A Critical Comparison of SEUT and Prospect Theory

Abstract

This article explores two key theories in behavioral finance: Subjective Expected Utility Theory (SEUT) and Prospect Theory, outlining their development as responses to historic economic paradoxes, challenging traditional notions of rationality in economic decision-making. SEUT extends the concepts of expected value and rational choice, incorporating individual utility functions and subjective probabilities. Despite its comprehensive approach, SEUT struggles to explain certain behaviors under risk and uncertainty. Prospect Theory, conceived by Kahneman and Tversky, offers an alternative. It introduces decision weighting, focusing on how individuals differently perceive gains and losses relative to a reference point. This theory explains human biases like loss aversion and framing effects, which SEUT overlooks. Through practical examples and empirical studies, the article demonstrates scenarios where human behavior deviates from SEUT predictions, influenced by psychological factors. However, both theories provide insights into economic decision-making, they have their respective strengths and limitations. The article suggests a more integrated approach, recognizing the complexities of human decision-making in economic contexts.