Prospect Theory - Essay Example

ranked based on the level of preference to the consumer despite the notion that utility derived from goods cannot be measured (Kahneman and Amos 265). The sum spent on a good or service is used to measure the utility since a rational consumer is bound to spend more on a good if the resulting marginal utility is less than that of another preferred good. Notably, the marginal utility of a specified good is related to its price. The two theories are dependent on different principles. The expected utility theory is based on the expectations, asset integration, and risk aversion.

The expectation can be defined as the anticipated utility of an outcome that depends on the price of an item or service. Asset integration results to the measurement of the utility through the prospect of a consumers assets (Kahneman and Amos 266). Utility from one asset alone should exceed the utility of the other assets. Risk aversion shows the level of risk that a consumer is willing to undertake for a defined item. It is equal to the concavity of the utility function. On the other hand, prospect theory is based on principles such as the measurement of gains and losses.

The principles lead to a two-way process that involves the editing and evaluation of a consumers defined situation. During the editing stage, a consumer uses a personal reference point to make adjustments on wealth based on the choice being made. As a result, consumers tend to be reluctant to adjustments known as gain and prefer losses to make their final decision. During the evaluation phase, the consumer will tend to prefer likely events and defer the likely events. Utility is the computed value of evaluation that is based on respective probabilities sand the potential outcomes (Kahneman and Amos 266).

Decision makers in the utility theory are consistent and ordered. They can also rank their choices based on their current situations and attractiveness of each alternative. Preferences cannot be the nature of the choice