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 suggests that people are more sensitive to potential losses than to equivalent gains, which leads to behaviors that deviate from traditional expected utility theory. This theory highlights how cognitive biases and emotional reactions can influence decision-making processes, particularly in uncertain situations.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a response to the limitations of expected utility theory in explaining real-world decision-making.
2. According to Prospect Theory, individuals experience a greater emotional impact from losses compared to an equivalent amount of gains, which can lead to irrational decision-making.
3. The value function in Prospect Theory is defined as concave for gains and convex for losses, indicating diminishing sensitivity as outcomes move further from the reference point.
4. Prospect Theory also incorporates the concept of probabilities being weighted, where people overweigh small probabilities and underweigh moderate to high probabilities when assessing risk.
5. This theory has significant implications for understanding behaviors in financial markets, insurance choices, and consumer behavior, illustrating how psychological factors can impact economic decisions.

Review Questions

• How does Prospect Theory challenge traditional expected utility theory in terms of decision-making under risk?
  • Prospect Theory challenges traditional expected utility theory by demonstrating that individuals do not always act rationally when faced with risk. While expected utility theory assumes that people evaluate options based solely on their outcomes' probabilities and values, Prospect Theory reveals that emotions and cognitive biases significantly influence decisions. For example, individuals often weigh potential losses more heavily than equivalent gains, leading to choices that may contradict the rational maximization of utility.
• Discuss the role of loss aversion in Prospect Theory and its impact on consumer behavior.
  • Loss aversion is a core principle of Prospect Theory that indicates individuals experience losses more intensely than equivalent gains. This tendency can significantly impact consumer behavior, as people may avoid making purchases or investments if they fear potential losses, even if the expected value is favorable. Marketers often leverage this bias by framing offers in a way that emphasizes potential losses from not acting, thereby encouraging consumers to take action to avoid those losses.
• Evaluate the implications of the framing effect in relation to Prospect Theory's predictions about decision-making under uncertainty.
  • The framing effect illustrates how different presentations of the same information can lead to varying decisions, aligning with Prospect Theory's insights about irrational behavior under uncertainty. For instance, when a scenario is framed in terms of potential gains, individuals may take risks, whereas the same scenario framed as potential losses may lead to more conservative choices. This indicates that decision-making is not only influenced by objective probabilities but also by how options are contextualized and presented, reinforcing the idea that cognitive limitations affect rationality.

Related terms

Loss Aversion: The tendency for individuals to prefer avoiding losses rather than acquiring equivalent gains, often leading to risk-averse behavior.

Framing Effect: The phenomenon where people's decisions are influenced by the way information is presented, highlighting how context can alter perceptions of risk and value.

Reference Point: A baseline or standard against which individuals compare their gains and losses, influencing their perception of value and satisfaction.