Prospect Theory and Loss Aversion

Comments on Kahneman and Tversky The paper “Prospect Theory: An Analysis of Decision Under Risk” by Daniel Kahneman and Amos Tversky presents a critique of expected utility theory as a descriptive model of decision making under risk and develop an alternative model, which called the prospect theory. In their explanation, there are two ways how prospect theory deviate from expected utility theory. Firstly, while utility is linear, value is not. Secondly, whereas utility is dependent on final wealth, value is defined in terms of gains and losses. Hence, in the following, they examine how prospect theory explains three effects that people use when they are making decisions. The first effect is called the certainty effect, which illustrates subjects’ choices depend on whether the options are framed as a gain or a loss. People overweigh options that are certain over options that have a chance at winning more but also risk getting nothing.

For example, when giving a choice between getting $1000 with certainty or having a 50% chance of getting $2500 participants will choose the certain $1000 in preference to the uncertain chance of getting $2500, however when confronting with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss do often choose the risky alternative. Hence, when dealing with certain losses, people engage in risk-seeking behaviour to avoid a bigger loss, and risk averse for gains. The second effect is the isolation effect, which refers to people’s tendency to disregard elements that the alternatives share, and focus on the components that distinguish them. Discarding common elements lessens the burden of comparing alternatives, but also preferences may be altered by different representations of probabilities. Then, Daniel Kahneman and Amos Tversky present participants with 2 scenarios. In both cases subjects are given an initial amount of money, and then have to choose between two alternatives.(Problem11 and 12)

Although the initial amounts are different in the two cases, it turns out that the two situations are equivalent. However, participants have made opposite choices in the two cases, the majority choose the risk-averse option B in Scenario 1 and the loss-averse option C in scenario 2. The last effect has been introduced is the loss aversion. One significant result of Kahneman and Tversky’s work is that people's attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. Most people will behave in a way where they are able to avoid losses since people’s reaction to loss is more extreme than their reaction to gain, even though the probability of getting those losses is tiny. The pain of losing also explains why, when gambling, winning $100 and then losing $80 feels like a net loss even though you are actually ahead by $20. In conclusion, people normally perceive outcomes as gains and losses, rather than as final states of wealth or welfare. By examining certainty effect, isolation effect and loss aversion, Kahneman and Tversky figure out that people’s risk-seeking behaviour for losses and risk-averse behaviour for gains.

Under prospect theory, value is assigned to gains and losses rather than to final assets, also probabilities are replaced by decision weights. Therefore, the value function is defined on deviations from a reference point and is normally concave for gains, convex for losses, and is generally steeper for losses than for gains (loss aversion).

Kahneman and Tversky’s use of hypothetical scenarios relies on the assumption that people often know how they would behave in real situations, and also subjects do not disguise their true preferences. However, given what we know from Holt and Laury, behaviours do tend to differ under real and hypothetical incentive effects. Hence, the reliance on hypothetical choices in this paper raises questions regarding the validity of their methods and generalizability of the results.