Prospect Theory And Expected Utility Theory

Prospect theory is considered "substantive rationality" rather than "procedural rationality." Substantive rationality is the optimization of a given goal under given conditions and constraints, and is a function of goals and situational constraints but not intervening reasoning process. While procedural rationality focuses on the decision-making process. Therefore, the prospect theory cannot be adapted to the "cognitive-rational debate". The evaluation stage in the prospect theory is more similar to the rational economic theory. But it is the theory editing and framing have more in common with cognitive process theories. To conclude, the prospect theory research program is a limitation of the theory but not a fatal flaw.

Kahneman’s article is an analysis of intuitive thinking and how it guides our decision-making. Although primarily aimed at the field of psychology, it is an interdisciplinary article with applications in economic theorising. Kahneman attempts to differentiate between two systems of thought, one of intuition (system 1) and one of reasoning (system 2), and argues that many judgements and choices are made intuitively, rather than with reason (a slower and more deliberate process). Intuitive decision making, which encompasses heuristics, although generally more efficient and rapid, makes the agent potentially subject to errors due to framing effects or violations of dominance. The analysis of the studies and theoretical situations also provides criticism of the commonly held model of the rational agent within economics. The article also further conceptualises Kahneman’s theory, the Prospect Theory (Kahneman & Tversky, 1979), which has descriptive applications of people’s choice in decision-making situations involving risk and known probability of outcomes. These situations are typically unexplained by the more normative rational agent model.

17. Environments exist when decision makers lack complete certainty regarding the outcomes of various courses of action, but they are aware of the probabilities associated with their occurrence

However, it’s unknown exactly what kinds of situations will cause ambiguity to be avoided or preferred. The literature is also unclear as to whether the reaction is from the, “missing probability parameter itself, or (2) motivational or attributional factors…” (Rode et al. 1999) associated with comparing opitions. The authors hypothesized that, “people associate ambiguous probabilities with highly variable outcomes” (Rode et al. 1999). If the outcome that the person needs is higher than the average payoff of each option, then the person should actually default to the ambiguous option because it would have more variability, which could have a greater chance

Challenges are presented to people on the daily basis. What to eat, drink, where they have to go, who they need to see, and etc... These things all impact the decision making process and the decisions made. In financial decision making, highly successful people do not make investment decisions based on past sunk outcomes, rather by examining choices with no regard for past experiences; this approach conflicts with what one may expect. In addition to past experiences, there are several cognitive biases that influence decision making.

According to the lesson this week, Principle of Utility points that “to the desire for good choices and the connection to the community rather than to the individual”, which means in this type of dilemma, I think the final decision that the police had to make in order to save the hostage and the guerrillas is ethical and reasonable (Week 5 Lesson). The police's main purpose is to save the Israeli hostage as well as the majority of guerrillas. They did try everything they could without harming anyone, but unfortunelaly the plan didn't success. The police now faced with the decision either kill the guerrillas leader or let the hostage and many other innocents die. He did apply Principle of Utility and the end based theory by making a decision

One factor that influences a person’s choice to take a risk would be their emotions. People tend to make decisions based on their emotions over logical thought. Alan Sanfey found through his ultimatum game, that despite the knowledge that if people rejected the sum of money offered they would get nothing, people rejected the money when they felt the split was unfair. This rejection is thought to have occurred because people were angry that the money was not split fairly (Goldstein, 2015, p.386). Personally, I consistently lost spins, despite that I was more likely to win. I became a bit annoyed, and since it was not real money, I decided to just keep spinning the well to see what would happen. Another factor that could influence a person’s likeliness to engage in risky behavior is his or her observations. Even when a person knows everything about a situation, he or she may make a decision based on how he or she perceives the situation. This may occur because of the framing effect, as a different way of wording a situation may cause a person to alter their decision. Veronica Denes-Raj and Seymour Epstein had subjects try to pick red jellybeans out of a bowl filled with white beans. People tended to choose the bowl that had more red beans, despite knowing that there was a lower probability of picking a red bean. The increased number of red beans increased their confidence in their ability to pick a red bean, even if the probability was lower (Goldstein, 2015,

As a result, individual expectations, experiences, and biases may influence the way that people view probability of financial events or failures. It is possible to understand that human thinking is impacted by the most important things in life for a person. Fear

