Prospect Theory

Definition

Prospect Theory is a behavioral economic theory that describes how individuals make decisions under risk, highlighting that people value gains and losses differently. This theory explains that individuals are more sensitive to potential losses than to equivalent gains, leading to risk-averse behavior when faced with potential profits and risk-seeking behavior when faced with potential losses. It also introduces concepts like loss aversion, which indicates that losses weigh heavier on individuals compared to gains of the same size.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by Daniel Kahneman and Amos Tversky in 1979 as an alternative to classical utility theory, highlighting how real-life decision-making deviates from purely rational models.
2. The theory posits that individuals evaluate outcomes based on a reference point, leading them to feel dissatisfied with outcomes that fall below this point, regardless of absolute wealth changes.
3. In scenarios involving risk, people tend to exhibit risk aversion when choices involve potential gains and are more likely to take risks when confronted with potential losses.
4. The value function in Prospect Theory is concave for gains and convex for losses, illustrating the diminishing sensitivity to both as you move away from the reference point.
5. Prospect Theory has significant implications for various fields, including economics, finance, and psychology, as it helps explain behaviors such as gambling, investment decisions, and consumer choices.

Review Questions

• How does Prospect Theory differ from traditional utility theory in explaining decision-making under risk?
  • Prospect Theory diverges from traditional utility theory by illustrating that individuals do not always act rationally when faced with risk. While utility theory assumes that people make choices solely based on expected utility maximization, Prospect Theory highlights the influence of psychological factors like loss aversion and framing. Individuals often exhibit irrational behaviors influenced by how choices are presented and their relative perception of gains and losses.
• Discuss the role of loss aversion in Prospect Theory and its impact on decision-making.
  • Loss aversion plays a critical role in Prospect Theory by asserting that losses have a more substantial emotional impact on individuals compared to equivalent gains. This tendency leads people to prefer avoiding losses over acquiring gains, which can result in overly cautious or risk-averse behaviors when making decisions about investments or other risky scenarios. Understanding loss aversion allows us to predict how individuals might behave irrationally by avoiding opportunities simply because they fear losses.
• Evaluate how the principles of Prospect Theory can inform strategies for effective leadership in uncertain environments.
  • Understanding Prospect Theory equips leaders with insights into how their team members might respond to risk and uncertainty. By recognizing the significance of loss aversion, leaders can frame decisions and communicate potential changes in ways that minimize perceived threats while highlighting positive outcomes. This approach fosters a supportive environment where team members feel more comfortable taking calculated risks and embracing innovative ideas, ultimately enhancing collective decision-making processes during challenging times.

Related terms

Loss Aversion:

The principle that people prefer to avoid losses rather than acquiring equivalent gains, meaning that losing $100 feels worse than gaining $100 feels good.

Framing Effect:

The cognitive bias where people make different decisions based on how options are presented or framed, such as emphasizing potential gains versus potential losses.

Utility Theory: A traditional economic theory suggesting that individuals make decisions by maximizing their expected utility, often assuming rational behavior in choices involving risk.