Risk preferences and transaction costs

Kahneman and Tversky have collected evidence of behavior in the face of risk which is seemingly at odds with von Neumann-Morgenstern expected utility theory. To account for their observations they propose a new approach which they christen ‘Prospect Theory’. This note argues that introducing transactions costs into expected utility theory systematically accounts for many empirical results without unduly straining the conventional analysis. It may therefore be premature to abandon expected utility theory.