Risky choices are made without advanced knowledge of eventual consequences, like wether or not to buy travel insurance when you go on holiday. Since the consequences in this scenario depends on uncertain events, the decision may be understood as an acceptance of a gamble that can give various outcomes. So, studies of decision making under risk has used simple gambles with financial outcomes and specified probabilities in order to reveal basic attitudes towards value and risk.
Kahneman and Tversky (1983) uses an approach to risky choice that developed from a psychophysical analysis of responses to money and probability. People are generally unwilling to risk, but more willing to risk in the case of increasing wealth.
In order to illustrate the phenomena of risk aversion, Kahneman and Tversky (1983) uses the choice between an 85 % chance o win $1000 (and therefore a 15 % chance of winning nothing) and the choice of receiving $800 for sure. Even though the gamble has higher mathematical expectation, a large majority of people (myself included!) prefer choosing the sure thing. The preference of the sure gain is an example of risk aversion. It is suggested that people do not judge probability by the expectation of their financial gain, but by the expectation of the feelings of these outcomes. The subjective value (ones feelings) is a weighted average, but now it is the subjective value of each outcome that is weighted by its probability. The subjective value (utility) is proposed as a concave function of money. In other words, the difference between the utilities of $200 and $100 is greater than the utility difference between $1200 and $1100.
It is usual in decision analysis to describe the outcomes in terms of total wealth. For example, tossing a fair coin is represented as a choice between current wealth and an even chance to double the current wealth or lose it. Only, people do not usually think of small outcomes in terms of wealth. Much more common is to rather view it in terms of neutral outcomes or gains or losses. If the subjective value is a change of wealth rather than an ultimate state of wealth, the psychophysical analysis of outcomes should be applied to losses and gains instead of total assets. This assumption plays a central role in the Prospect Theory. So, a loss is more unattractive than a gain is attractive.
The assumption of risk aversion has played a central part in economic theory. As the value of gains makes risk aversion, the value of losses makes risk seeking. In a situation where one is forced to choose between an 85 % chance to lose $1000 (and a 15 % chance to lose nothing) and a sure loss of $800 a large majority prefer to gamble. Risk seeking is, in other words, more likely in the gambling of a loss.
