5( + 2000 1000) + 0.5( + 2000)
= 0.5 + 1000 + 0.5 + 2000
(2) = ( + 2000 500) = ( + 1500)
Expected utility with asset integration could not account
for the observation.
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Reference Dependence

1/22/2015

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Reference Dependence
Consider the following example
Ice water in left hand bowl; hot water in right
hand bowl; room temperature in the middle bowl.
Immerse left hand in left bowl, and right hand in
right bowl.
And then dip both hand in the middle.

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Reference Dependence
DM separates gain and loss relative to a
reference point without asset integration
1 = 0.5 1000 + 0.5 0 , and (1) =
(500)
2 = 0.5 0 + 0.5 1000 , and
2 = 500
We could have both 1 1 and 2 2 given
some function.

1/22/2015

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Risk Aversion
You are asked to choose between A1: (3,000)
and B1:(4,000,0.8).
Most people choose A1 B1, risk averse in the
gain domain

You are asked to choose between A2: (-3,000)

and B2: (-4,000,0.8).
Most people choose B2 A2, risk seeking in the
loss domain
This is not consistent with the usual assumption of
risk aversion
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Diminishing Sensitivity
Principle of diminishing sensitivity applies to
sensory dimensions (Weber-Fechner law).
Turning on a weak light in a dark room versus
turning on a weak light in a bright room

Diminishing sensitivity in gain, u(x)<0 for x>0;

diminishing sensitivity in loss, u(x)>0 for x<0.
The difference between getting 900 and 1000 is
smaller than the difference between getting 100
and 200.
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Loss Aversion
You are asked to choose between A1: 0 and
B1: 100, 0.5; 100, 0.5
Most people choose A1 B1, risk averse across
gain and loss domain
0.5(100) + 0.5(100) < (0) = 0
=> (100) < (100)

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Loss Aversion
0.5 + 0.5 < 0
=> () < ()
Loss looms larger than gain.

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Valuation Function
Gain/loss relative to reference dependence
Diminishing sensitivity towards gain and loss
Loss aversion (Loss looms larger than gain)

Reference
point

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Sensitivity to probability
Russian roulette: a potentially lethal game of
chance in which a player places n bullets in a
revolver (full with 6 bullets), spins the cylinder,
places the muzzle against his or her head, and
pulls the trigger. What is your willingness to pay
for each of the reduction of bullets as follows.
6 to 5 (From sure to 5/6 chance)
3 to 2
1 to 0 (From 1/6 chance to impossible)

People like to pay more for 6 to 5, and for 1 to 0.

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Allais Paradox: Common Ratio

It is commonly observed that
(3000, 0.90) (6000, 0.45)
(6000, 0.001) (3000, 0.002)

The expected utility of the choice:

0.9u(3000)> 0.45u(6000)
0.001u(6000)>0.002u(3000)
Contradiction!
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Allais Paradox: Common Ratio

Here we show that it violates the independence

:(3000, 0.90) , :(6000, 0.45), R=0, =2/900

+ 1 =(3000, 0.002).
+ 1 =(6000, 0.001).
Hence (3000, 0.90) (6000, 0.45) and (6000,
0.001) (3000, 0.002) violates independence.
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Allais Paradox: Common Ratio

When expected utility, U = +
1 , could not account for the choice
behavior, we need to extend the theory further.
We introduce probability weighting function
to have U = () + 1
We examine the properties of

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Allais Paradox: Common Ratio

We derive the condition for , under which
it can exhibit the choice patterns.
0.90 (3000) > 0.45 (6000)
0.001 (6000) > 0.002 (3000)

0.45
0.90

<

3000
6000

<

0.001
0.002

Subproportionality:

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<

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Allais Paradox: Common Consequence

It is commonly observed that
2400 (2500, 0.33; 2400, 0.66)
(2500, 0.33) (2400, 0.34)

The expected utility of the choice:

2400 > 0.33 2500 + 0.66 2400
0.33 2500 > 0.34 2400
Contradiction!
Check violation of independence axiom!
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Allais Paradox: Common Consequence

Suppose there are 100 balls numbered from 1 to 100.
You randomly pick a ball, the number drawn
determines your earning as follows.
Gamble A1

1-33 (0.33)
2500

34 (0.01)
0

35-100 (0.66)
2400

Gamble B1
Gamble A2

2400
2500

2400
0

2400
0

Gamble B2

2400

2400

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Allais Paradox: Common Consequence

Similarly, we derive the condition for
0.33 2500 > 0.34 2400
2400 > 0.66 2400 + 0.33 2500
(1 0.66)) 2400 > 0.33 2500 > (0.34)(2400
0.66 + 0.34 < 1

Subcertainty: + 1 < 1
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Gambling and Insurance

Gambling: (5000, 0.001) (5)
Expected utility: 0.001 5000 > 5
5
5000

< 0.001

If () > 0,
contradiction!

5
5000

> 0.001,

Insurance: (-5) (-5000, 0.0001)

Check whether it contradicts the expected utility!
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Gambling and Insurance

Similarly, we derive the condition for
0.001 5000 > 5
0.001 >

5
5000

> 0.001

Overweighting small p: >

Check for insurance: (-5) (-5000, 0.0001)!
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Subadditivity for small p

It is commonly observed that
(0.001,6000) (0.002, 3000)
Expected utility: 0.001 6000 >
0.002 3000 (3000)/(6000) < 0.5
If () > 0,

3000
6000

> 0.5,

contradiction!
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Subadditivity for small p

Similarly, we derive the condition for
0.001 (6000) > 0.002 (3000)
(0.001)/(0.002) > (3000)/(6000) >
1/2
Subadditivity: () > () for small
probability
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Probability Weighting Function

Subproportionality
Subcertainty
Overweighting for small p
Subadditivity for small p

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Theory
Editing Phase
Coding
Combination
Cancellation
Simplification
Detection of Dominance

Evaluation Phase
Valuation
Probability Weighting
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Theory
2 or 3 outcomes
N-outcomes
Violation of dominance
What is reference point?

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Earlier Works
Markowitz (1952)

Karmarkar (1978)

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Earlier Works
Columbus is viewed as the discoverer of America, even
though every school child knows that the Americas were
inhabited when he arrived, and that he was not even the
first to have made a round trip, having been preceded by
Vikings and perhaps others. What is important about
Columbus discovery of America is not that it was the
first, but that it was the last. After Columbus, America
was never lost again.
Al Roth

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