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11 - Prospect theory: An analysis of decision under risk

Published online by Cambridge University Press:  05 June 2012

Daniel Kahneman
Affiliation:
University of British Columbia
Amos Tversky
Affiliation:
Stanford University
Peter Gärdenfors
Affiliation:
Lunds Universitet, Sweden
Nils-Eric Sahlin
Affiliation:
Lunds Universitet, Sweden
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Summary

Introduction

Expected utility theory has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (Keeney and Raiffa, 1976), and widely applied as a descriptive model of economic behavior (e.g., Friedman and Savage, 1948, and Arrow, 1971). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (von Neumann & Morgenstern, 1944, and Savage, 1954), and that most people actually do, most of the time.

The present paper describes several classes of choice problems in which preferences systematically violate the axioms of expected utility theory. In the light of these observations we argue that utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model and we propose an alternative account of choice under risk.

Critique

Decision making under risk can be viewed as a choice between prospects or gambles. A prospect (x1, p1; …; xn, pn) is a contract that yields outcome xi with probability pi, where p1 + p2 + … + pn = 1. To simplify notation, we omit null outcomes and use (x, p) to denote the prospect (x, p; 0, 1 – p) that yields x with probability p and 0 with probability 1 – p. The (riskless) prospect that yields x with certainty is denoted by (x). The present discussion is restricted to prospects with so-called objective or standard probabilities.

Type
Chapter
Information
Decision, Probability and Utility
Selected Readings
, pp. 183 - 214
Publisher: Cambridge University Press
Print publication year: 1988

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