Skip to content

IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility

In prospect theory, as proposed by Kahneman and Tversky, outcomes are evaluated mainly as gains or losses relative to a reference point. Which feature describes the shape of the value function?

The prospect theory value function is concave for gains and convex for losses, and it is steeper for losses than for gains. This reflects diminishing sensitivity away from the reference point together with loss aversion, so a loss hurts more than an equal gain pleases.

  1. AConcave for gains and convex for losses, with losses steeper than gainsCorrect
  2. BConvex for gains and concave for losses, with gains steeper than losses
  3. CLinear throughout, with a kink at the reference point only
  4. DConcave throughout, with identical slopes for gains and losses
  5. Convex throughout, with losses less steep than gains

Explanation

Prospect theory has diminishing sensitivity: the value function is concave over gains and convex over losses. It is also steeper for losses than for gains, which is loss aversion. The option with reversed curvature and slopes contradicts both properties.

Did you get it right without looking?

One question tells you little. A timed set on Rational choice theory and utility shows your real accuracy, how long you take and where you lose marks.

Practise Rational choice theory and utilityFree diagnostic mock

More Rational choice theory and utility questions