An Experimental Comparison of Risky and Diskless Choice – Limitations of Prospect Theory and Expected Utility Theory

Abstract

Prospect theory, widely used descriptively for decisions under both risk and certainty, presumes concave utility over “gains” and convex utility over “losses”; a pattern widely seen in lottery tasks. Although such gain-loss asymmetry is also widely used to model riskless choices, limited empirical evidence supports this use. In incentive-compatible experiments we find that in riskless choice gain-loss asymmetries are not observed as predicted by prospect theory even while in the same participants gain-loss asymmetries are observed under risk. Our results imply that utility functions under conditions of certainty can be more closely approximated using neoclassical rather than prospect theoretic preferences.

Keywords: indifference curve; riskless choice; reflection effect; reference point; losses

JEL Classification: D81