Prospect Theory: An Alternative Model To Utility Theory

Prospect Theory has been defined as a psychological relation that describes the decision making process that individuals use under conditions of uncertainty or risk. This may involve decisions about nearly anything where the outcome of the decision is somewhat risky. Individuals will look at the difference in gains or losses when making a decision where the outcome is uncertain, so an element of risk is present. This theory states that individuals will value gains and losses differently and therefore will base their decisions on realised gains rather than losses. Therefore, if an individual was given two identical (equal) choices, one described in terms of gains and the other in terms of losses, he would chose the former. Value is assigned to gains and losses. Prospect Theory is an alternative model to Utility Theory.

The Utility Theory is a measure of the level of satisfaction that is derived from the consumption of a good or service. It has been widely accepted that all ‘reasonable’ individuals will follow the axioms of utility theory. The axioms of utility theory are: Completeness and rankability which implies consumers can make comparisons across all sets of goods that they

There are three main paradoxes involved with the Utility Theory, namely the St Petersburg paradox (based on a particular game in which a random variable has an infinite expected value but seems to only be worth a small amount); the Allais paradox (the addition of an independent event may influence the behaviour of an individual and their choices); and the Ellsberg paradox (refers to an individual’s aversion to ambiguity when they have to make choices – an individual will choose a known quality even if the odds of winning are less than loosing). The expected Utility Theory axioms were violated under several choice problems so an alternative theory was needed to compensate for these