Question

Explain in plain language how a standard probability weighting function (i.e. underestimating the probability of very likely events and overestimating the probability of very unlikely events) can lead a person to simultaneously gamble and purchase insurance

Answer 1

The overweighting of small probability events is the result of a two-stage process.In the first stage of overestimation of rare events, decision makers take information they receive from the world and then recruit from their memory and convert that infor-mation into a psychological representation of probability. As such, this stage is particularly susceptible to many of the basic cognitive limitations and shortcuts identified by psycho-logical research, biasing the resulting judgments in a predictable manner. Though by nomeans an exhaustive list, we have identified several of the most important, including the availability heuristic, anchoring on the ‘‘igno-rance prior,’’ and coarse chance categories.In the second stage of overweighting of small probability events, these probabilities are distorted upwarddue to the psychophysics of chance and affect.Although eliminating these biases altogether is probably unrealistic, it is nevertheless possible to reduce these biases.Many of the most effective approaches will require identifying and then addressing the particular psychological mechanism that produced the biased probability judgmentThe major difference between prospect theory and the classical theory is that the valuation of outcomes is governed bythe value function, v(x), while the valuationof the probabilities is governed by the probability can lead a person simultaneously gamble and purchase insurance