Compare and contrast standard Expected Utility theory and Prospect theory - Essay Example

Standard expected utility theory represents preference over risky objects, by weighted average of utility assigned to each possible outcome, where the weights are the probability of each outcome (Expected Utility Theory, 2008). This theory analyses all the risk factors before taking decisions. For example, investments in share markets may yield a good return or a big loss. But investments in term deposits may guarantee a fixed return. Thus many of the investors opt for the investments in term deposits in order to avoid risks in investing in share markets.

Prospect theory on the other hand analyses decisions among alternatives which involve risks. “Under prospect theory, value is assigned to gains and losses rather than to final assets; also probabilities are replaced by decision weights” (Prospect Theory, n. d). For example, investments in share market and mutual funds involve risks. But compared to share market investment, mutual fund investment are safer. Prospect theory thus helps people to take proper decisions among the risky alternatives available.

This paper compares and contrast Standard expected utility theory and prospect theory. Sebora (1995) has mentioned that expected utility theory suggests that choices should be made by weighing the outcomes (gains or losses) of actions by their probabilities and the alternative which has the maximum utility should be selected. Prospect theory, on the other hand, indicates that, decision makers prefer to simplify their choices cognitively whenever possible, satisfying rather than maximizing (Sebora, 1995, p.4). Gain or losses is given more emphasise in expected utility theory.

Big gains expected with high risks will be given least preferences compared to small gains with least risks according to the expected utility theory. For example, consider a person with the choices of getting an excellent salaried job with high risk and a moderately salaried job with low