Prospect Theory

Prospect Theory
• Alternate Theory of Choice; a mathematical alternative to the
Expected Utility Theory

• Expected utility cannot fully account for observed decision making

under risk

• Resembles the Utility theory where individuals are presented as

maximizing the weighted sum of utilities

• Differs from the Utility theory in weighting

– E(U) : weights assigned are the probabilities
– Prospect Theory: weights are determined by Value Function
 Prospect Theory
• Daniel Kahneman and Amos Tversky :
Prospect Theory: An Analysis of Decision under Risk (Econometrica, Vol.
47, No. 2. (Mar., 1979) pp. 263-292)

• Building block of Prospect Theory :

– Value Function
– Use of decision weights rather than probabilities

• It is a positive theory  firmly based on how people behave

 Key Aspects of Observed Behavior

Decision (i): P1($240) and P2 (0.25, $1000)

Decision (ii): P3($-750) and P4(0.75, $-1000)

 Key Aspects of Observed Behavior
Decision (i): P1($240) and P2 (0.25, $1000)
Decision (ii): P3($-750) and P4(0.75, $-1000)

Solution:
• 84% choose P1 (consistent with risk averse)
• 87% chose P4 (consistent with risk seeking)

People sometimes exhibit risk aversion and sometimes exhibit risk

seeing depending on the nature of the prospect
 Key Aspects of Observed Behavior

Decision (i): Assume you are richer by $300 than you are today
Choose P5($100) and P6 (0.50, $200)

Decision (ii): Assume you are richer by $500 than you are today
Choose P7(-$100) and P8 (0.50, -$200)
 Key Aspects of Observed Behavior
Decision (i): Assume you are richer by $300 than you are today Choose
P5($100) and P6 (0.50, $200)
Decision (ii): Assume you are richer by $500 than you are today Choose P7(-
$100) and P8 (0.50, -$200)

Note: The two decisions are effectively the same

The decision is between $400 with certainty and prospect with a 50%
chance of 500 and a 50% chance of 300; Yet:

72% chose P5 Risk Averse

64% chose P8  Risk Seeking
 Key Aspects of Observed Behavior
• Risk attitude is not same across gains and losses
• It is the change in wealth rather than the level of wealth that matters
to people
• People evaluate an outcome based on the gains or losses from a
reference point (usually taken to be the current wealth)
• Expected Utility Theory (EUT) assumes that people value outcome
based on the final wealth position (level of wealth) regardless of the
person’s initial wealth and not changes in wealth
• Peoples’ valuation of prospects depend on gains and losses relative
to a reference point. This reference point is usually a status quo
• People are averse to losses because losses loom larger than gains
(Loss Aversion)
 Value Function
• Utility is measures in terms of the level of wealth
• Value is defined by gains and losses relative to reference point
• People exhibit risk aversion in positive domain and risk seeking in
negative domain
– Value function is concave in positive domain and convex in negative
domain
• Decisions are made by focusing on gains and losses
– Argument for the value function is not wealth but rather changes in
wealth
• People dislike losses so that the value function is steeper for losses
than gains
 Value Function

• Concave in the positive

domain consistent with risk
aversion

• Convex in the negative domain

consistent with risk seeking Differences in wealth

• Losses loom larger than gains

implying losses are felt more
stronger than gains of equal
size
Fig: A hypothetical value function
 Value Function
Instead of using simple probability, Prospect theory uses decisions
weights
The decision weights are functions of probabilities
For a prospect P (pr, z1, z2) value is:

V(pr,z1,z2) = V(P) =∏(pr) * v(z1) + ∏(1- pr) * v(z2)

where:
v(z) = value of wealth change (z is used instead of w, which refers to
wealth level)
∏(pr) = decision weight associated with probability pr
V(p) = Value of prospect (analogous to U(P), the E(U) prospect)
 Lottery Tickets and Insurance
• Why do people who buy lottery tickets also
purchase insurance?
• Why some people buy lottery tickets and
insurance at a time?
• Prospect theory incorporates overweighting
low-probability events by using decision
weights (∏(pr)), rather than event
probabilities (pr) to determine the value of
the prospect.
 Lottery Tickets and Insurance

Lottery Insurance

Choose between Prospects: Choose between Prospects:

P9 (0.001, $5000) P11 (0.001, -$5000)

