Question1.2 According to prospect theory, investors are:Select one alternative: Risk seekers with regard to losses and risk averse with regard to gains. Risk neutral with regard to gains and risk averse with regard to losses. None of the options is correct. Risk neutral with regard to gains and risk seekers with regard to losses. Risk seekers with regards to gains and risk averse with regard to losses. ResetMaximum marks: 2.5 Flag question undefined

Question

BlackTom AI · Accepted Answer

Prospect theory’s value function is concave for gains and convex for losses, and losses loom larger than equivalent gains (loss aversion). These are the key concepts: reference dependence (outcomes judged as gains or losses relative to a reference point), diminishing sensitivity (concavity/convexity), and loss aversion (steeper slope for losses).

Step-by-step reasoning and illustration:
1. Reference point: outcomes are measured as gains or losses relative to a reference level (often current wealth).
2. Diminishing sensitivity: for gains the value function bends downward (concave), implying risk aversion; for losses it bends upward (convex), implying risk seeking.
3. Numerical example for gains: choose between a sure +$100 or a 50/50 gamble of +$200 or $0. A concave value function makes the sure +$100 more attractive (most people prefer the sure gain) — this shows risk aversion for gains.
4. Numerical example for losses: choose between a sure −$100 or a 50/50 gamble of −$200 or $0. A convex value function makes the gamble more attractive (many prefer to gamble to avoid a sure loss) — this shows risk seeking for losses.
5. Loss aversion: the slope for losses is steeper, so a loss of $100 hurts more than the pleasure from a gain of $100.

Why the correct answer is correct:
- “Risk seekers with regard to losses and risk averse with regard to gains” exactly matches the concave-for-gains/convex-for-losses prediction of prospect theory and is supported by the examples above.

Why the other options are incorrect:
- Any option claiming risk neutrality for gains or losses contradicts the documented curvature (diminishing sensitivity) of the value function.
- Stating the opposite (risk seeking for gains and risk averse for losses) reverses the empirically supported shape of the value function and conflicts with typical experimental choices.
- “None of the options” is incorrect because one option matches prospect theory.

Conclusion: The correct choice is “Risk seekers with regard to losses and risk averse with regard to gains,” matching the provided answer.

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