Module: Behavioural Insights (BM3028)

1           Introduction

Decisions under uncertainty are typically characterised by a lack of comprehensive information or knowledge regarding a given situation. This lack of information pertains to various aspects, such as the available alternatives, the probabilities associated with their occurrence, and the potential outcomes (Gembarski, Plappert and Lachmayer, 2021).

Consequently, individuals making these decisions are not fully aware of these critical factors. The sources of uncertainty exhibit heterogeneity. Uncertainty can manifest in two ways: internal uncertainty, which pertains to personal doubts or indecisiveness and external uncertainty, which refers to situations where the outcome or occurrence of an event is uncertain (Muñoz, Pineda and Morales, 2022).

The field of decision-making in uncertainty has primarily been influenced by the theory of expected utility (EUT), which provides a comprehensive framework for understanding individuals’ behavioural choices. It seeks to quantify the level of utility associated with a particular course of action in situations where the outcome is characterised by uncertainty (Fischhoff, Goitein and Shapira, 2021).

The criticisms directed towards expected utility theory have categorised this particular theory as a descriptive model for decision-making under conditions of risk. The insufficiency of prevalent kinds of EUT in sufficiently explaining the complicated nature of decision-making has been posited, leading to the proposal of another theoretical structure called prospect theory (PT).

This framework offers a more comprehensive explanation for decision-making in situations involving risk and effectively addresses the limitations of previous theories (Taroni, Bozza and Biedermann, 2020; Clark, 2019).  The theory under consideration presents a challenge to the dominant economic perspective that assumes rational actors aim to optimise their expected utility.

Nevertheless, Tonelli et al. (2017) stated that it is important to acknowledge that the ramifications of PT extend beyond the realm of economics. Therefore, it is essential to critically analyse the weakness and strengths of each theory and deep insight into the relevant theory that can provide an effective understanding of decision-making. The aim of this report is to provide a critical analysis of the expected utility theory and prospect theory for decision-making under uncertainty for Assignment Writing Services visit

2           Expected Utility Theory (EUT)

Cappello, Zonta and Glišić (2016) stated that the evaluation of the model of rational choice for decision-making under uncertainty often begins with the EUT, as it serves as a foundational framework from which many other theories can be seen as extensions or generalisations. Prior to the 1940s, EUT held a position of prominence as the prevailing model utilised for the characterisation of financial decision-making processes.

Navarro-Martinez et al. (2018) discussed that axioms of EUT are based on rationality, transitivity, independence, completeness and continuity. Similarly, De Castro et al. (2016) explained that the essence of EUT lies in the presence of a logical decision-maker who possesses a thorough understanding of the surrounding environment, a structured set of preferences, and proficient technical abilities to effectively determine the most advantageous solutions. Decision-makers engage in a process of “satisficing” rather than optimising (Charles-Cadogan, 2016).

The satisficing principle posits that individuals opt for satisfactory solutions in a more realistic world, rather than pursuing optimal solutions in a simplified world. According to the fundamentals of EUT, individuals who make decisions are inclined to select the option that increases their anticipated utility, which can be understood as the average utility they expect to derive from that particular choice.

Buchholz (2023) highlighted the positive aspects of EUT and stated that the model has the capability to incorporate risk attitudes, which refer to individuals’ preferences towards uncertain outcomes. For instance, certain individuals exhibit risk aversion, indicating a preference for a guaranteed outcome as opposed to a make investments possessing an equivalent expected value, conversely, others display risk-seeking behaviour, manifesting a preference for a make investments rather than a certain result with an equivalent expected value.

The differences in individuals’ valuation of outcomes based on their risk attitudes can be effectively captured by expected utility theory through the utilisation of distinct utility functions. On the other hand, Pettigrew (2015) argued that the process of eliciting and quantifying the utility and probability parameters necessary for the application of EUT can pose challenges. Individuals may exhibit a lack of clearly outlined or consistent preferences regarding outcomes, or they may encounter difficulty in articulating these preferences in quantitative terms for Cheap Assignment Help visit

Additionally, Gaspar and Silva (2023) noted that people might not be able to make accurate or reliable judgments about the probability of uncertain events, or they might have issues changing their minds when presented with new information.

