After reading "Thinking Fast and Slow" and half a day of internet search on this topic I resort now to asking this question here.
Prospect Theory seems to only attribute value to changes in wealth. The reference point in wealth is only used to calculate the change in wealth. The change is then valued according to a value function where losses weigh heavier than gains and both have diminishing marginal utility (see figure below). It seems to me however that the absolute value of the reference point matters, but is ignored.
The diminishing marginal utility of wealth from expected utility theory is still a valid concept, as is the utility of change of wealth from prospect theory. In my view they should be combined. Losses weigh heavier than gains and the size of your reference wealth influences how you weigh the loss/gain.
In other words, this is a typical value function in Prospect Theory:
I think it needs a third axis for the reference wealth value. Higher reference wealth values lead to flatter curves while lower reference wealth values lead to taller curves. A rich person has a different value function than a poor(er) person. They value the loss (or gain) of 500 euro differently.
To illustrate this think of the following "Thinking Fast and Slow"-style problems:
- Anna had 1500 euro yesterday. Today she wakes up with 1000 euro.
- Ben had 20000 euro yesterday. Today he wakes up with 19500 euro.
It seems to me Anna and Ben would not attribute the same (negative) value to their loss. Prospect Theory seems to claim they would. They incur the same loss (-500 euro) with the same (weighted) probability and value it using the same value function. I haven't found an explanation of Prospect Theory where absolute wealth influences the value function.
In Thinking Fast and Slow, Kahneman does allure to an influence of your reference wealth (page 284):
All bets are off, of course, if the possible loss is potentially ruinous, or if your lifestyle is threatened.
But this seems a sidenote covering an exception rather than a intrinsic part of the theory.
Does prospect theory ignore the influence of reference wealth size on the value curve? And if it does, why is that valid to do?