Propensity to Risk and the Prospect Theory

Abstract

The main aim of the chapter is a discussion of the prospect theory in context of propensity to risk. In prospect theory and, generally, in behavioural economics, there are many methodological attitudes. Propensity theory gives possibility to standardise them, and this is the general motivation of the chapter. Presented methods of analysing propensity could help operationalise the prospect theory and other behavioural economics concepts. In the first part, general definition of propensity, as well as methods of measuring propensities is shortly discussed. In the next part of the chapter, propensity to risk is analysed in context of the prospect theory. Frequency measures of propensity to risk are used to specify a value function in the prospect theory. The first measure is based on nominal scale. This method might be useful when we have two outputs (safe and risky one), such as in the first version of the prospect theory (Kahneman and Tversky in Econometrica 47:2, 1979). Also, method of measuring propensity to risk that is based on game against nature is proposed. This method might be used in case of cumulative prospect theory, where we have more than two outputs.