We tend to ignore the final outcome of a decision and focus on the certainty or uncertainty of it. The value we place on winning and losing vary, which is what the Prospect Theory suggests. The Prospect Theory is a model that psychologists created to explain our behavior when it comes to decision making and how we make decisions. Typically, if a decision has to do with a gain, people will lean towards the most certain option because they may fear that if they selected the other option that would be disappointed. On the other hand, decisions that have to do with loses are seen as the opposite by the majority of people. This is because we feel more risky when selecting the uncertain option over the certain option because we are trying to avoid a significant loss. The Prospect Theory provides an explanation on how people make choices under strained conditions of gains and losses in their applications of the real

Apart from highlighting the status quo bias, according to Anderson, (2003) the difference between of decision makers take the status quo option when priorities change, uncertainty, or change the cost exists. Every decision has a status quo, which acts as an anchor for any possible alternatives and have an influence on the final decision (Samuelson and Zeckhauser, 1988). Samuelson and Zeckhauser term (1988) the tendency of agents to comply with the decision or the decision of an already existing as a status quo bias. There are several categories to describe the status quo tendency of misconceptions cognitive, psychological commitment, and make rational

In order to demonstrate flaws of the traditional view, Kahneman supports three principles of prospect theory with various examples. First, by pointing out errors in Bernoulli’s model and the indifferent model, Kahneman emphasizes the broad range of the reference point, that it is not only the change of wealth, but also the context and the mindset. Second, Kahneman analyzes loss aversion, one of the dominant mindsets. Third, Kahneman argue that sensitivity has great impact on decision making by providing gambling cases of rare and risky events. With the knowledge of these three principles, Kahneman further implies that people can be trained to against these intuitive system one thinking patterns.

In part, Prospect Theory offers insights into why people make non-optimizing decisions rather than only those that are profit maximizing. Prospect Theory is central to much of Behavioural Finance and is often contrasted with the more conventional Efficient Market Hypothesis and Expected Utility Theory.

Deliberate thinking. Limitations in the ability to utilize numerical uncertainty information could also be more general than numeracy, such as the failure to think deliberately about the information. According to the two systems approach, there are two modes of thought. System 1 is rapid, automatic, associative, emotional, and roughly synonymous with intuition, and System 2 is slow, deliberate, rule-based, and effortful (Kahneman, 2003). When faced with a decision, a person may substitute an inaccurate verbal “gist” for the numeric estimate given which would lead to worse decisions. This attribute substitution is a System 1 process: the automatic substitution of an easier interpretation for a more difficult one (Kahneman & Frederick, 2002). A person who also employs System 2, which is deliberate and systematic, may be more likely to take into account all of the relevant factors, including precise numerical information, especially when likelihood is low but it is appropriate to take action. In other words, they have the mental restraint needed to avoid making rushed decisions. Previous research shows that in the domain of losses, the individuals who relied on system 1 made worse use of risk information, choosing a risky gamble with a lower expected value over a sure loss (Frederick, 2005). People with a more analytical/systematic processing style are also less susceptible to framing effects (McElroy & Seta, 2003). Thus relying on system 1 may decrease the ability to utilize

Fifty years after Jeremy Bentham’s initial defention of utility, the German economist Hermann Heinrich Gossen introduced the term marginal utility and the law of diminishing marginal utility. The term marginal utility is defined as “the pleasure or pain from an additional unit or ‘dose’ of a good.” The introduction of marginal utility to economic thought and vocabulary was revolutionary, reducing the need to measure total pleasure or pain because “Even if marginal utilities were measured on a cardinal scale, they would tell us nothing about how much total utility there was (even if it was maximized) because they are still only measured up to an additive constant.” An additional benefit of marginal utility was the introduction of the principle of marginal utility theory, which Gossen explained as, “Man maximizes his total life pleasure if he distributes his entire money income ... among the various enjoyments ... so that the last atom of money spent on each single pleasure yields the same amount of pleasure.” Marginal utility was considered easier to measure than utility as a whole, although still very difficult to define. At the same time, Gossen was also introducing the law of diminishing marginal utility, which was one of the most important steps in developing the economic theory around utility.

order to create the maximal utility. This is where Virtue in ethics comes into play, by bringing together pupils and their moralities. When one is able first solve their own moral issues they are way more inclined to help solve others such as sanitation which is important to most cultures. A major virtue is cleanliness which is second in line to importance to godliness, when sanitation is lacking, then people are unable to attain full internal and external cleanliness. I think that if I had to choose the most important viewpoint, it would have to be Utilitarianism because of all the ways the theory can be interpreted. Whether it’s from a group to start with or one’s own interests, when this takes flight it’s imperative to promote the greatest happiness for the greatest number of people. In the end, I believe that both are vital in the means of making sanitation a top priority, but the ideas should be posed from a Utilitarianism approach.