The Effect of the Prospect Theory on Previously Published Economic Articles
Contemporary Economics in Historical Perspective
Lana van Duijnhoven
Student number 7653085
Tutor: Merve Burnazoglu
Introduction
In our class, we discussed the history of economics in the 20 th century. Around 1900 economics was
merely a literary, more philosophical science, but the discipline grew into a more fact-based science
within the domain of the social sciences by using models and mathematics and running experiments.
During one of these experiments, Kahneman and Tversky found striking results, which they
summarized and marked as their Prospect Theory. (Kahneman & Tversky, 1979) This theory contrasts
with the earlier set-up Expected Utility Theory (EUT) (Von Neumann & Morgenstern, 1944).
I will further in this essay explain both theories more in-depth, but for now, the Expected Utility
Theory describes how people should make rational choices, while the Prospect Theory shows that
people do not always go for the choice that is supposed to be rational, prescribed by the Expected
Utility Theory. The research of Kahneman & Tversky is quite important in the economic field, because
many studies have been built upon the Expected Utility Theory, either explicit or more abstract. This
implies earlier studies might not be reliable as their findings are discovered under wrong
assumptions.
This led me to the research question; ‘What effect does the finding of the Prospect Theory have on
previously published economic articles?’ To formulate an answer to this question, I will use the
articles in which the Expected Utility Theory and the Prospect Theory are stated in; ‘Theory of Games
and Economic Behavior’ by von Neumann and Morgenstern (in particular the first 2 chapters) and
‘Prospect Theory: An Analysis of Decision under Risk’ by Kahneman and Tversky. In addition, to
analyze the effect of the Prospect Theory on the reliability of theories and ideas based on rational
behavior outside the setting of risk decision as the main subject, I will pay close attention to another
article which is using the Expected Utility Theory, ‘Existence of an Equilibrium for a Competitive
Economy’ by Arrow and Debreu. Multiple other papers use the assumption of rational behavior to do
research, which we have discussed in class. However, I chose this paper because I found here the
assumption is stated most clearly and explicitly.
Word count: 2040
, A reflection of rational behavior & Prospect Theory in the articles
I will start with defining the Expected Utility Theory (EUT), followed by how this is used in the article
‘Existence of an Equilibrium for a Competitive Economy’ and then go on with explaining the Prospect
Theory from ‘Prospect Theory: an Analysis of Decision under Risk’.
Theory of Games and Economic Behavior
Von Neumann and Morgenstern stated that some formulation is needed to capture the behavior of
people deciding under risk, which the EUT is a normative theory of. (Von Neumann & Morgenstern,
1944, p. 1) Economic agents, either individuals or firms, are assumed to behave rationally, meaning
they desire to maximize their utility; the outcome the agents get from the situation. The agent will
choose between different options by comparing the expected utility values of each option, these
values are calculated as the weighted sum of the outcomes multiplied by their probability of
occurring (Briggs, 2023). When an individual behaves according to this theory, they are rational. (Von
Neumann & Morgenstern, 1944, p. 9)
In the second chapter of their book the authors then discuss 2 types of economies; a Robinson
Crusoe Economy and a Social Exchange Economy, where they compare how individuals can obtain
maximum utility and by which factors they are influenced and have to deal with. Here they use the
EUT in some sort of application, rather than forming the theory. They use these types of economies
to discuss applying the Expected Utility Theory practically.
Existence of an Equilibrium for a Competitive Economy
Arrow and Debreu try to prove the existence of an equilibrium for a competitive economy, where
perfect competition is present in some form. They then state; ‘Under the usual assumptions of
perfect competition, the economic motivation for production is the maximization of profits taking
prices as given.’ (Arrow & Debreu, 1954, p. 268). The authors investigate (perfect) competition and
assume throughout the whole paper rational behavior, which is confirmed multiple times, like; ‘The
basic economic motivation in the choice of a consumption vector is that of maximizing utility among
all consumption vectors which satisfy the budget restraint.’ (Arrow & Debreu, 1954, p. 270) This
statement explains the mathematical application of the EUT; the consumption vector yielding the
highest utility (possible) should be chosen. The assumption of rational behavior is also shown in; ‘An
equilibrium point is characterized by the property that each individual is maximizing the pay-off to
him.’ (Arrow & Debreu, 1954, p. 273) Here the authors state that their found equilibrium is built upon
the rational behavior of agents by maximizing their utility.
Prospect Theory: an Analysis of Decision under Risk
Kahneman and Tversky found results conflicting with the original EUT and captured them together in
their Prospect Theory. When making choices, people tend to focus on the changes in their wealth
occurring, rather than deciding on the option that is best for their total, final wealth. Expected utility
values are replaced by a value function, which shows higher values put on losses than the values
attached to gains, meaning people care more for losses. People also tend to overweight outcomes
given certain and neglect more probable outcomes. The authors found that people neglect the
process of coming to their final choice-making, they focus on parts of choices that differ from each
other rather than taking the whole situation into account. In the EUT, expected utilities were not
correctly calculated, Kahneman & Tversky introduced decision weights to integrate people’s
preferences when they decide under risk. With these numbers, the authors also were able to set up a
value function in which you can see people base their decision on a reference point rather than the
total outcome.
