Prospect theory tells us that individuals attitude towards risk vary. Some individuals are risk seekers while some individuals are risk averse. These attitudes also vary depending on whether it's a gain or a loss.
Before I talked about more about the prospect theory I would like you to introduce you to a problem that was later termed as the Allias paradox. Just have a look at the sample of questions below :
Participants are usually asked to choose one of these options.
Gamble A: A 100% chance of receiving £1 million.
Gamble B: A 10% chance of receiving £5 million, an 89% chance of receiving £1 million, and a 1% chance of receiving nothing.
After their decisions have been made they are then presented with two more options to chose from
Gamble C: An 11% chance of receiving £1 million, and an 89% chance of receiving nothing.
Gamble D: A 10% chance of receiving £5 million, and a 90% chance of receiving nothing.
Most people usually prefer gamble A to B and gamble Dto C. Expected Utility theory infer that if a person prefer gamble A over B then the person must prefer gamble C over D. That is because they are maximising the expected utility or wealth. If a person prefer A and D together then there is an inconsistent in the expected utility theory. Expected utility theory convey that rational decision makers should weight the utility of the outcome by their probability of occurrence. That is equal outcomes to added to each of the choices should cancel out.
A series of experiment has been conducted by Kahneman and Tversky using this paradox and in each case there has been a violation in the axiom. Thus people do not seem to prefer B and D and A and C. What they found was that people overweight outcomes that are certain relative to outcomes that are merely probable. They termed this the certainty effect. It also indicated how people are risk averse when it comes to sure gains and risk seeking when it involves sure looses. Most people prefer a sure gain over a chance of gain but when the outcomes are looses then most people prefer the risky option to the sure loss. Thus people prefer to gamble when they have something to loose.