The utilisation of EUT offers a valuable conceptual framework for examining scenarios wherein individuals are required to make decisions in the absence of complete information regarding potential outcomes associated with the decisions (Marcarelli, 2022). EUT can be beneficial for making decisions under conditions of uncertainty.

Individuals in this context will select the course of action that optimises the expected utility, which is determined by aggregating the probabilities of all potential outcomes and multiplying the result by the respective utilities associated with each outcome. The selection will also be contingent upon the level of risk aversion exhibited by the agent, as well as the utility preferences of other agents (Eriksson, 2016). Hence, this theoretical framework provides a mathematical elucidation for the decision-making of an individual impacted by their attitudes towards uncertainty and risk, as well as their evaluations of potential gains and losses.

3           Prospect Theory

Taroni, Bozza and Biedermann (2020) discussed that behavioural decision theory posits that individuals often deviate from rationality and rely on rational boundaries, as proposed by Kahneman and Tversky (1979), which introduces a new conceptual framework that challenges the underlying assumptions of classical decision theory.

According to PT, people have a stronger tendency to prioritise preventing losses over achieving gains, a behaviour known as loss aversion. Werner and Zank (2019) added that the updated version of Tversky and Kahneman’s (1992) PT theoretical model incorporates the idea of the accumulated function and broadens the scope of its applicability to include uncertain or risky prospects, regardless of the number of possible outcomes. Some appealing features of both developments were incorporated into the cumulative prospect theory (CPT) model.

The traditional cumulative model disregards this difference (Wang, Wang and Martnez, 2017). It also offers a comprehensive plan for handling both risk and uncertainty. According to Wang et al. (2020), Kahneman and Tversky (1979) conducted tests to look at people’s propensities to prioritise gains and losses, with a focus on their risk appetite. These tests provided empirical support for this theory. The same authors contend that contrary to conventional economic theories, individual decisions show a variety of outcomes, such as reflection, certainty, and isolation.

Pan (2019) discussed Kahneman and Tversky identified that PT is based on the idea that decision-making is influenced by the relative gains and losses in relation to a reference point, rather than the absolute final outcomes. This theory revealed that investors engage in two distinct phases when engaging in selection and decision-making. These stages are referred to as the editing and evaluation phases .

The editing stage of the main task involves the collection and organisation of information, as well as the corresponding pre-treatment. The process comprises four distinct components, namely data coding, combination, separation, and cancellation.  During the evaluation stage, investors assess and evaluate each edited prospect, subsequently selecting the most favourable prospect (Long and Nasiry, 2015).

Furthermore, Ebert and Strack (2018) explored that the theoretical framework underpinning the PT is grounded in empirical evidence and seeks to accurately depict human behaviour, in contrast to traditional theories that posit rational decision-making as the norm. Hence, this theoretical framework is grounded in empirical evidence and centres on individuals’ attitudes and behaviours in situations characterised by risk.

4           Critical Assessment

Based on the above discussion it can be stated that PT represents an important shift from the conventional EUT when it comes to comprehending decision-making in situations of uncertainty. While the EUT operates under the assumptions of rationality, consistent choices, and precise probability evaluations (Meng and Weng, 2018), whereas PT involves incorporates behavioural insights and acknowledges the influence of cognitive assumptions on the process of decision-making (Liua, Liu, and Qin, 2018), a key distinction exists in the assessment of profits and losses. EUT posits the use slop of a utility function to represent the decreasing marginal benefit of gains and losses.

However, PT introduces a value function signifying the slope for profits and losses. The presence of this imbalance leads to the emergence of loss aversion, a phenomenon in which individuals exhibit a greater aversion towards losses compared to their attraction towards equivalent gains. Tian et al. (2022) stated that the assumption of EUT is based on the idea that individuals possess the ability to accurately evaluate probabilities, whereas PT introduced the concept of probability weighting.

This phenomenon describes how individuals tend to distort probabilities, resulting in a tendency towards seeking risks when it comes to gains with low probabilities, and displaying risk-averse behaviour in the face of losses with low probabilities.

As per Barberis, Jin and Wang (2021), the EUT exhibits a high level of comprehensibility and versatility when employed across diverse contexts. The decision-making process is characterised by adherence to the principles of transitivity and consistency, which guarantees the maintenance of logical consistency.

