This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob- abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. EXPECTED UTILITY THEORY has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (24), and widely applied as a descriptive model of economic behavior, e.g. (15, 4). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (47, 36), and that most people actually do, most of the time. The present paper describes several classes of choice problems in which preferences systematically violate the axioms of expected utility theory. In the light of these observations we argue that utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model and we propose an alternative account of choice under risk. 2. CRITIQUE

/pdf/prospect-theory-an-analysis-of-decision-under-risk-4z6oysdahj.pdf

Prospect theory: an analysis of decision under risk

Studies of risk perception examine the judgements people make when they are asked to characterize and evaluate hazardous activities and technologies. This research aims to aid risk analysis and policy-making by providing a basis for understanding and anticipating public responses to hazards and improving the communication of risk information among lay people, technical experts, and decision-makers. This work assumes that those who promote and regulate health and safety need to understand how people think about and respond to risk. Without such understanding, well-intended policies may be ineffective.

http://science.sciencemag.org/content/sci/236/4799/280.full.pdf

Perception of risk.

Two studies investigated the tendency of people to be unrealistically optimistic about future life events. In Study 1, 258 college students estimated how much their own chances of experiencing 42 events differed from the chances of their classmates. Overall, they rated their own chances to be above average for positive events and below average for negative events, ps<.001. Cognitive and motivational considerations led to predictions that degree of desirability, perceived probability, personal experience, perceived controllability, and stereotype salience would influence the amount of optimistic bias evoked by different events. All predictions were supported, although the pattern of effects differed for positive and negative events. Study 2 tested the idea that people are unrealistically optimistic because they focus on factors that improve their own chances of achieving desirable outcomes and fail to realize that others may have just as many factors in their favor. Students listed the factors that they thought influenced their own chances of experiencing eight future events. When such lists were read by a second group of students, the amount of unrealistic optimism shown by this second group for the same eight events decreased significantly, although it was not eliminated.

http://psych415.class.uic.edu/Readings/Weinstein,%20Unrealistic%20optimism,%20JPSP,%201980.pdf

Unrealistic optimism about future life events

Fast and frugal heuristics - simple rules for making decisions with realistic mental resources - are presented here. These heuristics can enable both living organisms and artificial systems to make smart choices, classifications, and predictions by employing bounded rationality. But when and how can such fast and frugal heuristics work? What heuristics are in the mind's adaptive toolbox, and what building blocks compose them? Can judgments based simply on a single reason be as accurate as those based on many reasons? Could less knowledge even lead to systematically better predictions than more knowledge? This book explores these questions by developing computational models of heuristics and testing them through experiments and analysis. It shows how fast and frugal heuristics can yield adaptive decisions in situations as varied as choosing a mate, dividing resources among offspring, predicting high school drop-out rates, and playing the stock market.

Simple Heuristics That Make Us Smart

A review is presented of the book “Heuristics and Biases: The Psychology of Intuitive Judgment,” edited by Thomas Gilovich, Dale Griffin, and Daniel Kahneman.

Heuristics and Biases: The Psychology of Intuitive Judgment

One of the fundamental questions addressed by risk-benefit analysis is “How safe is safe enough?” Chauncey Starr has proposed that economic data be used to reveal patterns of acceptable risk-benefit tradeoffs. The present study investigates an alternative technique, in which psychometric procedures were used to elicit quantitative judgments of perceived risk, acceptable risk, and perceived benefit for each of 30 activities and technologies. The participants were seventy-six members of the League of Women Voters. The results indicated little systematic relationship between perceived existing risks and benefits of the 30 risk items. Current risk levels were generally viewed as unacceptably high. When current risk levels were adjusted to what would be considered acceptable risk levels, however, risk was found to correlate with benefit. Nine descriptive attributes of risk were also studied. These nine attributes seemed to tap two basic dimensions of risk. These dimensions proved to be effective predictors of the tradeoff between acceptable risk and perceived benefit. The limitations of the present study and the relationship between this technique and Starr's technique are discussed, along with the implications of the findings for policy decisions.

