Prospect Theory Versus Expected Utility Theory: Assumptions, Predictions, Intuition and Modelling of Risk Attitudes

• Autorzy: Michał Lewandowski
• Języki publikacji: EN

Abstrakty

EN

The main focus of this tutorial/review is on presenting Prospect Theory in the context of the still ongoing debate between the behavioral (mainly descriptive) and the classical (mainly normative) approach in decision theory underriskanduncertainty. ThegoalistodiscussProspectTheoryvs. Expected Utility in a comparative way. We discuss: a) which assumptions (implicit and explicit) of the classical theory are being questioned in Prospect Theory; b) how does the theory incorporate robust experimental evidence, striving, at the same time, to find the right balance between the basic rationality postulates of Expected Utility (e.g. monotonicity wrt. First-Order Stochastic Dominance), psychological plausibility and mathematical elegance; c) how are risk attitudes modeled in the theory. In particular we discuss prospect stochastic dominance and the three-pillar structure of modeling risk attitudes in Prospect Theory involving: the non-additive decision weights with lower and upper subadditivity and their relationship to the notions of pessimism and optimism, as well as preferences towards consequences separated into preferences within and across thedomainsofgainsandlosses(correspondingtobasicutilityandlossaversion), d) example applications of Prospect Theory. (original abstract)

Słowa kluczowe

EN

Loss aversion; Prospect theory; Expected utility theory

PL

Awersja do strat; Teoria perspektywy; Teoria oczekiwanej użyteczności

• Czasopismo: Central European Journal of Economic Modelling and Econometrics (CEJEME)
• Rocznik: 2017
• Tom: 9
• Numer: nr 4
• Strony: 275--321