(Kahneman & Tversky, 1979)
Contemporary Economics in Historical Perspective
Lana van Duijnhoven
Student number 7653085
Tutor: Merve Burnazoglu
Introduction
In our class, we discussed the history of economics in the 20 th century. Around 1900 economics was
merely a literary, more philosophical science, but the discipline grew into a more fact-based science
within the domain of the social sciences by using models and mathematics and running experiments.
During one of these experiments, Kahneman and Tversky found striking results, which they
summarized and marked as their Prospect Theory. (Kahneman & Tversky, 1979) This theory contrasts
with the earlier set-up Expected Utility Theory (EUT) (Von Neumann & Morgenstern, 1944).
I will further in this essay explain both theories more in-depth, but for now, the Expected Utility
Theory describes how people should make rational choices, while the Prospect Theory shows that
people do not always go for the choice that is supposed to be rational, prescribed by the Expected
Utility Theory. The research of Kahneman & Tversky is quite important in the economic field, because
many studies have been built upon the Expected Utility Theory, either explicit or more abstract. This
implies earlier studies might not be reliable as their findings are discovered under wrong
assumptions.
This led me to the research question; ‘What effect does the finding of the Prospect Theory have on
previously published economic articles?’ To formulate an answer to this question, I will use the
articles in which the Expected Utility Theory and the Prospect Theory are stated in; ‘Theory of Games
and Economic Behavior’ by von Neumann and Morgenstern (in particular the first 2 chapters) and
‘Prospect Theory: An Analysis of Decision under Risk’ by Kahneman and Tversky. In addition, to
analyze the effect of the Prospect Theory on the reliability of theories and ideas based on rational
behavior outside the setting of risk decision as the main subject, I will pay close attention to another
article which is using the Expected Utility Theory, ‘Existence of an Equilibrium for a Competitive
Economy’ by Arrow and Debreu. Multiple other papers use the assumption of rational behavior to do
research, which we have discussed in class. However, I chose this paper because I found here the
assumption is stated most clearly and explicitly.
Word count: 2040
, A reflection of rational behavior & Prospect Theory in the articles
I will start with defining the Expected Utility Theory (EUT), followed by how this is used in the article
‘Existence of an Equilibrium for a Competitive Economy’ and then go on with explaining the Prospect
Theory from ‘Prospect Theory: an Analysis of Decision under Risk’.
Theory of Games and Economic Behavior
Von Neumann and Morgenstern stated that some formulation is needed to capture the behavior of
people deciding under risk, which the EUT is a normative theory of. (Von Neumann & Morgenstern,
1944, p. 1) Economic agents, either individuals or firms, are assumed to behave rationally, meaning
they desire to maximize their utility; the outcome the agents get from the situation. The agent will
choose between different options by comparing the expected utility values of each option, these
values are calculated as the weighted sum of the outcomes multiplied by their probability of
occurring (Briggs, 2023). When an individual behaves according to this theory, they are rational. (Von
Neumann & Morgenstern, 1944, p. 9)
In the second chapter of their book the authors then discuss 2 types of economies; a Robinson
Crusoe Economy and a Social Exchange Economy, where they compare how individuals can obtain
maximum utility and by which factors they are influenced and have to deal with. Here they use the
EUT in some sort of application, rather than forming the theory. They use these types of economies
to discuss applying the Expected Utility Theory practically.
Existence of an Equilibrium for a Competitive Economy
Arrow and Debreu try to prove the existence of an equilibrium for a competitive economy, where
perfect competition is present in some form. They then state; ‘Under the usual assumptions of
perfect competition, the economic motivation for production is the maximization of profits taking
prices as given.’ (Arrow & Debreu, 1954, p. 268). The authors investigate (perfect) competition and
assume throughout the whole paper rational behavior, which is confirmed multiple times, like; ‘The
basic economic motivation in the choice of a consumption vector is that of maximizing utility among
all consumption vectors which satisfy the budget restraint.’ (Arrow & Debreu, 1954, p. 270) This
statement explains the mathematical application of the EUT; the consumption vector yielding the
highest utility (possible) should be chosen. The assumption of rational behavior is also shown in; ‘An
equilibrium point is characterized by the property that each individual is maximizing the pay-off to
him.’ (Arrow & Debreu, 1954, p. 273) Here the authors state that their found equilibrium is built upon
the rational behavior of agents by maximizing their utility.
Prospect Theory: an Analysis of Decision under Risk
Kahneman and Tversky found results conflicting with the original EUT and captured them together in
their Prospect Theory. When making choices, people tend to focus on the changes in their wealth
occurring, rather than deciding on the option that is best for their total, final wealth. Expected utility
values are replaced by a value function, which shows higher values put on losses than the values
attached to gains, meaning people care more for losses. People also tend to overweight outcomes
given certain and neglect more probable outcomes. The authors found that people neglect the
process of coming to their final choice-making, they focus on parts of choices that differ from each
other rather than taking the whole situation into account. In the EUT, expected utilities were not
correctly calculated, Kahneman & Tversky introduced decision weights to integrate people’s
preferences when they decide under risk. With these numbers, the authors also were able to set up a
value function in which you can see people base their decision on a reference point rather than the
total outcome.
(Kahneman & Tversky, 1979)
