I am new to decision theory and currently I am reading the book 'Making Better Decisions: Decision Theory in Practice' by Itzhak Gilboa. I am fascinated by the discussion of utility function and risk aversion. After reading the corresponding chapters, the following problem is imposed:
It is often argued that the value function in Kahneman and Tversky's prospect theory is convex in the domain of losses, that is, individuals behave in a risk loving way when it comes to losses. How can this be reconciled with the fact that people buy insurance (where premiums exceed expected losses)?
I think I did not completely 'digest' the ideas introduced in the book. I understand that there is gain-and-loss asymmetry and therefore people tend to averse losses. For the question above, since people do not want to suffer from accident, they are willing to pay more so as to prevent such loss. Am I right? But if I pay the premium, isn't it already a loss to me? I hope that some of you can explain this to me briefly.
Thanks in advance.
Maybe I quote what the book says about the loss aversion:
...The decision maker has a certain reference point with with payoffs are compared... This loss aversion goes beyond the obvious fact that people prefer more money to less. It suggests that a given amount of money, if perceived as a loss relative to the reference point, will be considered a more painful outcome than the same amount when perceived as a gain.. Importantly, prospect theory holds that people react to changes rather than absolute levels.