Question

People’s subjective probability is known to have an inverse-S-shaped weighting function---from probability of 0 to probability of 1, first a concave function and then a convex function. In their 1979 and 1992 works, Tversky and Kahneman developed the famous prospect theory and it has been widely used to explain peoples’ risk seeking behavior in a loss and risk averse behavior in a gain, and the utility function under the prospect theory is an S-shaped function. Read the following questions and give your response intuitively:

1. Explain why the subjective probability weighting function is inverse-S-shaped, and the utility function under the prospect theory is S-shaped.

2. Discuss how to use the S-shaped utility function under prospect theory to explain the inverse-S-shaped subjective probability weighting function. 1

3. Give an example that people’s subjective probability is different from the actual probability and how it affects people’s decision making. 2

Answer 1