Prospect Theory

Definition

Prospect Theory is a behavioral economic theory that describes how individuals make decisions based on the potential value of losses and gains rather than the final outcome. It highlights that people tend to value losses more heavily than equivalent gains, leading to risk-averse or risk-seeking behaviors depending on the context of the decision, especially in uncertain situations. This theory sheds light on the cognitive biases and heuristics that influence decision-making processes.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as a response to traditional economic theories that assumed rational decision-making.
2. The theory introduces the concept of a value function that is concave for gains and convex for losses, indicating diminishing sensitivity to changes in wealth.
3. According to Prospect Theory, people are generally risk-averse when it comes to gains but risk-seeking when facing potential losses.
4. The 'certainty effect' is another aspect of Prospect Theory, where people give disproportionately higher weight to outcomes that are certain compared to those that are probable.
5. Prospect Theory has significant implications in fields such as marketing, finance, and public policy, where understanding consumer behavior and decision-making can lead to better outcomes.

Review Questions

• How does Prospect Theory explain the difference in decision-making between gains and losses?
  • Prospect Theory explains that individuals are more sensitive to losses than to gains, a phenomenon known as loss aversion. This means that when faced with a choice involving potential gains, people tend to act cautiously and prefer guaranteed outcomes. Conversely, when dealing with potential losses, they may take risks in hopes of avoiding the loss altogether. This difference in sensitivity affects how decisions are made in uncertain situations, leading to varied behaviors based on whether individuals perceive a situation as one of potential gain or loss.
• Discuss how the framing effect relates to Prospect Theory and influences decision-making.
  • The framing effect is closely linked to Prospect Theory as it highlights how the presentation of information can sway people's decisions. When choices are framed in terms of potential gains, individuals may lean towards risk-averse behaviors. However, if the same choices are framed in terms of potential losses, they may exhibit risk-seeking behavior. This illustrates how context and perspective can alter the perceived value of outcomes, reinforcing the idea that human decision-making is often irrational and influenced by cognitive biases.
• Evaluate the broader implications of Prospect Theory on economic models and policy-making.
  • Prospect Theory challenges traditional economic models that assume rational behavior among individuals. By recognizing that people's decisions are often influenced by biases such as loss aversion and framing effects, policymakers can design interventions that account for these tendencies. For example, understanding how people react to risk can help in creating better financial products or public health campaigns. Evaluating the real-world behavior through the lens of Prospect Theory leads to more effective strategies for influencing positive outcomes in various fields like finance, healthcare, and consumer behavior.

Related terms

Loss Aversion: The tendency for people to prefer avoiding losses over acquiring equivalent gains; it suggests that losing $100 feels worse than gaining $100 feels good.

Framing Effect: The phenomenon where people’s choices are influenced by how information is presented, such as emphasizing potential gains or losses.

Endowment Effect: A cognitive bias where individuals assign more value to items simply because they own them, making them reluctant to trade or sell.