Prospect Theory and Utility Theory: Temporary Versus Permanent Attitude towards Risk

Abstract

Prospect Theory (PT), which relies on subjects' behavior as observed in laboratory experiments, contradicts the behavior predicted by the Expected Utility (EU) paradigm. Having wealth of $100,000 or having wealth of $90,000 and wining $10,000 in a lottery is the same by EU paradigm but not the same by Markowitz (1952) and by PT (1979) which emphasizes the importance of change of wealth rather total wealth on welfare. In this study, we resolve this contradiction by introducing the concept of Temporary Attitude Towards Risk (TATR) and Permanent Attitude Towards Risk (PATR). Using these concepts, we build a model that merges both the PT and the EU paradigms. The TATR and PATR concepts explain recent experimental findings and the observed stock price overreaction. We show that a positive risk premium with decreasing absolute risk aversion (DARA) can be consistent with the S-shaped value function used in PT.

Keywords: Utility Theory, Prospect Theory, value function, risk attitude

JEL Classification: D81, G0