IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility
Prospect theory includes a probability weighting function. Which description of its typical shape is correct?
In prospect theory, small probabilities are overweighted while moderate and high probabilities are underweighted compared with their objective values. This helps explain why people buy lottery tickets and insurance against unlikely events, and why certainty carries a special premium.
- ASmall probabilities are overweighted and moderate to high probabilities are underweightedCorrect
- BAll probabilities are weighted exactly by their objective values
- CSmall probabilities are underweighted and high probabilities are overweighted
- DOnly certain outcomes are overweighted, and all other probabilities are set to zero
- The weights always sum to exactly one across outcomes and equal true probabilities
Explanation
Decision weights overweight small probabilities, which helps explain both lottery buying and insurance purchase, and underweight moderate and high probabilities relative to certainty. The other options reverse or deny this pattern.
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