Behavioral models of decision making under risk

Abstract

This chapter reviews experiments testing theories of how people make choices between risky prospects, gambles in which the consequences and their probabilities are specified. When people prefer a small amount of cash to the expected value of a gamble, they are said to be risk averse. The St. Petersburg paradox is an extreme case of risk aversion in which people prefer a small cash payment rather than one chance to play a gamble of infinite expected value. Expected utility theory was proposed to explain this paradox by allowing that the utility of money is not a linear function of its cash value but instead shows diminishing marginal returns. Allais proposed two paradoxes that contradicted expected utility theory, and a number of modern theories have been proposed to explain the Allais paradoxes. Among these are original and cumulative prospect theory, configural weighting theory, the priority heuristic, and others. The chapter notes that some decisions are based on experience, where consequences and their probabilities are learned. The chapter also considers models of the variability in decision behavior. New critical tests and their results are reviewed that conclude that neither version of prospect theory can be retained as accurate descriptions of choice behavior and that tests of the heuristic models have yielded data that systematically violate the predictions of those models. The configural weight models remain the best description of the evidence so far accumulated.