Great Expectations: Prospect Theory with a Consistent Reference Point

23 Pages Posted: 22 Aug 2013 Last revised: 29 Aug 2013

See all articles by Asa Palley

Asa Palley

Indiana University - Kelley School of Business - Department of Operation & Decision Technologies

Date Written: August 28, 2013

Abstract

This paper introduces a prospect theory model of risk preferences with an endogenously determined expectation that serves simultaneously as both the reference point for and the certainty equivalent of a lottery. This model accommodates a number of psychologically motivated and empirically observed risk preferences. We show that an agent can always form a consistent expectation for any gamble and derive a parametric formula for binary gambles, which can then be used to examine the effects of loss aversion, risk aversion, and probability weighting on behavior under risk. To illustrate the applicability of the results, we use this model to consider the incentives of an agent purchasing insurance against the possibility of a loss and show that it is optimal for him to either purchase full insurance or purchase no insurance.

Keywords: Prospect Theory, Endogenous Reference Point, Consistent Expectations, Loss Aversion, Insurance

JEL Classification: D03

Suggested Citation

Palley, Asa, Great Expectations: Prospect Theory with a Consistent Reference Point (August 28, 2013). Available at SSRN: https://ssrn.com/abstract=2313851 or http://dx.doi.org/10.2139/ssrn.2313851

Asa Palley (Contact Author)

Indiana University - Kelley School of Business - Department of Operation & Decision Technologies ( email )

Hodge Hall 4100
1275 E 10th St.
Bloomington, IN 47405
United States

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