P10 (1.0, $5) P12 (1.0, -$5)

Expected value of both prospects same People prefer P12

People prefer P9 risk seeking even in Risk aversion in negative domain
domain of gain
 Lottery Tickets and Insurance
• Kahneman and Tversky: the fourfold pattern of risk attitudes
– We normally have risk aversion in the positive domain where there is
quite a low probability of payoff this generally shifts to risk seeking
– We normally have high risk seeking in the negative domain, when
there is a quite low probability of a loss this generally shifts to risk
aversion
• The pattern suggest risk aversion for gains and risk seeking for losses
when outcome probability is high, and risk seeking for gains and risk
aversion for losses when the outcome probability is low
 Weighting Function

Decision (i): Choose between

P13(0.80, $4000) and P14 (1.00, $3000)

Decision (ii): Choose between

P15(0.20, $4000) and P16(0.25, $3000)
 Weighting Function
Difference between highly probable outcomes and certain outcomes.
Decision (i): Choose between
P13(0.80, $4000) and P14 (1.00, $3000)
Decision (ii): Choose between
P15(0.20, $4000) and P16(0.25, $3000)

• This example is based on Allais

• Decision (i): 80% chose 3000 (P14)  risk averse
Preference for a certain choice is called Certainty Effect
Underweight outcome that are merely probable in comparison with
outcomes that are obtained with certainty

• Decision (ii): 65% chose 4000 (P15) risk lover

 Weighting Function
• Common Ratio Effect: Lowering the probability from 100% to 25%
(P14 to P16) has a larger effect than lowering the probability from 80%
to 20% (P13 to P15)
– People value what is certain relative to that which is merely
probable
• Slope of the weighting function in the neighborhood of certainty is
relatively steep (i.e. slope > 1)
 Weighting Function
What should the weighting function look like in the neighborhood of
highly unlikely events?

Decision (i): Choose between

P17(0.45, $6000) and P18 (0.90, $3000)

Decision (ii): Choose between

P19(0.001, $6000) and P20(0.002, $3000)
 Weighting Function
Decision (i): Choose between
P17(0.45, $6000) and P18 (0.90, $3000)
Decision (ii): Choose between
P19(0.001, $6000) and P20(0.002, $3000)

• Risk neutral decision maker P17 ̴P18 and P19 ̴P20expected returns are
identical
• However,
86% picked P18 (risk aversion)
73% picked P19 (risk seeking)
• Overweighting is greatest for lowest probabilities (overweighting for 0.001>
.002)
• Weighting function is relatively steep in the neighborhood of zero
• Weighting function is steep in the neighborhood of pr=0 and pr=1.
 Weighting Function
• Weighting function is steep in
the neighborhood of both pr =0
and pr =1

• Using above condition and

setting ∏(0) =0 and ∏(1) =1, for
intermediate probabilities, the
slop of the weighting function is
relatively flat (slope <1)
Fig: Typical Weighting Function
• Also described as in inverted S-
curve
 Weighting Function
𝑍𝛼 0<𝛼<1 𝑖𝑓 𝑍≥0
• 𝜗 𝑍 = −𝜆 −𝑍 𝛽 𝜆>1,0<𝛽<1 𝑖𝑓𝑍<0
• According to K and T Value of α and β each to be
0.88 and value of 𝜆 =2.25
𝑝𝑟 𝛾
• 𝜋 𝑝𝑟 = 1 𝛾 > 0, 𝑖𝑓 𝑍 ≥ 0
𝑝𝑟 𝛾 + 1−𝑝𝑟 𝛾 𝛾

•
𝑝𝑟 𝜒
• 𝜋 𝑝𝑟 = 1 𝜒 > 0, 𝑖𝑓 𝑍 < 0
𝑝𝑟 𝜒 + 1−𝑝𝑟 𝜒 𝜒
 Weighting Function
• While pr + (1-pr) =1, the ∏(pr)+ ∏(1- pr) <1
• K and T find the average value of 𝛾 and 𝜒 = 0.65
• Putting these values we get ∏ (0.9) = 0.7455 and
∏ (0.1)= 0.1152
• Lottery example revisiting
• V(P9) = ∏ (0.001) * V(5000)= 0.011 * 1799.26=
19.864
• V(10) = ∏ (1) * V(5)= 1 * 4.12= 4.12