Prospect Theory

Definition

Prospect theory is a behavioral economic theory that describes how individuals evaluate potential losses and gains when making decisions under uncertainty. It suggests that people are more sensitive to losses than to equivalent gains, leading to risk-averse or risk-seeking behavior depending on the framing of the decision. This theory highlights cognitive biases in decision-making, illustrating how emotions and perceptions can skew rational thought.

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 expected utility theory, which often fails to predict actual human behavior.
2. The value function in prospect theory is defined as concave for gains and convex for losses, illustrating diminishing sensitivity to changes in wealth.
3. People tend to display risk aversion when it comes to potential gains but exhibit risk-seeking behavior when faced with potential losses.
4. The theory emphasizes that individuals assess outcomes relative to a reference point, often leading to irrational decision-making based on perceived gains or losses.
5. Prospect theory has significant implications for various fields, including finance, marketing, and public policy, as it helps explain consumer behavior and investment strategies.

Review Questions

• How does prospect theory challenge traditional utility theories in understanding human decision-making?
  • Prospect theory challenges traditional utility theories by highlighting that individuals do not always act rationally and instead exhibit behaviors driven by cognitive biases. While utility theory assumes people make decisions solely based on objective probabilities and outcomes, prospect theory reveals that emotions related to potential losses and gains play a crucial role in decision-making. This insight helps explain why people may make choices that seem illogical from a purely economic perspective.
• Discuss the implications of loss aversion as described by prospect theory on financial decision-making.
  • Loss aversion, a key component of prospect theory, implies that investors are more likely to avoid risks associated with potential losses than they are motivated by potential gains. This tendency can lead individuals to hold onto losing investments too long or avoid making necessary changes due to fear of loss. Understanding loss aversion can help financial advisors guide clients in making more balanced investment decisions that consider both potential risks and rewards.
• Evaluate how the framing effect demonstrates the principles of prospect theory in real-world scenarios.
  • The framing effect illustrates how the presentation of choices can significantly impact decisions, aligning with the principles of prospect theory. For instance, if a medical treatment is framed as having a 90% success rate versus a 10% failure rate, people may choose differently even though the statistics are identical. This demonstrates how individuals evaluate options based on perceived gains or losses relative to a reference point, underscoring the importance of context in decision-making processes.

Related terms

Loss Aversion: A principle stating that individuals prefer to avoid losses rather than acquiring equivalent gains; losses weigh heavier in decision-making.

Framing Effect: The phenomenon where people's decisions are influenced by how information is presented, rather than just the information itself.

Utility Theory: A traditional economic theory that assumes individuals make decisions to maximize their utility based on objective outcomes and probabilities.