Editing Risk aversion (section)

==Limitations of expected utility treatment of risk aversion==
Using expected utility theory's approach to risk aversion to analyze ''small stakes decisions'' has come under criticism. [[Matthew Rabin]] has showed that a risk-averse, expected-utility-maximizing individual who,

''from any initial wealth level [...] turns down gambles where she loses $100 or gains $110, each with 50% probability [...] will turn down 50–50 bets of losing $1,000 or gaining any sum of money.''<ref>{{cite journal |last=Rabin |first=Matthew |year=2000 |title=Risk Aversion and Expected-Utility Theory: A Calibration Theorem |journal=[[Econometrica]] |volume=68 |issue=5 |pages=1281–1292 |doi=10.1111/1468-0262.00158 |citeseerx=10.1.1.295.4269 |s2cid=16418792 }}</ref>

Rabin criticizes this implication of expected utility theory on grounds of implausibility—individuals who are risk averse for small gambles due to diminishing marginal utility would exhibit extreme forms of risk aversion in risky decisions under larger stakes. One solution to the problem observed by Rabin is that proposed by [[prospect theory]] and [[cumulative prospect theory]], where outcomes are considered relative to a reference point (usually the status quo), rather than considering only the final wealth.

Another limitation is the reflection effect, which demonstrates the reversing of risk aversion. This effect was first presented by [[Kahneman]] and [[Amos Tversky|Tversky]] as a part of the [[prospect theory]], in the [[behavioral economics]] domain.
The reflection effect is an identified pattern of opposite preferences between negative as opposed to positive prospects: people tend to avoid risk when the gamble is between gains, and to seek risks when the gamble is between losses.<ref name="j1914185">{{cite journal |last1=Kahneman |first1=Daniel |last2=Tversky |first2=Amos |title=Prospect Theory: An Analysis of Decision under Risk |journal=Econometrica |date=March 1979 |volume=47 |issue=2 |pages=263 |doi=10.2307/1914185 |jstor=1914185 |citeseerx=10.1.1.407.1910 }}</ref> For example, most people prefer a certain gain of 3,000 to an 80% chance of a gain of 4,000. When posed the same problem, but for losses, most people prefer an 80% chance of a loss of 4,000 to a certain loss of 3,000.

The reflection effect (as well as the [[certainty effect]]) is inconsistent with the expected utility hypothesis. It is assumed that the psychological principle which stands behind this kind of behavior is the overweighting of certainty. Options which are perceived as certain are over-weighted relative to uncertain options. This pattern is an indication of risk-seeking behavior in negative prospects and eliminates other explanations for the certainty effect such as aversion for uncertainty or variability.<ref name="j1914185"/>

The initial findings regarding the reflection effect faced criticism regarding its validity, as it was claimed that there are insufficient evidence to support the effect on the individual level. Subsequently, an extensive investigation revealed its possible limitations, suggesting that the effect is most prevalent when either small or large amounts and extreme probabilities are involved.<ref>{{cite journal |last1=Hershey |first1=John C. |last2=Schoemaker |first2=Paul J.H. |title=Prospect theory's reflection hypothesis: A critical examination |journal=Organizational Behavior and Human Performance |date=June 1980 |volume=25 |issue=3 |pages=395–418 |doi=10.1016/0030-5073(80)90037-9 }}</ref><ref>{{cite journal |last1=Battalio |first1=RaymondC. |last2=Kagel |first2=JohnH. |last3=Jiranyakul |first3=Komain |title=Testing between alternative models of choice under uncertainty: Some initial results |journal=Journal of Risk and Uncertainty |date=March 1990 |volume=3 |issue=1 |doi=10.1007/BF00213259 |s2cid=154386816 }}</ref>