Prospect theory

Definition

Prospect theory is a behavioral economic theory that describes how individuals make decisions based on potential losses and gains, highlighting that people tend to weigh losses more heavily than equivalent gains. This concept challenges traditional economic assumptions of rational decision-making by illustrating how emotions and cognitive biases influence choices, especially under risk. It emphasizes the role of reference points, suggesting that people evaluate outcomes relative to a baseline rather than in absolute terms.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979, providing a framework for understanding decision-making under uncertainty.
2. One key insight of prospect theory is that losses are perceived as more significant than gains of the same size, leading to loss aversion.
3. The theory introduces the value function, which is concave for gains and convex for losses, demonstrating diminishing sensitivity to changes as one moves away from the reference point.
4. Prospect theory has been influential in explaining real-world behaviors such as why investors might hold onto losing stocks longer than they should.
5. The theory highlights that people often use heuristics or mental shortcuts in decision-making, which can lead to systematic biases and errors.

Review Questions

• How does prospect theory illustrate the concept of loss aversion in decision-making?
  • Prospect theory demonstrates loss aversion by showing that individuals are more sensitive to losses than to gains of equal magnitude. This means that the pain of losing a certain amount is greater than the pleasure of gaining the same amount. As a result, people often make decisions that prioritize avoiding losses, even if it means missing out on potential gains. This principle helps explain why individuals may avoid risky investments despite possible rewards.
• Discuss the significance of reference points in prospect theory and how they impact decision-making.
  • Reference points are crucial in prospect theory as they serve as benchmarks for evaluating potential outcomes. People assess their choices relative to these reference points, which can be based on past experiences or expectations. This leads to different reactions when faced with gains or losses, influencing their overall satisfaction and decision-making. For example, if someone expects a gain but experiences a loss relative to their reference point, they may feel more disappointment than if they had not set such an expectation.
• Evaluate how prospect theory can be applied in multinational team settings to improve decision-making outcomes.
  • In multinational teams, understanding prospect theory can enhance decision-making by addressing cultural differences in risk perception and evaluation of gains and losses. Team members from different backgrounds may have varying levels of loss aversion and differing reference points, which can affect their contributions and consensus-building processes. By recognizing these differences, leaders can facilitate discussions that consider diverse perspectives on risk and reward, ultimately leading to more balanced and effective decisions that account for emotional factors at play across cultures.

Related terms

Loss Aversion: The psychological phenomenon where individuals prefer to avoid losses rather than acquiring equivalent gains, leading to risk-averse behavior.

Reference Point: The baseline or standard against which individuals compare potential gains and losses, significantly influencing their decision-making process.

Framing Effect: The tendency for people's decisions to be influenced by the way information is presented, particularly whether it highlights potential gains or losses.