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Academian comments on Prospect Theory: A Framework for Understanding Cognitive Biases - Less Wrong

66 Post author: Yvain 10 July 2011 05:20AM

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Comment author: Academian 23 July 2011 09:22:46AM *  1 point [-]

The main descriptive difference between prospect theory and EU theory is that for monetary decisions, EU theory uses one curve (utility function), whereas prospect theory uses two curves (a value function and weight function) as well as a framing variable

The other big difference is that the prospect theory value function is defined relative to a reference point

That's what Yvain and I are calling framing.

When people are actually given choices like $10 for sure vs. $21 w. p=.5, they tend to choose $10 for sure just as prospect theory predicts (and EU theory does not).

What you're calling EU theory is a very restricted version of EU theory, where you require utility to be a function of total monetary wealth, or total material wealth. You might call it "Expected Utility of Wealth" theory. EU theory is actually much more general, and assigns utility to outcomes rather than amounts of money or even lists of possessions. This is all discussed in

http://en.wikipedia.org/wiki/Von_Neumann%E2%80%93Morgenstern_utility_theorem , and


But for predictive purposes, EU theory is so ridiculously general (there are so many situational parameters) that, as far as anyone knows, it has almost no predictive power. So for the purposes of prediction, I think you're justified in talking about "EUW" theory, because without a highly restrictive assumption like utility being a function of wealth, EU theory has no chance of making predictions.

Nonetheless, I want to encourage you, and anyone else, to make explicit the assumption "utility is a function of wealth" when you're making it. My reason is that, in toy decision-theory problems, EU theory is usually part of the framework, and it's a reasonable framework provided we don't impose the restrictions that make it predictively meaningful and false.