How safe is safe enough? a psychometric study of attitudes towards technological risks and benefits

A series of 5 experiments with 660 adult Ss studied how people judge the frequency of death from various causes. The judgments exhibited a highly consistent but systematically biased subjective scale of frequency. Two kinds of bias were identified: (a) a tendency to overestimate small frequencies and underestimate larger ones; and (b) a tendency to exaggerate the frequency of some specific causes and to underestimate the frequency of others, at any given level of objective frequency. These biases were traced to a number of possible sources, including disproportionate exposure, memorability, or imaginability of various events. Ss were unable to correct for these sources of bias when specifically instructed to avoid them. Comparisons with previous laboratory studies are discussed, along with methods for improving frequency judgments and the implications of the present findings for the management of societal hazards. (36 ref) (PsycINFO Database Record (c) 2012 APA, all rights reserved)

/pdf/judged-frequency-of-lethal-events-4bjv3ydjwl.pdf

Judged frequency of lethal events

W Life is dangerous, even in the most modern societies. Although great progress has been made towards reducing illness and deaths from infectious diseases, this improvement has been significantly offset by increased vulnerability to natural disastersl and the hazards of technology.2 Because society is limited in its capacity to worry about risk and to provide resources to reduce it. hazards must compete with one another for public attention. Unfortunately, there is evidence that people's perceptions of risk are subject to large and systematic biases.) These misconceptions undoubtedly influence the way that people think about and respond to hazards in their personal lives. Such biases may misdirect the actions of publicinterest groups and government agencies,

Newspaper Coverage of Causes of Death

A series of laboratory studies of insurance decision making shows that people buy more insurance against events having a moderately high probability of inflicting a relatively small loss than against low-probability, high-loss events. Two explanations are discussed, both contrary to traditional utility theory. One postulates a utility function convex over losses. The second asserts that people refuse to protect themselves against losses whose probability is below some threshold. This research provides insight into other, often puzzling, facts about people's insurance behavior. Relevance for public policy is discussed. What determines whether people will act to protect themselves from the severe consequences arising from a low probability event? The answer to this question is vital for understanding how people cope with the risks from accidents, diseases, and natural hazards and for helping them to manage their lives more effectively in the face of such risks. The importance of this question has motivated a major research project concerned with one class of risks, those from natural hazards (floods and earthquakes), and one class of protective mechanisms, insurance.' The project staff, under the direction of Howard Kunreuther, interviewed 2,000 homeowners residing in flood-prone areas, half of whom were insured and half uninsured. In addition, 1,000 homeowners residing in earthquakePaul Slovic, Ph.D., Baruch Fischhoff, Ph.D., and Sarah Lichtenstein, Ph.D., are Research Associates; Bernard G. Corrigan, M.A., is Research Programmer/Analyst; and Barbara J. Combs, M.A., is Research Assistant, all with Decision Research in Eugene, Oregon. Slovic, Fischhoff, and Lichtenstein have worked together for a number of years on psychological studies of judgment, risk taking, and decision processes. They have recently reviewed this field for the Annual Review of Psychology. Slovic and Fischhoff are consultants to the National Research Council's Committee on SocioEconomic Effects of Earthquake Predictions. Slovic is a member of the socio-political resource group of the National Academy of Sciences Study of Nuclear and Alternative Energy Systems and is Adjunct Professor, Department of Psychology, University of Oregon. 1 This research was supported by NSF-RANN Grant ATA 73-03064-A03 to the Wharton School of the University of Pennsylvania under subcontract to the Oregon Research Institute. We thank Howard Kunreuther, Daniel Kahneman, and Amos Tversky for their invaluable contributions to this project. Frank Conklin supplied us with a prototype for the farm game. Comments and reprint requests may be addressed to the authors at Decision Research, 1201 Oak Street, Eugene, Oregon 97401.

Preference for Insuring Against Probable Small Losses: Insurance Implications

: A series of experiments involving over 650 individuals studied how people judge the frequency of various recurrent events. The judgements exhibited a highly consistent but systematically biased subjective scale of frequency. Two kinds of bias were identified: (a) a tendency to overestimate small frequencies and underestimate larger ones, and (b) a tendency to exaggerate the frequency of some specific events and to underestimate the frequency of others, at any given level of objective frequency. These biases were traced to a number of possible sources including disproportionate exposure, memorability or imaginability of various events. Subjects were unable to correct for these sources of bias when specifically instructed to avoid them. Comparisons with previous laboratory studies are discussed, along with methods for improving frequency judgements.

Barbara Combs

Papers

How safe is safe enough? a psychometric study of attitudes towards technological risks and benefits

Judged frequency of lethal events

Newspaper Coverage of Causes of Death

Preference for Insuring Against Probable Small Losses: Insurance Implications

Perceived Frequency of Recurrent Events