Utility versus Prospect - Case Study Example

Comparison and contrast between Expected Utility Theory and Prospect Theory Introduction Both Expected Utility and Prospect theories are used predict how a decision maker would behave in a situation involving risk or uncertainty. But the theories are in stark contrast with each other many respects. There has been a long time debate on which Theory offers better prediction and there are supporters to both. But Prospect Theory is more sophisticated and is able to explain seemingly irrational behavior to which Expected Utility Theory fails to answer. Expected Utility Theory suggests that choices are coherently and consistently made by multiplying outcomes (gains or losses) of actions by their respective probabilities, where payoffs assumed to be independent of probabilities. The alternative which is selected is the one that offers the maximum utility (Einhorn and Hogarth, 1981). The basic tenets of the Expected Utility Theory, regarding the processes that take place when decisions are made under uncertainty and risk are: (1) consistency of preferences for alternatives; (2) linearity of decision weights; and (3) judgment in reference to a fixed asset position (Kahneman and Tversky, 1979).On the basis of these assumptions, Expected Utility Theory attempts to predict that the decision maker will always choose better alternative (Kahneman and Tversky, 1984). According to Expected Utility Theory characteristics of the context of the decision would have no influence on the choice made by the decision maker. While Prospect Theory offers various empirical evidences of choice problems where preferences violate the axioms of Expected Utility Theory" (Kahneman and Tversky, 1979: 263). Prospect Theory proposes that human beings are cognitively constrained and thus decision makers tend to simplify their choices cognitively whenever possible, which leads to bounded rationality i.e. satisficing which means opting for suboptimal choices and not striving for the best possible outcome that, as Simon (1955) found. Prospect Theory proposed that decision makers consistently violate the assumptions of Expected Utility Theory. First, decision makers look at choices as adjustments to their current wealth from a personal reference point. They tend to avoid risk toward adjustments in case of gains, and behave as loss averse toward adjustments seen as losses from this reference point. Second, while assigning probabilities decision makers are predisposed to overweight unlikely events and underweight likely events, and they do not adequately discriminate between large numbers while making choices. Finally, there can be great influence, on the choices being made, of the manner in which alternatives are presented to them as suggested by Bell et al. (1988). Contrast between Expected Utility Theory and Prospect Theory The two theories can be distinguished on the basis of following points. 1) Consistency in Preferences - Expected Utility Theory suggests that people will consistently prefer dominant alternatives. Alternatives with greater utility potential will always be preferred over the ones with potential for utility. Moreover, Expected Utility Theory predicts that the choice does not vary in response to variation in the manner of presentation of the alternatives. The underlying assumption here in this view is that decision makers are aware of multiple choices and both cognitively able and motivated to work through the complexities to reach the best choice. Prospect Theory admits the limitedness of information processing displayed by human decision makers and their predisposition toward a decision which is good enough and may not be the best. This implies that people can’t be expected to be immune from the order of presentation of the choices, because of their limited information processing capacity or tendency they likely make decision from the first alternatives offered to them and may not wait for the best alternative to figure. For example while shopping online people may access all the available options and can compare them on several bases but people will stick to a number of pages they visit before making decisions, while pages which figured early in the Google’s list need not be the best decisions. After all, a company’s strength in SEO does not translate in to its product being the best choice for everybody. There are two aspects of bounded rationality which seem to influence choice behavior. First, decision makers strive to reduce cognitive effort by simplifying the process. For example, concurrent choices are framed as separate choices by (Tversky and Kahneman, 1981). Second, the decision makers sequentially process the separate choices. As decision makers simplify and process alternatives sequentially, there is a sizable probability that they can overlook the possibility that, concurrently viewed, separate reasonable choices may result in a suboptimal choice. This may happen other way round also. By failing to deal with concurrent choices decision makers can fail to see that, concurrently viewed, two seemingly unreasonable separate choices can actually produce a superior outcome. How so ever it happens, the option producing the maximum payoff is not selected, which is in stark contrast with the axiom of “consistency of preference” held by Expected Utility Theory. 