I'm learning about utitlity theory just now, but I hadn't heard about prospect theory before. Thanks for posting it.
I know the main point of the post was to introduce prospect theory, but I wanted to add a comment about standard utility theory. In the text you write that standard utility theory predicts Prospero should be indifferent between a certain $5,000 and a 50-50 chance of either $0 or $10,000. This isn't quite right, maximising expected utitlity isn't the same as maximising expected wealth.
In standard utility theory you have a utility function U(W), so Prospero has the choice between U(5,000) and a 50-50 chance of U(0) or U(10,000).... (read more)
I'm learning about utitlity theory just now, but I hadn't heard about prospect theory before. Thanks for posting it.
I know the main point of the post was to introduce prospect theory, but I wanted to add a comment about standard utility theory. In the text you write that standard utility theory predicts Prospero should be indifferent between a certain $5,000 and a 50-50 chance of either $0 or $10,000. This isn't quite right, maximising expected utitlity isn't the same as maximising expected wealth.
In standard utility theory you have a utility function U(W), so Prospero has the choice between U(5,000) and a 50-50 chance of U(0) or U(10,000).... (read more)