IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility
Many people buy lottery tickets and also buy insurance. Which feature of prospect theory explains this pattern most directly?
The overweighting of small probabilities by the probability weighting function explains both behaviours. Rare big gains and rare big losses are given more decision weight than their true probability, making lottery tickets and insurance appealing together.
- AConstant absolute risk aversion in final wealth
- BOverweighting of small probabilities by the probability weighting functionCorrect
- CPerfectly rational expectations of all outcomes
- DLinear utility over gains and losses
- The efficient markets hypothesis in its strong form
Explanation
Small probabilities, such as winning a lottery or suffering a rare large loss, receive decision weights above their true values. This makes long-shot gambles and insurance against unlikely losses both attractive. Expected utility with a single concave function cannot easily explain both behaviours.
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