Prospect Theory and Utility Theory - Book Report/Review Example

Thus, today the utility theory does not provide sufficient explanation of choice under risk. Therefore, the authors have come up with alternate theories based on their observations. Decision making under risk is considered as “choice between prospects or gambles” (Kahneman & Tversky, 1979, p.263). A prospect can be a contract that can yield either expected results or unexpected results. Kahneman and Tversky have focused their discussion on the latter. The authors have stated that when the outcome has the probability of being positive or negative, people tend to choose that option which in their perspective offers maximum probability of positive results.

Based on their experiments, the authors have observed that the substitution axiom of utility theory is generally violated. According to the substitution axiom, when people prefer a particular object over another object then any kind of mixture with the latter will be more preferable than any kind of mixture with the latter. However, this theory has been negated in all the experiments conducted by the authors. Kahneman and Tversky have explained that utility theory, i.e. people choice between several options is based on three basic rules – expectation, asset integration, and risk aversion.

Expectation is the assumed perspective of people regarding the outcome of a choice. Second, people choose those options when their assets have less utility than the utility derived from integrating their prospects with their assets. The idea of risk aversion is quite simple in the sense that people tend to accept that choice which has absolute certainty of expected outcome over the choice which is risky with the same expected outcome. This phenomenon of preferring certainty over risky outcomes is termed as certainty effect.

However, Kahneman and Tversky have explained in their article