Embracing the Cognitive Dissonance Between Expected Utility Theory and Prospect Theory

Abstract:     
Initially noted with Allais' paradox in 1953 and further supported by Kahneman and Tversky in 1979, violations of expected utility theory and the associated biases individuals exhibit gave birth to a new paradigm of decision under uncertainty. These findings provided impetus to declare expected utility theory irrelevant. However, when investigating the violations of expected utility theory, we uncover deficiencies in the translation of the observed fourfold of risk pattern to a twofold value function. We recreate the Allais paradox and prospect theory question set with updated amounts and percentages, offering the survey online to willing global participants. We find subjective wealth to be the major determinant of risk-aversion and parity thereof between domestic United States and international responses. We also find location of residence to be a major influence on risk-aversion. Assuming the reflection effect of prospect theory, we are able to construct a fourfold utility function demonstrating both prospect theory and expected utility theory are quite relevant.

Keywords: Expected Utility, Allais, Prospect Theory, Loss-aversion, Risk Seeking

JEL Classification: D1

working papers series