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Deriving foundations of the prospect theory

Free «Deriving foundations of the prospect theory» Essay Sample

By consideration, if the Kahneman and Tverskey experiments provide a chance for two scenarios with one having the choices between two gambles with an initial $1000 such that the subject chooses gamble A as an even chance of winning, while gamble B provides $500 with certainty, there is need to elucidate the best choices depending on the initial wealth and the upfront amount. In the second scenario, the situation is such that in addition to the $2000 upfront, the subject has a choice of two gambles such that gamble c gives an even chance of losing $1000 or nothing. Moreover, gamble D results in the loss of $500 with certainty. This implies that through application of the prospect theory of uncertainty, there is a possibility of prescription of different choices to the subject depending on the initial financial conditions, which forms the essence of this paper.


In this regard, suppose Standard Stan makes choices under uncertainty according to the expected utility theory. If Stan is risk neutral, and his initial wealth is before upfront payment is zero, then he has a number of choices to make under each scenario. Firstly, he has the jurisdiction of application of gamble B is the first scenario and gamble C in the second scenario. There is a likelihood of these choices bearing in mind that the prospect theory of uncertainty states that for every gamble, the most probable choice depends on the most certain outcomes, while the initial conditions forms the constant factor for this proportionality. By consideration, these are the best gambles since they offer lower probabilities for loss of aversion. This implies that allocation of resources in a market situation is independent of the allocation of property rights especially when the less costly trades are most prevalent.

Conversely, if the contender is risk averse, the choices tend towards the most probable outcomes depending on the initial conditions. For risk free gambles, the subject has the jurisdiction of making choice A in the first scenario and choice C in the second scenario. This is because the utility theory known as the prospect theory offers the values for the possibility of the best outcomes inclined on most certain prospects. In this respect, the subject has a room for aversion of the possible risks, in which the choices given give the foundation for the best outcome.  On the other hand, if 16% of the subjects choose chose A in the first scenario while 68% chose C in the second scenario, then it is hard to reconcile with the expected utility theory since it is most probable that most contenders fall for even chances of winning than even chances of losing $1000. Given the exuberant amounts paid upfront in the first scenario, it is evident that there would be preference to the latter than the former in both scenarios. This would also be the same case for application of choices for the prospect Pete in the alternative prospect theory. 

The utility curve for prospect Pete in the alternative prospect theory offers a good correlation between the different scenarios, where different choices depend on the status of the initial conditions.

It is evident that the graph differs from that of the Karison, Loewenstein and Seppi utility curves in that as much as the former puts emphasis on the bad news defects of the ostrich effect, the latter is a veering into the good news defects of the ostrich effect. Consequently, the ostrich effect gives an insight into the argument that investors tend to make investments depending on the conditions of the bad or good news within the markets with the good news effects being the most preferred.

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