Prospect theory

Definition

Prospect theory is a behavioral economic theory that describes how individuals evaluate potential losses and gains when making decisions under risk. It highlights that people tend to be loss-averse, meaning they are more sensitive to losses than to equivalent gains, leading to irrational decision-making in uncertain situations. This theory contrasts with traditional expected utility theory, which assumes that individuals make rational choices based on objective probabilities and outcomes.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a way to explain why people often make irrational financial decisions.
2. The value function in prospect theory is concave for gains and convex for losses, illustrating the diminishing sensitivity to changes in wealth as one moves away from the reference point.
3. Individuals tend to overweight small probabilities while underweighting larger ones, affecting their decision-making in gambling and insurance contexts.
4. The theory emphasizes the importance of the reference point, meaning that people evaluate outcomes relative to a specific reference level rather than in absolute terms.
5. Prospect theory has significant implications for understanding economic behavior, influencing fields like marketing, finance, and public policy.

Review Questions

• How does prospect theory differ from expected utility theory in explaining decision-making under risk?
  • Prospect theory differs from expected utility theory by emphasizing that individuals do not always act rationally when faced with risk. While expected utility theory assumes that people make decisions based solely on objective probabilities and outcomes to maximize their utility, prospect theory highlights how individuals are influenced by biases like loss aversion and the framing of choices. This leads to systematic deviations from rational behavior, where people may reject better options due to fear of losses or misjudgment of probabilities.
• Discuss the role of loss aversion in prospect theory and its impact on financial decision-making.
  • Loss aversion plays a central role in prospect theory, positing that losses weigh more heavily on individuals than equivalent gains. This can lead to overly cautious behavior in financial decision-making, where individuals may avoid taking risks even if potential gains outweigh the losses. For example, investors might hold onto losing stocks longer than is rational out of fear of realizing a loss, while being quick to sell winning stocks to secure gains. This behavior can negatively impact overall investment performance and lead to suboptimal financial strategies.
• Evaluate the implications of prospect theory for designing effective policies aimed at improving public health outcomes.
  • Evaluating the implications of prospect theory for public health policy involves understanding how people's perceptions of risk and benefits influence their behaviors. For instance, since individuals are loss-averse, framing health interventions as avoiding losses (such as preventing illness) rather than focusing solely on gains (like improved health) may motivate better adherence to public health recommendations. Additionally, understanding biases such as the framing effect can help policymakers design communications that resonate better with the public, encouraging behaviors like vaccination or healthy lifestyle choices by emphasizing potential losses associated with inaction.

Related terms

Loss Aversion: A principle that suggests losses have a greater emotional impact on individuals than an equivalent amount of gains.

Framing Effect: The tendency for people's decisions to be influenced by how information is presented, rather than just by the information itself.

Expected Utility Theory: A classical economic theory that suggests individuals make rational choices to maximize their expected utility based on known probabilities and outcomes.