Prospect Theory

Definition

Prospect Theory is a behavioral economic theory that describes how people make decisions based on the potential value of losses and gains rather than the final outcome. It highlights that individuals tend to evaluate potential losses more heavily than equivalent gains, leading to risk-averse or risk-seeking behavior depending on the context of the decision. This theory helps explain various biases and irrational decision-making patterns observed in everyday choices.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by Daniel Kahneman and Amos Tversky in 1979, significantly changing how economists view human decision-making under risk.
2. The theory introduces the concept of a value function that is concave for gains and convex for losses, showing diminishing sensitivity as outcomes move away from a reference point.
3. Individuals typically exhibit risk aversion when faced with potential gains but may become risk-seeking when dealing with potential losses.
4. The reference point in Prospect Theory is crucial; it determines how outcomes are perceived, which can change depending on context and individual experiences.
5. Prospect Theory has applications in various fields, including finance, marketing, and public policy, helping to explain behaviors like investment choices and consumer preferences.

Review Questions

• How does Prospect Theory explain the concept of loss aversion in decision-making?
  • Prospect Theory explains loss aversion by demonstrating that individuals weigh potential losses more heavily than equivalent gains. This means that the negative impact of losing a certain amount is felt more intensely than the positive impact of gaining the same amount. As a result, when faced with decisions involving risk, people often make choices that prioritize avoiding losses rather than maximizing gains.
• Discuss how the framing effect interacts with Prospect Theory to influence consumer decisions.
  • The framing effect interacts with Prospect Theory by altering how options are perceived based on their presentation. For instance, if a product is marketed as having a '90% success rate' versus a '10% failure rate', consumers may respond differently despite the same information. This highlights how individuals’ responses can shift based on whether they perceive a scenario in terms of potential gains or losses, which is central to the understanding of decision-making in Prospect Theory.
• Evaluate the implications of Prospect Theory for understanding irrational decision-making in financial markets.
  • Evaluating the implications of Prospect Theory reveals how it can explain various irrational behaviors in financial markets, such as panic selling or holding onto losing investments. Investors often overreact to losses due to loss aversion, leading them to make decisions that do not align with rational market behavior. By understanding these psychological biases outlined in Prospect Theory, financial analysts and policymakers can develop strategies to mitigate irrational behavior and enhance decision-making processes within market dynamics.

Related terms

Loss Aversion: A principle of Prospect Theory stating that losses loom larger than gains, meaning that the pain of losing is psychologically more powerful than the pleasure of an equivalent gain.

Framing Effect: A cognitive bias where people react differently depending on how information is presented, especially when it comes to choices involving risk and uncertainty.

Endowment Effect:

A phenomenon where people place a higher value on things simply because they own them, often leading to irrational decision-making.