Twórcy

autor

Michał Lewandowski

• Warsaw School of Economics, Poland

Bibliografia

• [1] Allais M. (1953). Le comportement de l'homme rationnel devant le risque: Critique des postulats et axiomes de l'ecole americaine. Econometrica 21(4),503- 546.
• [2] Anscombe F.J., Aumann R.J. (1963). A definition of subjective probability. The Annals of Mathematical Statistics 34(1), 199-205.
• [3] Arrow K.J. (1964). The role of securities in the optimal allocation of risk-bearing. The Review of Economic Studies 31(2), 91-96.
• [4] Arrow K. J. (1965). The theory of risk aversion. [in:] Aspects of the theory of risk-bearing, Yrjo Jahnsonin Saatio, Helsinki.
• [5] Barberis N. C. (2013). Thirty years of prospect theory in economics: A review and assessment. The Journal of Economic Perspectives 27(1), 173-195.
• [6] Benartzi S., Thaler R. H. (1995). Myopic loss aversion and the equity premium puzzle. The Quarterly Journal of Economics 110(1), 73-92.
• [7] Birnbaum M. H., Zimmermann J. M. (1998). Buying and selling prices of investments: Configural weight model of interactions predicts violations of joint independence. Organizational Behavior and Human Decision Processes 74(2), 145-187.
• [8] Bowman D., Minehart D., Rabin M. (1999). Loss aversion in a consumption- savings model. Journal of Economic Behavior & Organization 38(2), 155-178.
• [9] Camerer C. F. (2004). Prospect theory in the wild: Evidence from the field. [in:] Advances in behavioral economics, [ed.:] C.F. Camerer, G. Loewenstein, M. Rabin, Princeton University Press, 148-161.
• [10] Cicchetti C. J., Dubin J. A. (1994). A microeconometric analysis of risk aversion and the decision to self-insure. Journal of Political Economy 102(1), 169-186.
• [11] Clotfelter C. T., Cook P. J. (1993). Notes: The "gambler's fallacy" in lottery play. Management Science 39(12), 1521-1525.
• [12] Cohen M.(1992). Security level, potential level, expected utility: A three-criteria decision model under risk. Theory and Decision 33(2), 101-134.
• [13] Conlisk J.(1989). Three variants on the Allais example. The American Economic Review 79(3), 392-407.
• [14] Cox J.C., Sadiraj V.(2006). Small- and large-stakes risk aversion: Implications of concavity calibration for decision theory. Games and Economic Behavior 56(1), 45-60.
• [15] De finetti B. (1931). Sul concetto di media. Istituto Italiano degli Attuari.
• [16] De finetti B. (1937). La prévision: ses lois logiques, ses sources subjectives. [in:] Annales de l'institut Henri Poincaré, Volume 7, 1-68.
• [17] Diecidue E., Wakker P. P. (2001). On the intuition of rank-dependent utility. Journal of Risk and Uncertainty 23(3), 281-298.
• [18] Edwards W.(1954).The theory of decision making. Psychological Bulletin 51(4), 380-417.
• [19] Ellsberg D. (1961). Risk, ambiguity and the savage axioms. The Quarterly Journal of Economics 75(4), 643-669.
• [20] Foster D. P., Hart S. (2009). An operational measure of riskiness. Journal of Political Economy 117(5), 785-814.
• [21] Friedman M. (1957). The permanent income hypothesis. [in:] A theory of the consumption function, M. Friedman, Princeton University Press, Princeton, 20- 37.
• [22] Friedman M., Savage L. J. (1948). The utility analysis of choices involving risk. Journal of Political Economy 56(4), 279-304.
• [23] Gilboa I. (2009). Theory of decision under uncertainty. Econometrics Society Monographs, Cambridge University Press, Cambridge.
• [24] Gollier C., Pratt J. W. (1996). Risk vulnerability and the tempering effect of background risk. Econometrica, 64(5), 1109-1123.
• [25] Greer J. M., Levine D. K. (2006). A dual-self model of impulse control. The American Economic Review 96(5), 1449-1476.
• [26] Grether D. M., Plott C. R. (1979). Economic theory of choice and the preference reversal phenomenon. The American Economic Review 69(4), 623-638.
• [27] Hardy G., Littlewood J., Pólya G. (1934). Inequalities. Cambridge University Press, Cambridge.
• [28] Harless D. W. (1992). Predictions about indifference curves inside the unit triangle: A test of variants of expected utility theory. Journal of Economic Behavior & Organization 18(3), 391-414.
• [29] Hausch D. B., Ziemba W. T. (1995). Efficiency of sports and lottery betting markets. Handbooks in Operations Research and Management Science 9, 545- 580.
• [30] Heath C., Tversky A. (1991). Preference and belief: Ambiguity and competence in choice under uncertainty. Journal of Risk and Uncertainty 4(1), 5-28.
• [31] Hey J. D., Orme C. (1994). Investigating generalizations of expected utility theory using experimental data. Econometrica 62(6), 1291-1326.
• [32] Horowitz J.K., McConnell K.E. (2002). A review of WTA/WTP studies. Journal of Environmental Economics and Management 44(3), 426-447.
• [33] Kahneman D., Knetsch J. L., Thaler R. H. (1990). Experimental tests of the endowment effect and the coase theorem. Journal of Political Economy 98(6), 1325-1348.
• [34] Kahneman D., Tversky A. (1979). Prospect theory: Ananalysis of decision under risk. Econometrica 47(2), 263-291.
• [35] Kahneman D., Tversky A. (1981). The framing of decisions and the psychology of choice. Science 211(4481), 453-458.
• [36] Knetsch J. L., Sinden J. A. (1984). Willingness to pay and compensation demanded: Experimental evidence of an unexpected disparity in measures of value. The Quarterly Journal of Economics, 99(3), 507-521.
• [37] KnightF.H.(1921). Risk, uncertainty and profit. Hart Schaffner and Marx, New York.
• [38] Köbberling V., Wakker P. P. (2005). An index of loss aversion. Journal of Economic Theory 122(1), 119-131.
• [39] Kontek K. (2015). Continuous or discontinuous? estimating indifference curves inside the Marschak-Machina triangle using certainty equivalents. available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2575526
