Jinwen here.
Prospect Theory
Human decision making
has many biases: there are two major components of the prospect theory.
1. Gain-Loss Utility function and flaming effect.
2. Probability-weighting
function.
Gain and Loss Utility
Functions
Q1-1
You have $200, and you have an opportunity
- To get $100 for sure
Or
- To get $200 with 50% probability
Which one do you choose?
Q1-2
You have $400, and you have an opportunity
- To lose $100 for sure
Or
- To lose $200 with 50% probability
Which one do you choose?
Q2-1
Assume there is disease affecting 600 people and there were two choices:
- Program A, where 200 of the 600 people will be saved.
- Program B, where there is 30% chance that all 600 people will be saved, and 66% chance that nobody will be saved.
Which one do you choose?
Q2-2
Assume there is disease affecting 600 people and there were two choices:
- Program A, where 400 people will die.
- Program B where there is a 33% chance that nobody will die, and 66% chance that all 600 people will die.
To the above questions, the majority of people choose:
1 for Q1-1
2 for Q1-2
1 for Q2-1
2 for Q2-2
Why?
This is because of the Gain-Loss Utility function and flaming effect in the prospect theory.
Gain--Risk avoidance
Loss--
Risk Seeking
Probability Weighting Function
Q1
- You get $400 with 80% of probability and $0 with 20% of probability.
- You get $300 for sure
Which one do you choose?
Q2
- You get $400 with 20% of probability and $0 with 80% of probability.
- You get $300 with 25% of probability and $0 with 75% of probability.
Which one do you choose?
To the above two questions, the majority of people choose:
2 for Q1
2 for Q2
Why?
This is because of the Probability Weighting Function.
- We prefer good things for sure.
- When the same good things happen with very high probability, we underestimate our utility.
- On the other hand, when the same good things happen with very low probability, we overestimate our utility comparing to nothing.