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Handbook??Decision-Making Under Uncertainty??Advanced Topics? Prospect Theory - Introduction Printer Friendly Decision-Making Under Uncertainty - Advanced Topics An Introduction to Prospect Theory Over time, researchers have become all too aware of the limitations of expected utility theory, especially those raised by the?St. Petersburg,?Allais, and?Ellsberg?paradoxes. As a result, numerous alternative theories have been developed to overcome the limitations of expected utility theory without losing its explanatory power. Prospect theory, developed by Daniel Kahneman and Amos Tversky is perhaps the most well-known of these alternative theories. This section covers the following topics: Motivation -- certainty, reflection, and isloation effects The editing and evaluation phases Properties of the value and weighting functions Cumulative Prospect Theory Motivation In 1979, Daniel Kahneman and Amos Tversky conducted a series of thought experiments testing theAllais Paradox?in Israel, at the University of Stockholm, and at the University of Michigan. Everywhere, the results followed the same pattern. The problem was even framed in many different ways, with prizes involving money, vacations, and so on. In each case, the?substitution axiom?was violated in exactly the same pattern. Kahnemann and Tversky called this pattern the?certainty effect?- meaning, people overweight outcomes that are certain, relative to outcomes which are merely probable.?Using the term prospect to refer to what we have so far called lotteries or gambles, (i.e. a set of outcomes with a probability distribution over them), Kahnemann and Tversky also state that where winning is possible but not probable, i.e. when probabilities are low, most people choose the prospect that offers the larger gain. This is illustrated by the second decision stage in the?Allais Paradox.?More generally, if x and y are outcomes; 0 p,q,r 1, where p, q, and r refer to probabilities, they state that:?(y, p*q)??(x,