Answered: Suppose you must choose between the two…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Suppose you must choose between the two prospects, (40,000, 0.025) or (1,000): The prospect of winning 40,000 with a probability of 2.5% or winning 1,000 with certainty. Suppose, too, that the following three graphs represent your utility function (according to expected utility theory) and your weighting and value scales (according to prospect theory). Finally, suppose that your current wealth is 20,000.

d. Based on prospect theory, which prospect would you choose? Why?

e. Why is your decision different under the two theories? (Hint: what is one of the common human traits that prospect theory captures that expected utility theory cannot?)

Weighting Function
1.0
0.75
0.50
0.25
0.12
0.025
0.25
0.50
0.75
1.0
Probability
Value Function
80
70
50
8.
Losses
Gains
-60,000
40.000
-20,000
1000
20.000
40,000
60,000
-10
-20
Decision Weights

Expected Utility
280
265
200
170
165
100
20,000
60,000
40,000
80,000
21,000
Wealth
Utils

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