In: Economics
Discuss how to use the S-shaped utility function under prospect theory to explain the inverse-S-shaped subjective probability weighting function.
Answer:
The prospect theory replaces the utility function which was used
earlier with value function over gains and losses relative to a
given point called as reference point. When the corresponding
distance between relative points increases it leads to diminishing
of marginal impact change in value. This theory also intriduces
various types of comparisons in the evaluation of risky choices
under situation. In simple terms this theory explains subjective
transformations of ovjective outcome. Decision makers select one of
the choices ignoring minor differences in choice.
Condition of probability weighting functionare convexity, concavity
and related conditions between them.
In both the theories S-shaped curve is bieng used which explains the reason behind value diminishing is mainly because of Concavity and Convexity. In probability weighting theory as well it shows the range of small probabilities are greater than larger counterparts. But in prospect theory, there is a concept of refernce point which is being denoted. Using that we can calculate the exact gain and loss from this extra unit of probability.
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