Prospect theory for uncertainty

Abstract

Tversky & Kahneman (1992) corrected the theoretical problem of probability weighting of Kahneman & Tversky's (1979) original prospect theory. Thus, the theory could be extended to general probability-contingent prospects and this was the topic of Chapter 9. A more important advance of Tversky & Kahneman (1992) was that it extended prospect theory from risk to uncertainty. A common misunderstanding in decision theory today is that prospect theory supposedly concerns only risk, and that other models should be used for ambiguity. This chapter shows that prospect theory is well suited for analyzing uncertainty and ambiguity. Prospect theory for risk generalizes rank dependence by adding reference dependence, with risk attitudes for losses different from those for gains. Although there have not been many studies into ambiguity with losses, the existing evidence suggests that ambiguity attitudes for losses deviate much from those for gains, with ambiguity seeking rather than ambiguity aversion prevailing for losses (references in §12.7). Hence, for the study of ambiguity, the reference dependence of prospect theory is highly desirable. All models presented so far were special cases of the model of this chapter, and all preceding chapters have prepared for this chapter. All the ingredients have, accordingly, been developed by now. Hence, all that remains to be done is to put these ingredients together. This chapter on the most important model of this book will accordingly be brief, and will only add some theoretical observations.