Prospect Theory

Definition

Prospect theory is a behavioral economics model that describes the way individuals make choices in situations involving risk and uncertainty. It suggests that people's decisions are influenced by how the options are presented, rather than solely by the objective outcomes.

5 Must Know Facts For Your Next Test

1. Prospect theory posits that people make decisions based on the potential value of losses and gains rather than the final outcome.
2. Individuals tend to be risk-averse when facing potential gains, but risk-seeking when facing potential losses.
3. The value function in prospect theory is typically S-shaped, with a steeper slope for losses than for gains, reflecting the phenomenon of loss aversion.
4. The framing effect in prospect theory suggests that the way a decision is presented can significantly influence an individual's choice, even when the underlying options are the same.
5. Prospect theory provides an alternative to the traditional expected utility theory, which assumes that individuals make decisions based on the maximization of expected utility.

Review Questions

• Explain how the concept of loss aversion in prospect theory influences consumer decision-making.
  • According to prospect theory, individuals tend to be more sensitive to losses than equivalent gains. This loss aversion leads consumers to be risk-averse when faced with potential gains, as they want to avoid the pain of a loss. However, when facing potential losses, consumers may become risk-seeking in an attempt to avoid the negative outcome. This asymmetric valuation of gains and losses can significantly impact consumer choices, as individuals will often make decisions to minimize potential losses rather than maximize potential gains.
• Describe how the framing effect, as explained by prospect theory, can impact consumer behavior in the context of consumer choice.
  • Prospect theory suggests that the way information is presented, or framed, can influence an individual's decision-making, even when the underlying options are the same. For example, a consumer may be more likely to choose a product that is framed as a '75% chance of success' rather than a '25% chance of failure,' even though the probabilities are equivalent. This framing effect can lead consumers to make different choices based on how the options are presented, rather than solely on the objective outcomes. Marketers and policymakers can leverage the framing effect to nudge consumer behavior in desired directions, highlighting potential gains or losses to influence decision-making.
• Analyze how the concept of reference points in prospect theory can affect consumer decision-making in the context of consumer choice.
  • Prospect theory posits that individuals evaluate potential gains and losses relative to a reference point, which serves as a baseline or point of comparison. This reference point can have a significant impact on consumer decision-making. For example, if a consumer's reference point is a higher-priced product, they may perceive a lower-priced alternative as a gain, even if it is still more expensive than their typical purchase. Conversely, if the reference point is a lower-priced product, the same alternative may be perceived as a loss. This sensitivity to reference points can lead consumers to make different choices based on how the options are framed in relation to their existing expectations or experiences. Understanding the role of reference points in prospect theory can help marketers and policymakers design more effective interventions to influence consumer behavior.

Related terms

Framing Effect:

The phenomenon where people's decisions are influenced by the way information is presented, even when the underlying information is the same.

Loss Aversion:

The tendency for people to strongly prefer avoiding losses to acquiring equivalent gains, often leading to risk-averse behavior.

Reference Point: The baseline or point of comparison that individuals use to evaluate potential gains and losses when making decisions under uncertainty.