Prospect Theory – an Alternative to the Expected Utility Theory

Stanislav Škapa, Martin Vémola

Abstract


Purpose of the article: Economic theory has long relied on a descriptively sparse model of individuals behavior based on the premise that people are rational and held in accordance with the expected utility theory, but in the reality there are many situations when people behave irrationally (e.g. buying stocks when the prices are too hight and selling stocks when prices sharply drop, underwrite the event with an extremely low probability, playing a lottery). We present a number of empirical demonstrations that are inconsistent with the classical theory, expected utility.
Scientific aim of this article: The aim of the article is a critically describe the problems related with anomalies of expected utility theory and introduce descriptive theory, a prospect theory, of how individuals choose among risky alternatives.
Methodology/methods: The primary and secondary research was applied. Selected scientific articles and other literature published with the theme of expected utility theory and prospect theory are mainly used to support a critical analyse of how individuals choose among risky alternatives. Regarding the primary research the questionaires method was used.
Findings: Based on our research, we discovered several situations in the process of individuals decision making among risky alternatives, which are not consistent with some axioms of the theory of expected utility. Therefore, we propose to build on the prospect theory for individuals decision making among risky alternatives.
Conclusions: The prospect theory is a descriptive model of decision making under uncertainty. According to this theory, individuals can assess risk through asymmetric valuation function that is defined on gains and losses, is concave to convex on the gains and losses. Prospect theory uses a transformed probability rather than an objective function using weighting. The prospect theory is more representative of human behavior than the expected utility theory.

Keywords


Expected utility theory; prospect theory; probability; risk

JEL Classification


D01; D12

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Online: 2013-10-21