Embracing the Cognitive Dissonance Between Expected Utility Theory and Prospect Theory

40 Pages Posted: 14 Jan 2012 Last revised: 11 Mar 2016

See all articles by Fred Viole

Fred Viole

OVVO Financial Systems; Fordham University

David N. Nawrocki

Villanova University - Department of Finance

Date Written: January 13, 2012

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

Suggested Citation

Viole, Fred and Nawrocki, David N., Embracing the Cognitive Dissonance Between Expected Utility Theory and Prospect Theory (January 13, 2012). Available at SSRN: https://ssrn.com/abstract=1984661 or http://dx.doi.org/10.2139/ssrn.1984661

Fred Viole (Contact Author)

OVVO Financial Systems ( email )

NJ
United States

Fordham University ( email )

Bronx, NY 10458
United States

David N. Nawrocki

Villanova University - Department of Finance ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States
610-519-4323 (Phone)
610-519-6881 (Fax)

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