This dissertation is an empirical comparison of the expected utility (EU) and prospect theories of behavior under uncertainty using data on people's health insurance choices. In addition, this project will develop and test families' health insurance coverage provides a valuable data set for comparing these two theories because it includes information on people's actual choices among risky alternatives that had significant financial consequences. EU theory states that in an uncertain environment a person will choose the alternative that maximizes expected utility. This theory is widely accepted as the paradigm of rational behavior in risky situations. It predicts, for example, that people will prefer a health plan that provides catastrophic coverage over one that covers the first dollar of expense without protecting against high- cost, low-probability events. Prospect theory, developed by Kahneman and Tversky, differs from the EU model in several ways. It proposes that people evaluate possible outcomes as changes from their current income, rather than as final income levels without reference to the status quo. Prospect theory says that people behave differently with respect to possible gains than with respect to possible losses. it predicts that people may ignore completely low-probability events, no matter what the cost. This project uses probabilistic choice theory and probit analysis to estimate the parameters of each model. Several statistical tests are then used to compare the fit of the data to each model. The results of this study will help refine the theory of behavior under uncertainty and will also have implications for policy on the structure of health insurance plans. Prospect theory tells us that people's reactions to risky choices depends on the status quo. It could be more difficult than merely eliminating the tax subsidy on employer contributions to health insurance to encourage people to assume a greater degree of risk in health care expenditures if they have become accustomed to plans that have little or no risk.
