Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/76225
Authors: 
Herold, Florian
Netzer, Nick
Year of Publication: 
2010
Series/Report no.: 
Working Paper, Socioeconomic Institute, University of Zurich 1005
Abstract: 
The economic concept of the second-best involves the idea that multiple simultaneous deviations from a hypothetical first-best optimum may be optimal once the first-best itself can no longer be achieved, since one distortion may partially compensate for another. Within an evolutionary framework, we translate this concept to behavior under uncertainty. We argue that the two main components of prospect theory, the value function and the probability weighting function, are complements in the second-best sense. Previous work has shown that an adaptive S-shaped value function may be evolutionary optimal if decision-making is subject to cognitive or perceptive constraints. We show that distortions in the way probabilities are perceived can further enhance fitness. The second-best optimum involves overweighting of small and underweighting of large probabilities. Behavior as described by prospect theory might therefore be evolution's second-best solution to the fitness maximization problem. Our model makes empirically testable predictions about the relation between individuals' value and probability weighting functions.
Subjects: 
Probability Weighting
Prospect Theory
Evolution of Preferences
JEL: 
D01
D03
D81
Document Type: 
Working Paper

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