In contrast,  Kalinowski (2020) criticised that this theory is restricted to rationality and the maximisation of utility due to which it is not effective in comprehensively capturing the intricate nature of human decision-making. Therefore, it is important to acknowledge that in certain scenarios, the application of expected utility theory may prove to be unrealistic or unattainable because of the potential violation of assumptions such as rationality, completeness, and transitivity.

For instance, individuals may not consistently behave in alignment with their anticipated utility, instead opting to rely on emotions, heuristics, or social norms. Individuals may exhibit incoherent preferences, hence indicating their inability to effectively rank or compare all potential outcomes. Based on these arguments, it can be stated that human decision-making frequently diverges from the predictions made by EUT (Buchholz, 2023: Kalinowski, S., 2020), thus underscoring the limited descriptive capacity of this theory.

Linde (2020) believed that due to various limitations of EUT, behavioural finance has emerged as an enormous rival to traditional finance in later years, incorporating psychological elements that exert influence on the decision-making process. The process of decision-making of individuals in situations characterised by uncertainty is influenced by the presence of cognitive and heuristics biases.

Felder and Mayrhofer (2022) argued that investors exhibit various levels of satisfaction or rationality when making decisions. Furthermore, the decision-making process of investors can be influenced by various factors, including herd behaviour, crowd psychology and negative recollections of previous financial or investment choices.

One widely accepted notion in the field of behavioural finance is that investors base their decision-making on the principles outlined in PT (Häckel, Pfosser and Tränkler, 2017). As per Lewandowski (2017), PT offers a more precise depiction of the decision-making process employed by individuals when faced with uncertain circumstances.

The inclusion of empirical research on heuristics and cognitive biases enhances the portrayal of human behaviour, providing a more accurate depiction. Nevertheless, Shaban (2023) criticised that this fails to elucidate the psychological mechanisms involved, particularly pertaining to the emotional aspects of human decision-making. Despite receiving criticism, PT has been significantly utilised for the comprehension of individuals’ decision-making processes.

Moreover, Werner and Zank (2019) highlighted that PT is a more inclusive framework for understanding decision-making, particularly in contexts characterised by uncertainty and risk and as this incorporates a range of cognitive biases, including framing effects and loss aversion, that are frequently observed in decision-making contexts within the real world.

Bouchouicha and Vieider (2017) stated that individuals frequently make decisions by taking into account the possible advantages and disadvantages in relation to a point of reference, instead of merely considering outcomes and probabilities. This is consistent with the notion that decision-making is subject to the influence of emotions, prior experiences, and the manner in which choices are presented or framed.

Therefore, PT relies on cognitive biases while making any decision. However, Moscati (2021) highlighted that EUT, despite its mathematical nature, operates under the assumption that decision-makers possess complete rationality and consistently make decisions solely based on the anticipated worth of various outcomes. The validity of this belief has been challenged by various studies and demonstrated instances where human decision-making diverges from the anticipated outcomes predicted by EUT (Buchholz, 2023).

Thus, the comparison of the two theories highlights the effective capacity of PT to comprehensively comprehend the intricacies of human decision-making and presents a more precise depiction of observed deviations from expected behaviour and furnishes a more resilient conceptual structure for comprehending decision-making in situations involving uncertainty and risk. Nevertheless, it is crucial to acknowledge that the procedure of decision-making is complex and encompasses various dimensions, rendering it impossible for any singular theory to comprehensively encapsulate its entirety.

5           Conclusion and recommendation

PT and EUT exhibit shared characteristics in their basic principles and beliefs regarding rational decision-making. However, they diverge in their assessment of profits and losses, incorporation of probability weighting, focus on the source point, and elucidation of behavioural deviations.

The integration of behavioural insights into PT enhances its capacity to elucidate and forecast decisions made by individuals in situations characterised by uncertainty, thus representing a notable progression in the realm of behavioural economics. Therefore, it is recommended to utilise PT as a model to understand decision-making, as it can provide a deep understanding of the biases of the decision-maker.

However, it is recommended that future scholars explore more about the psychological aspect involved in the decision-making of an individual, as emotions play a critical role in the decision-making process. Thus, it is suggested that organisations and individuals should recognise the association of biases to make more effective decisions. Additionally, the decision-makers should emphasise the long-term consequences of the decision instead of emphasising short-term goals.

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