Prospect theory

Definition

Prospect theory is a behavioral economic theory that describes how people make decisions when faced with uncertain outcomes, particularly when it comes to risk and reward. It challenges traditional utility theory by emphasizing that individuals value gains and losses differently, leading to irrational decision-making behaviors. The theory highlights the concept of loss aversion, where losses are perceived as more significant than equivalent gains, ultimately influencing choices in situations involving risk.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979, providing a psychological perspective on economic decision-making.
2. The value function in prospect theory is defined as being concave for gains and convex for losses, indicating risk-averse behavior when considering potential gains and risk-seeking behavior when facing potential losses.
3. Prospect theory explains why people often make decisions that contradict rational economic behavior, such as holding onto losing investments longer than necessary.
4. The theory's implications extend beyond economics to areas like finance, healthcare decision-making, and marketing strategies by illustrating how choices can be affected by perceived risks and rewards.
5. In real-life situations, the framing of choices can significantly alter decisions; for instance, presenting a surgery with a 90% survival rate versus a 10% mortality rate can lead to different reactions.

Review Questions

• How does prospect theory differ from expected utility theory in explaining decision-making under risk?
  • Prospect theory differs from expected utility theory by focusing on how individuals perceive gains and losses rather than just their overall utility. While expected utility theory assumes rational decision-making based on probabilities and outcomes, prospect theory emphasizes behavioral biases such as loss aversion and the framing effect. This means people are more sensitive to potential losses than gains, leading to choices that may seem irrational when evaluated through the lens of traditional utility.
• Discuss the role of loss aversion in influencing financial decisions according to prospect theory.
  • Loss aversion plays a crucial role in financial decisions as it explains why individuals may avoid selling losing investments or take excessive risks to recover losses. According to prospect theory, the pain of losing money is felt more intensely than the pleasure of gaining the same amount. This leads to behaviors such as holding onto underperforming assets longer than rational analysis would suggest or being overly cautious with investment strategies due to fear of losses.
• Evaluate the broader implications of prospect theory in understanding consumer behavior and policy-making.
  • Prospect theory has significant implications for consumer behavior and policy-making by revealing how people’s perceptions of risk can shape their choices. Understanding loss aversion and the framing effect allows marketers and policymakers to design interventions that can lead to better decision-making outcomes. For example, by framing health-related information positively or highlighting potential gains from preventive measures, policymakers can encourage healthier behaviors among consumers. This insight into human psychology helps create strategies that align with how people actually think and behave.

Related terms

loss aversion:

A principle stating that people prefer to avoid losses rather than acquiring equivalent gains, making losses feel more impactful.

framing effect:

A cognitive bias where people's decisions are influenced by how information is presented or framed, affecting their choices.

expected utility theory: A classical economic theory that suggests individuals make rational choices based on the expected outcomes and their associated utilities.