Prospect Theory

Definition

Prospect theory is a behavioral economic theory that describes how people make decisions involving risk and uncertainty, particularly emphasizing that individuals value potential gains and losses differently. This theory suggests that people are generally more sensitive to losses than to gains, leading to a phenomenon known as loss aversion. This concept plays a crucial role in understanding decision-making, especially in contexts where individuals face uncertain outcomes and highlights the importance of framing and presentation of choices.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979, revolutionizing the way we understand decision-making under risk.
2. The theory introduces a value function that is concave for gains and convex for losses, reflecting diminishing sensitivity to changes in wealth as one moves away from a reference point.
3. One of the key insights from prospect theory is that people often exhibit risk-seeking behavior when faced with potential losses but become risk-averse when dealing with potential gains.
4. The reference point in prospect theory is crucial; it represents the status quo or an individual's expectations, which determines whether they perceive an outcome as a gain or a loss.
5. Prospect theory has significant implications in various fields, including finance, marketing, and public policy, influencing how choices are presented to encourage desired behaviors.

Review Questions

• How does prospect theory explain the behavior of individuals when faced with risky decisions involving potential gains and losses?
  • Prospect theory explains that individuals tend to evaluate potential outcomes based on perceived gains and losses relative to a reference point rather than absolute outcomes. This leads to loss aversion, where people feel the pain of losses more acutely than the pleasure from equivalent gains. As a result, individuals may take risks to avoid losses while being more conservative when it comes to securing gains.
• In what ways does the framing effect interact with prospect theory to influence decision-making under uncertainty?
  • The framing effect interacts with prospect theory by showing how the presentation of choices can alter perceptions of risk and benefit. When options are framed positively as gains, individuals are more likely to exhibit risk-averse behavior, preferring sure gains. Conversely, when options are framed negatively as losses, individuals may become risk-seeking in an effort to avoid a loss, demonstrating how framing can lead to different choices depending on how the information is presented.
• Critically analyze how prospect theory can be applied to improve choice architecture in policy-making and consumer behavior.
  • Prospect theory can be applied in choice architecture by structuring options in ways that account for human biases and preferences highlighted by the theory. For instance, policymakers can frame health interventions as potential losses (e.g., losing out on health benefits) rather than just gains (e.g., improving health), which may lead to higher participation rates. Similarly, marketers can use insights from prospect theory to design pricing strategies that leverage loss aversion, encouraging consumers to act quickly before perceived opportunities are lost. This strategic application can enhance decision-making by aligning choices with natural human tendencies.

Related terms

Loss Aversion: The tendency for individuals to prefer avoiding losses rather than acquiring equivalent gains, indicating that losses have a greater emotional impact than an equivalent amount of gains.

Framing Effect:

The cognitive bias that occurs when people's decisions are influenced by the way information is presented, rather than just the information itself.

Utility Theory: A traditional economic theory that assumes individuals make decisions based on the expected utility of outcomes, aiming to maximize their overall satisfaction or happiness.