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Reviewing Prospect Theory

Reviewing Prospect Theory. According to RCT options should be evaluated in terms of utilities and probabilities. Prospect Theory generalizes about the quantities that people seem to actually be using and calls them (prospective) values and weights.

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Reviewing Prospect Theory

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  1. Reviewing Prospect Theory • According to RCT options should be evaluated in terms of utilities and probabilities. • Prospect Theory generalizes about the quantities that people seem to actually be using and calls them (prospective) values and weights. • The main features of Prospect Theory are summarized in the following graphs. • But as we saw last time,we also need to postulate certainty and pseudocertainty effects.

  2. Another Pseudo-certainty Example • Situation I: Which of the following options do you prefer? • A. A sure win of $30 • B. An 80% chance to win $45 • &8% of T & K’s subjects chose option A.

  3. Changing Only the Odds • Situation III: Which of the following options do you prefer? • E. A 25% chance to win $30. • F. A 20% chance to win $45. • Now 42% favored E and 58% favored F.

  4. Introduce Pseudo-certainty • Situation II: Consider the following two-stage game. In the first stage, there is a 75% chance to end the game without winning anything, and a 25% chance to move into the second stage. If you reach the second stage you have a choice between: • C. A sure win of $30. • D. An 80% chance to win $45. • Your choice must be made before the game starts, i.e., before the outcome of the first stage is known. Please indicate which of the above options you prefer, C or D.

  5. Analysis • In Situation II, 74% went for option C. • Can each of the three results be explained using what Prospect Theory says about gains/losses and weights? • T & K conclude they need to have recourse to the notion of pseudocertainty.

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