Prospect Theory Basics

Definition

Prospect theory is a behavioral economic theory that describes how individuals evaluate potential losses and gains when making decisions under risk. It contrasts traditional utility theory by suggesting that people value gains and losses differently, leading to risk-averse behavior when facing potential gains and risk-seeking behavior when facing potential losses. This theory provides insights into why people may make irrational decisions, often deviating from expected utility maximization.

5 Must Know Facts For Your Next Test

1. Prospect theory introduces the idea that people experience diminishing sensitivity to gains and losses as they move away from the reference point.
2. Individuals are generally risk-averse for gains, preferring a sure gain over a gamble with a higher expected value.
3. When faced with potential losses, individuals tend to be risk-seeking, often opting for gambles that could avoid a loss altogether.
4. The theory suggests that people evaluate potential outcomes based on their perceived probabilities rather than actual probabilities, leading to distorted decision-making.
5. Framing effects play a significant role in prospect theory, where the way choices are presented can greatly influence decisions and perceived risks.

Review Questions

• How does prospect theory explain the difference in behavior when individuals face potential gains versus potential losses?
  • Prospect theory explains that individuals exhibit risk-averse behavior when faced with potential gains, preferring certain outcomes over uncertain ones. Conversely, when facing potential losses, individuals often display risk-seeking behavior, willing to gamble in hopes of avoiding a loss. This contrast highlights the impact of loss aversion, where the pain of losing is felt more acutely than the pleasure of gaining an equivalent amount.
• Discuss the implications of loss aversion within prospect theory for understanding consumer behavior in financial markets.
  • Loss aversion has significant implications for consumer behavior in financial markets, as investors may hold onto losing investments longer than they should due to the fear of realizing a loss. This can lead to suboptimal decision-making and market inefficiencies. Additionally, investors may avoid risky but potentially rewarding investments because the fear of loss outweighs the possibility of gain, ultimately impacting market dynamics and individual portfolio management.
• Evaluate the relevance of prospect theory in predicting real-world economic decisions compared to traditional utility theory.
  • Prospect theory is highly relevant in predicting real-world economic decisions as it accounts for irrational behaviors and cognitive biases that traditional utility theory often overlooks. Unlike traditional models that assume rational decision-making based solely on expected utility maximization, prospect theory acknowledges the psychological factors influencing choices, such as framing effects and reference points. This provides a more comprehensive understanding of actual behaviors observed in markets and personal finance, making it a valuable tool for economists and policymakers aiming to predict and influence decision-making.

Related terms

Loss Aversion: The concept that losses weigh heavier on individuals than equivalent gains, causing people to prefer avoiding losses over acquiring gains.

Reference Point: The baseline level against which individuals evaluate gains and losses; changes from this point influence decision-making and perceived outcomes.

Utility Function:

A mathematical representation of an individual's preferences, showing how they derive satisfaction or value from different levels of wealth or outcomes.