Tversky and Kahneman asked 72 respondents to choose between lottery 1 and lotter

Question

Tversky and Kahneman asked 72 respondents to choose between lottery 1 and lottery 2 and lottery 3 and lottery 4.

Lottery 1:

A .001 chance at winning $5,000 and a .999 chance of winning $0

Lottery 2:

A sure gain of $5

Lottery 3:

A .001 chance of losing $5,000 and a .999 chance of losing $0

Lottery 4:

A sure loss of $5

More than 75% of all participants preferred lottery 1 to lottery 2 and lottery 4 to lottery 3.

a Which choices would be made by a risk-averse decision maker?

b Which choices would be made by a risk-seeking decision maker?

c How does the observed behavior of the participants contradict expected utility maximization?

d How does prospect theory resolve the contradiction?

Lottery 1:

A .001 chance at winning $5,000 and a .999 chance of winning $0

Lottery 2:

A sure gain of $5

Lottery 3:

A .001 chance of losing $5,000 and a .999 chance of losing $0

Lottery 4:

A sure loss of $5

Explanation / Answer

a) Risk averse decision maker will choose lottery 2

b) Risk seeking decision maker will choose lottery 1

c) Observed behavior contradicts in the send that people want to win big , but would prefer losing small as compared to a chance of losing big, even if expected utility theory says otherwise.

d) Prospect theory says that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

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