Question

Provide a description of Prospect Theory (the nature of its value function, the probability weighting function, the loss aversion parameter, main characteristics of the theory etc.). Explain how the observed four-fold pattern of risk attitudes can be authenticated using the probability weighting function and the functional forms (positive and negative domain) of the value function.

Answer 1

prospective theory was created in 1979 and further developed by Daniel Kahneman and AmosTversky in 1992

they called it prospect theory as this theory is all about people's decision about gambling

it eliminates all confusions in the concept of expected utility theory

there are two kinds of functions in prospective theory

1.value function

2.probability weighting function i will explain you in a daigram

at kink point people think of low certainities they wont opt for high risks and they can be easily manipulated and the people who thinks of high risk wont care about utility that is the reason why they are in the shape of concave and convex inversly

and another function is called WEIGHTING FUNCTION.it deals with two things

1.How people infer

2.How do they deal with probabilities

even i will explain it in a diagram

let me tell you a example .

if you are planning to visit Tajmahal in india.you got your tickets booked.you never think of your plane meeting with an accident .but some people fear of such thing which have very ;low Infact rare Occurence .such people comes under zero category.they will get them insured .

As a business man if your market has many people with zero level then you can diversify your business inton insurance industry