The Expected Utility Theory and The Prospect Theory

The assessment of consumer choices has always been a challenge, especially where risk and uncertainty are involved. Research suggests that consumer choices can be assessed and justified based on natural or statistical evaluations of economic behavior. The expected utility theory and the prospect theory are some of the hypotheses that have been developed to describe human economic choices. The theories aim at explaining situations where humans are faced with uncertainties and explaining whether individuals may prefer selecting the choices that seem less risky. Kahneman and Tversky identify that the expected utility theory is one of the dominant hypothesis that has been used to explain the reasoning behind the economic choices that humans make (263). The expected utility theory describes that the gamble decisions made by an individual are based on a person’s valuations of the outcomes (Kahneman and Tversky 264). The theory is essential for analyzing incidences where there is uncertainty of the outcome.

According to information from the pivotal paper, the expected utility theory is built on three major tenets. The first principle is that of expectation. Kahneman and Tversky identify that expectation is the “overall utility of a prospect” (264). Individuals engage in risky economic circumstances with the expectation of gaining or improving their status. The second tenet is that of asset integration. According to the principle, prospects are acceptable if there is an overall improvement in the financial and asset position of an individual after asset investments on the prospect have been made. The final principle is that of risk aversion. The principle describes the human behavior of attempting to lowering uncertainty when they engage in risky economic circumstances. The theory predicts that individuals are most likely to make a choice that is more likely to bring out the highest utility. However, Kahneman and Tversky ascertain that the expected utility theory has not been as effective in explaining decision making under risk (263). The assessment of human economic choices requires an integrated approach if accurate justifications of human choices are expected.  

Research has identified the various weaknesses of the expected utility theory, which have been the central points of criticizing the hypothesis. Kahneman and Tversky establish that the utility theory can be disapproved using the certainty effect (265). The principle highlights that humans tend to consider outcomes that appear more probable. The assumption has been confirmed to be true using research. The utility theory’s principle that establishes that ”the utilities of outcomes are weighted by their probabilities” has been disapproved by the certainty effect (Kahneman and Tversky 265). The criticism has been based on the idea that people are more likely to prefer certain outcomes as compared to those with lower chances of occurring. Also, the axioms of the expected utility theory have been criticized on the grounds that, even in incidences where winning is possible but not certain, individuals are more likely to select the outcomes that offer a larger gain. The certainty effect further disapproves the expected utility theory through the identification that individuals are more likely to prefer risk aversion where gains are expected and to seek risks where losses are certain. Further, unlike in the expected utility theory, the making of economic choices requires a process that applies the principle of the isolation effect (Kahneman and Tversky 267). According to the principle, individuals usually ignore the features that are similar to the prospects and instead focus on the differences. Prospects that are well distinguished and are more likely to result in positive outcomes are mostly selected.

The authors of the pivotal paper develop the prospect theory in which they identify that the weaknesses of the expected utility theory have been addressed. The prospect theory describes that people make choices depending on the expected value of the gains or the losses, instead of their final position. Besides, the theory establishes that individuals apply certain principles and simple heuristics that are applicable to real-world situations when making economic choices. Kahneman and Tversky expand on the theory by identifying that normally, individuals usually make decisions after passing their prospects through the editing and evaluation phases (274). During the editing stage, individuals analyze the prospects lightly and make simpler representations of the offered prospects. Some of the operations engaged at this stage include coding, segregation and combination. In the evaluation phase, the edited prospects are assessed, and the outcome that has the highest gains, or the least loss is chosen.

Why are these Main Points Important?

The main points of the article ”Prospect theory: An Analysis of Decision under Risk” are important in explaining human behavior in the field of economics. The authors develop the prospect theory, which is introduced with the aim of addressing the various limitations found in the expected utility theory. Without their input, individuals in the field of economics would continually be misled by the expected utility theory. The corrections made by the researchers promote a better understanding and an explanation of decision making under risk. Hence, individuals can explain human behavior much easily and accurately.  The points are important for the advancements of human knowledge on economic choices. Besides, the points are relevant in explaining human behavior as evidenced in the field of economics. The prospect theory promotes an understanding of important principles such as the disposition effect, risk aversion, and risk seeking.

Why are these Main Points Relevant?

The main points develop in the research are essential in explaining human behavior in various economic situations that require decision making. The knowledge can be applied to understanding why consumers purchase insurance policies and lottery tickets. Besides, businesses, such as betting companies that make profits depending on the choices made by their customers can utilize the principles of the prospect theory in setting the odds in a manner that matches with the probability of a particular outcome to occur. The information can be integral in ensuring that companies remain profitable, and at the same time provide the best offers that are attractive to their customers. The prospect theory is also relevant in explaining the reactions of individuals to stock market fluctuations and in risk aversion among stock market investors. Finally, the information can be used in advancing research that explains human economic behavior.

What are the Main Conclusions Drawn from Each Pivotal Paper?

The paper establishes that an assessment of how humans make decisions whose outcomes are uncertain requires a keen evaluation of all the factors that people consider before arriving at a choice. Information from the paper heavily criticizes the expected utility theory and disputes its principles with accurate evidence. The authors establish that one of the principles that negate the ideas of the expected utility theory is the certainty effect. The principle establishes that individuals are more likely to avoid choices that are more likely to cause losses, and on the other hand prefer outcomes that increase chances of winning. The same case applies to incidences where losses are imminent. Individuals are more likely to averse risks where losses are high and seek risks where outcomes result in low losses. Finally, the theorists establish that decision making is a process that involves stages such as the editing phase and the evaluation phase. The stages are essential in helping individuals make choices that result in gains and an improvement of their asset position.

Work Cited

Kahneman, Daniel, and Amos Tversky. ”Prospect theory: An Analysis of Decision under Risk.” The Econometric Society Vol. 47, No. 2 (Mar., 1979), pp. 263-291.