According to prospect theory, a person who has just gained $1,000 and faces a choice between a certain gain of $500 and a 50% chance of gaining $1,000 (or nothing) will most likely...
AChoose the gamble because they are in the domain of gains and are risk-seeking
BChoose the certain $500 because the value function is concave in the domain of gains, producing risk aversion
CBe indifferent between the two options because the expected values are identical
DRefuse both options due to loss aversion
In the domain of gains, the prospect theory value function is concave — diminishing sensitivity means that the certain $500 is valued more than a 50% chance of $1,000 because the psychological difference between $0 and $500 is larger than between $500 and $1,000. This produces risk aversion for gains — the certainty of $500 is preferred. The mirror pattern holds for losses: in the loss domain, the convex value function produces risk seeking, which is why people gamble to avoid certain losses.
Question 2 True / False
Expected utility theory and prospect theory make identical predictions about how people evaluate risky choices.
TTrue
FFalse
Answer: False
The theories make systematically different predictions. Expected utility evaluates outcomes as final wealth states, is linear in probabilities, and predicts consistent risk attitudes. Prospect theory evaluates outcomes relative to a reference point, uses a nonlinear value function (concave for gains, convex for losses, with loss aversion), and applies a probability weighting function that overweights small probabilities and underweights large ones. These differences produce divergent predictions: prospect theory predicts the reflection effect (risk aversion for gains, risk seeking for losses), the certainty effect, and loss aversion — all of which violate expected utility.
Question 3 Short Answer
What is the reference point in prospect theory, and why does it matter so much for decision-making?
Think about your answer, then reveal below.
Model answer: The reference point is the baseline against which outcomes are evaluated as gains or losses. It is typically the status quo, but can be an expectation, aspiration level, or social comparison. It matters because the same objective outcome can be perceived as a gain or a loss depending on the reference point, and the value function treats gains and losses asymmetrically — losses loom roughly twice as large as equivalent gains. Shifting the reference point can reverse preferences even when the objective options are identical.
Reference-dependence is what makes prospect theory fundamentally different from expected utility theory, which evaluates outcomes as final wealth states independent of any starting point. A person with $100,000 who gained $10,000 is in a very different psychological state from a person with $100,000 who lost $10,000 — even though their current wealth is identical. The reference point introduces context-sensitivity into evaluation, which standard theory deliberately excludes but which profoundly affects real behavior.