Expected Utility and Prospect Theory
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This paper discusses how the theory of expected utility holds that the decision maker will choose between risky or uncertain prospects by comparing them to their expected utility values. It also looks at how the prospect theory was created in 1979 by Kahneman and Tversky in order to address what they felt were some of the shortcomings of expected utility theory. It analyzes the two theories in an attempt to discern differences. The paper further discusses how there are more similarities than differences between the two theories, and how some of the differences are spurious.
From the Paper:"The math behind prospect theory is similar, but slightly more complex. Prospect theory uses weighted outcomes as well, except instead of terming them 'probabilities' prospect theory terms them 'decision weights'. The difference between the two terms is subtle - a decision weight is the actual decision weight applied whereas the probability is the odds of an outcome occurring. The decision weight takes the probability of an event occurring and adds to it the behavioral element. These behaviors are the forms of irrationality observed by Kahneman and Tversky, including forms of risk aversion. The process of weighting the different outcomes is related to the risk aversion of the decision maker. Some common decision-making biases were identified by Kahneman and Tversky. While they may not be universally applied as the theory suggests, the concept of biases is an interesting idea. Decision makers each have individual sets of biases, which trend towards certain biases that become observable in the general population. The weight that the decision-maker gives to an outcome reflects then a combination of that outcome's probability and the aversion of the decision maker to that outcome. "
Sample of Sources Used:
- Mongin, P. (1997). Expected Utility Theory. Handbook of Economic Methodology. Retrieved April 14, 2010 from https://studies2.hec.fr/jahia/webdav/site/hec/shared/sites/mongin/acces_anonyme/page%20internet/O12.MonginExpectedHbk97.pdf
- Behavioural Finance.net. (no date). Prospect theory. Behavioural Finance.net. Retrieved April 14, 2010 from http://prospect-theory.behaviouralfinance.net/
Cite this Comparison Essay:
Expected Utility and Prospect Theory (2012, November 16) Retrieved July 10, 2020, from https://www.academon.com/comparison-essay/expected-utility-and-prospect-theory-152038/
"Expected Utility and Prospect Theory" 16 November 2012. Web. 10 July. 2020. <https://www.academon.com/comparison-essay/expected-utility-and-prospect-theory-152038/>