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

In the Kahneman-Tversky framing experiments, people choose a certain gain over a gamble with the same expected value, yet choose a gamble over a certain loss of the same expected value. Which statement correctly describes this and its implication for expected utility theory?

The pattern is the reflection effect: risk aversion for gains and risk seeking for losses. A single concave utility function of final wealth predicts risk aversion everywhere, so it cannot explain it, whereas prospect theory's S-shaped value function can.

  1. AIt shows risk aversion over gains and risk seeking over losses, which a single concave utility function of final wealth cannot produceCorrect
  2. BIt shows risk seeking over gains and risk aversion over losses, consistent with a concave utility function
  3. CIt shows risk neutrality in both domains, consistent with a linear utility function
  4. DIt shows risk aversion in both domains, consistent with any concave utility function
  5. It shows the reflection effect is absent when outcomes are framed relative to a reference point

Explanation

This is the reflection effect: risk aversion for gains and risk seeking for losses. A single concave utility of final wealth implies risk aversion everywhere, so it cannot explain choices flipping when outcomes are framed as losses. Prospect theory gets this through a value function that is concave for gains and convex for losses.

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