2) Linearity of Decision Weights - The second axiom of Expected Utility Theory is that decision weights while comparing alternatives are linear. In utility Theory, the value of an alternative is calculated by multiplying the utilities of possible outcomes by their relative probability of their occurrence. The best choice is that which gives the highest payoff, for example given to choose from two options 1) 1 % probability of winning 1million and 99 % probability of winning 0. 2) 100% probability of winning 8000 and 0% of 0. the decision maker will choose option (1) as it offers higher utility i.e. 10,000 Value (1) = 1% of 1mn + 99% of 0 = 10,000 + 0 = 10,000 Value (2) = 100 % of 8000 + 0% of 0 = 8000 + 0 = 8,000 But, Prospect Theory proposes that the decision weights are neither value free nor linear, which is essentially in violation of the decision weights axiom of Expected Utility Theory. Prospect Theory claims that people give unlikely events more weight than they actually deserve and highly probable events are assumed to be certainties. Prospect Theory also observes a strong certainty effect; when people are pleased with a payoff that they perceive as certain, they prefer it to an option that requires a gamble for a higher payoff. 3) Reference point while making decision - According to utility Theory, it is the fixed states of wealth are the outcomes to which a decision maker assigns the probabilities. Underlying this is an assumption that decisions reflect a thorough understanding of the decision makers alternatives. Alternatives are evaluated from a single, consistent reference point based on decision maker’s understanding of various states of wealth. Utility Theory suggests that the decisions are made considering the reference points and the final asset position i.e. the end state. And since the asset base does not change, thus the evaluation is linear. As such, in deciding among various options it does not matter to decision makers what are the consequences of trading among the alternatives. In stark contrast with the risk preference axiom of expected utility, Prospect Theory suggests that decisions are made by taking in to account the change (gains or losses) that each decision will bring to the current wealth of the decision maker. In addition, according to Prospect Theory decision makers tend to view payoffs from a reference point. They behave as risk averse above this reference i.e. while considering gains, while on the other hand acting as risk seekers or loss averse when choices involve losses. People’s responses to losses are more acute than that to gains (Kahneman and Tversky, 1979; Hershey and Schoemaker, 1980). 4) Possibility of Decision Reversal - Finally, as predicted by Expected Utility Theory, decision makers will never reverse their preferences irrespective of the context in which they encounter the problem and their preferred choice will always be the dominant outcome. But Kahneman and Tversky (1982) suggested that if we alter the description of the decision problem a reversal of preferences need not be impossible. They were of view that, a reversal of preferences occurs when reference points are altered. Preference reversals are possible because preference, linearity, and reference axioms may not hold. References Bell, D., Raiffa, H. and Tversky, A. (1988) Decision making: Descriptive, normative, and prescriptive interactions, Cambridge: Cambridge University Press. David, E. and Peter, H. (1986) ‘Perspectives on Utility’, Operations Research, vol. 34, no. 1, January, pp. 179-183. David, W. and Colin, F. (1994) ‘The Predictive Utility of Generalized Expected Utility’, Econometrica, vol. 62, no. 6, November, pp. 1251-1289. Einhorn, H. and Hogarth, R. (1981) ‘Behavioral decision Theory: Processes of judgment and choice’, Annual Review of Psychology , vol. 32, pp. 53-88. Hershey, J. and Schoemaker, P. (1980) ‘Risk Taking And Problem Context In The Domain Of Losses: An UnExpected Utility Analysis’, Journal of Risk And Insurance, vol. 47, pp. 111-132. Imran, S. and Rakesh, K. (1989) ‘Prospect versus Utility’, Management Science, vol. 35, no. 1, January, pp. 22-41. Kahneman, D. and Tversky, A. (1979) ‘Prospect Theory: An analysis of decision under risk’, Econometrica , vol. 47, pp. 263-291. Kahneman, D. and Tversky, A. (1982) ‘The psychology of preferences’, Scientific American , January, pp. 160-173. Kahneman, D. and Tversky, A. (1984) ‘Choices, Values, And Frames’, American Psychologist , vol. 39 pp. 341-350. Simon, H. (1955) ‘A behavioral model of rational choice’, Quarterly Journal of Economics, vol. 69, pp. 99-118. Tversky, A. and Kahneman, D. (1981) ‘The framing of decisions and the psychology of choice’, Science, vol. 211, no. 4481, January, pp. 453-458. Read More