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

In prospect theory, as proposed by Kahneman and Tversky, which feature of the value function best captures loss aversion?

Loss aversion is captured by a value function that is steeper for losses than for equal-sized gains measured from the reference point, so losses loom larger than gains. Symmetry or linearity would remove loss aversion.

  1. AIt is steeper for losses than for gains of the same size relative to the reference pointCorrect
  2. BIt is concave for losses and convex for gains
  3. CIt is linear in wealth for both gains and losses
  4. DIt is defined over final wealth levels rather than changes from a reference point
  5. It is symmetric about the reference point

Explanation

Prospect theory defines value over gains and losses relative to a reference point. The function is steeper for losses, so a loss hurts more than an equal gain pleases. Symmetry would imply no loss aversion, and concave gains with convex losses describes diminishing sensitivity, not loss aversion.

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