• [40] Kontek K., Lewandowski M. (2017). Range-dependent utility. Management Science. Articles in Advance, doi: 10.1287/mnsc.2017.2744.
• [41] Kőszegi B., Rabin M. (2006). A model of reference-dependent preferences. The Quarterly Journal of Economics 121(4), 1133-1165.
• [42] Kreps D. (1988). Notes on the Theory of Choice. Underground classics in economics, West view Press, Boulder.
• [43] Levy H., Wiener Z. (1998). Stochastic dominance and prospect dominance with subjective weighting functions. Journal of Risk and Uncertainty 16(2), 147-163.
• [44] Lewandowski M.(2013). Risk attitudes, buying and selling price for a lottery and simple strategies. Central and Eastern European Journal of Economic Modeling and Econometrics 5, 1-34.
• [45] Lewandowski M.(2014). Buying and selling price for risky lotteries and expected utility theory with gambling wealth. Journal of Risk and Uncertainty 48(3),253- 283.
• [46] Lewandowski M. (2017). Is expected utility an ex-hypothesis? some implications of a reference-dependent Expected Utility model. available at: https://papers. ssrn.com/sol3/papers.cfm?abstract_id=3064682.
• [47] Lichtenstein S., Slovic P. (1971). Reversals of preference between bids and choices in gambling decisions. Journal of Experimental Psychology 89(1), 46.
• [48] Lichtenstein S., Slovic P. (1973). Response-induced reversals of preference in gambling: An extended replication in las vegas. Journal of Experimental Psychology 101(1), 16.
• [49] Machina M. J. (1983). The economic theory of individual behavior toward risk: Theory, evidence and new directions. Technical report 433, Department of Economics, Stanford University.
• [50] Machina M. J. (1990). Expected utility hypothesis. [in:] Utility and Probability. The New Palgrave. [ed.:] J. Eatwell, M. Milgate, P. Newman, Palgrave Macmillan, London, 79-95.
• [51] Machina M. J., Schmeidler D. (1992). A more robust definition of subjective probability. Econometrica, 60(4), 745-780.
• [52] Markowitz H. (1952). The utility of wealth. Journal of Political Economy 60(2), 151-158.
• [53] Mehra R., Prescott E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics 15(2), 145-161.
• [54] Nau R. (2004). Phd seminar on choice theory. Lecture notes and readings. available at: https://faculty.fuqua.duke.edu/~rnau/choice/choice04. pdf.
• [55] Palacios-Huerta I., Serrano R. (2006). Rejecting small gambles under expected utility. Economics Letters 91(2), 250-259.
• [56] Pratt J. W. (1964). Risk aversion in the small and in the large. Econometrica 32(1/2), 122-136.
• [57] Rabin M. (2000). Risk aversion and expected-utility theory: A calibration theorem. Econometrica 68(5), 1281-1292.
• [58] Rabin M., Thaler R. (2001). Anomalies. risk aversion. Journal of Economic Perspectives 15(1), 219-232.
• [59] Rieger M. O., Wang M. (2008). Prospect theory for continuous distributions. Journal of Risk and Uncertainty 36(1), 83-102.
• [60] Rothschild M., Stiglitz J.E. (1971). Increasing risk II: Its economic consequences. Journal of Economic theory 3(1), 66-84.
• [61] Rubinstein A. (2012). Lecture notes in microeconomic theory: the economic agent. Princeton University Press, Princeton.
• [62] Samuelson W., Zeckhauser R.(1988). Status quo bias in decision making. Journal of Risk and Uncertainty 1(1), 7-59.
• [63] Savage L.J.(1954). The foundations of statistics. John Wiley & Sons, NewYork.
• [64] Schmeidler D. (1989). Subjective probability and expected utility without additivity. Econometrica, 57(3), 571-587.
• [65] Schneider M., Day R. (2016). Target-adjusted utility functions and expected-utility paradoxes. Management Science Articles in Advance, doi: 10.1287/mnsc.2016.2588.
• [66] Shea J. (1995). Myopia, liquidity constraints, and aggregate consumption: a simple test. Journal of Money, Credit and Banking 27(3), 798-805.
• [67] Shefrin H., Statman M. (1985). The disposition to sell winners too early and ride losers too long: Theory and evidence. The Journal of finance 40(3), 777-790.
• [68] Slovic P., Fischhoff B., Lichtenstein S. (1982). Response mode, framing, and information processing effects in risk assessment. [in:] New directions for methodology of social and behavioral science: Question framing and response consistency [ed.:] R. Hogarth, Jossey-Base, San Francisco, 21-36.
• [69] Sopher B., Gigliotti G. (1993). A test of generalized expected utility theory. Theory and Decision 35(1), 75-106.
• [70] Starmer C. (2000). Developments in non-expected utility theory: The hunt for a descriptive theory of choice under risk. Journal of Economic Literature 38(2), 332-382.
• [71] Starmer C., Sugden R. (1993). Testing for juxtaposition and event-splitting effects. Journal of Risk and Uncertainty 6(3), 235-254.
• [72] Sugden R. (2003). Reference-dependent subjective expected utility. Journal of Economic Theory 111(2), 172-191.
• [73] Thaler R. H., Ziemba W. T. (1988). Anomalies: Parimutuel betting markets: Racetracks and lotteries. The Journal of Economic Perspectives 2(2), 161-174.
• [74] Tversky A., Kahneman D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty 5(4), 297-323.
• [75] Tversky A., Wakker P. (1995). Risk attitudes and decision weights. Econometrica, 63(6), 1255-1280.
• [76] von Neumann J., Morgenstern O. (1944). Theory of games and economic behavior. Princeton University Press, Princeton.
• [77] Wakker P. (2010). Prospect theory: For risk and ambiguity. Cambridge University Press, Cambridge.
• [78] Yaari M. E. (1985). On the role of dutch books in the theory of choice under risk. [in:] Frontiers of Research in Economic Theory: The Nancy L. Schwartz Memorial Lectures 1983-1997, [ed.:] D. P. Jacobs, E. Kalai, M. I. Kamien, N.L. Schwartz, Cambridge University Press, Cambridge, 33-46.