Presentation on

Prospect Theory: An Analysis of Decision under Risk

Presented by:
Manuja Koirala
PhD Student
ICO NIDA
 Prospect Theory

 Prospect theory is a behavioral economic theory that describes the way

people choose between probabilistic alternatives that involve risk, where the
probabilities of outcomes are known. The theory states that people make
decisions based on the potential value of losses and gains rather than the
final outcome.
 Expected Utility Theory
■ Expected Utility Theory states that the decision maker chooses between risky or uncertain
prospects by comparing their expected utility values, i.e. the weighted sums obtained by adding
the utility values of outcomes multiplied by their respective probabilities.

■ It aims to make decisions among various possible prospects and has been used in economics as a
descriptive theory to explain various phenomenon such as purchase of insurance and gambling.

■ This study presents a critique of expected utility theory as a descriptive model of decision
making under risk and develops an alternative model, which they call prospect theory.
 This theory describes the decision processes in two stages i.e. editing and evaluation. Generally, people decide which
outcomes they consider equivalent, set a reference point and then consider lesser outcomes as losses and greater ones
as gains.
 In expected utility theory, people use probability to evaluate the utility of outcomes. However, in
this theory, the researchers argue that people overweight outcomes they consider to be certain,
relative to uncertain outcomes, which is referred as certainty effect. The study is based on a
modified version of Allais’ Paradox.
Ex 1: Choose Between:
A: 2,500 with probability .33 B: 2,400 with certainty
2,400 with probability .66
0 with probability .01
N = 72 [82*]
Ex 2: Choose Between:
C: 2,500 with probability .33 D: 2,400 with probability .34
0 with probability .67 0 with probability .66

N = 72 [83*] [17]

This shows that 82% choose B in problem 1 and 83% choose C in problem 2. This implies
that expected theory is not consistent in peoples’ preference.
The Isolation Effect

People often disregard components that the alternatives share and focus on the components
that distinguish them. This approach to choice problems may produce inconsistent preferences
because a pair of prospects can be decomposed into common and distinctive components in
more than one way, this phenomenon is known as isolation effect.

Ex: Consider the following two-stage game. In the first stage, there is a probability of .75 to
end the game without winning anything, and a probability of .25 to move into the second stage.
If you reach the second stage you have a choice between
(4,000, .80) [22*] and (3,000) [78*]
Your choice must be made before the game starts, i.e., before the outcome of the first stage is
known.
 The Value Function
The preference order of prospects is not greatly altered by small changers so the value function can be
represented as a function of the reference point. This function is similar to the principle of people’s
perception and judgment. We tend to evaluate changes and differences with respect to a reference point.
The value function is a function of two arguments:
i) The reference point
ii) The magnitude of change(positive/negative) from the reference
point.
 A Hypothetical Value Function
The curve is concave above the
line as decision makers will be
risk averse when choosing
between gains.

The curve convex below the

line as decision makers are
risk seeking when choosing
between losses.

The line at this point is

steeper because decision
makers are extreme risk
takers.
 The Weighting Function
 In prospect theory, the value of each outcome is multiplied by a decision weight. These weights,
π, measure the impact of events on the desirability of prospects and are not merely the perceived
likelihood of the events. These weights are a function of stated probabilities, p but we should
keep in mind that these could be influenced by other things such as vagueness and ambiguity.
 Summary
 Prospect theory is developed for simple prospects with monetary outcomes and stated
probabilities. It distinguishes two phases in the choice process: an early phase of editing and
a subsequent phase of evaluation.

 The present analysis of preference between risky options has developed two themes:
i) To determine how prospects are perceived.
ii) The judgmental principles that govern the evaluation of gains and losses and the weighting
of uncertain outcomes.
 Summary
 The study found that people underweight outcomes that are merely probable in comparison
with outcomes that are obtained with certainty; also that people generally discard components
that are shared by all prospects under consideration. Under prospect theory, value is assigned
to gains and losses rather than to final assets; also probabilities are replaced by decision
weights. 

 A change in reference point alters the preference point for prospects.