Prospect theory

Definition

Prospect theory is a behavioral economic theory that describes how people make decisions under risk and uncertainty, highlighting that individuals value potential losses and gains differently. This theory challenges the traditional economic assumption of rationality, showing that people are loss-averse, meaning they prefer to avoid losses rather than acquiring equivalent gains. It emphasizes how framing choices and potential outcomes can significantly affect decision-making processes.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by psychologists Daniel Kahneman and Amos Tversky in the late 1970s as a way to better understand economic decision-making.
2. One key aspect of prospect theory is the value function, which is concave for gains and convex for losses, indicating diminishing sensitivity as people move away from the reference point.
3. Prospect theory highlights that people often overweight small probabilities and underweight large probabilities when making decisions under uncertainty.
4. Framing effects, where the way information is presented influences choices, play a critical role in how people respond to potential outcomes in prospect theory.
5. This theory has significant implications for various fields such as finance, marketing, and public policy, as it provides insight into why individuals may behave irrationally in uncertain situations.

Review Questions

• How does prospect theory differ from traditional utility theory in understanding decision-making under uncertainty?
  • Prospect theory differs from traditional utility theory by emphasizing how people actually behave rather than how they should behave according to rational economic models. While utility theory assumes individuals act rationally to maximize their utility based on potential outcomes, prospect theory reveals that individuals are influenced by psychological factors like loss aversion and framing effects. This means that people often make decisions that do not align with traditional notions of rationality, preferring to avoid losses even at the cost of forgoing potential gains.
• What role does loss aversion play in prospect theory, and how can it impact financial decision-making?
  • Loss aversion plays a central role in prospect theory by demonstrating that individuals tend to react more strongly to potential losses than to equivalent gains. This can significantly impact financial decision-making, as investors may hold onto losing investments longer than advisable in hopes of recouping losses, while being quick to sell winning investments to secure gains. This behavior can lead to suboptimal investment strategies and contribute to market inefficiencies as emotional responses often overshadow rational analysis.
• Evaluate the implications of prospect theory for designing effective public policy interventions aimed at promoting healthier lifestyle choices.
  • The implications of prospect theory for public policy interventions are profound, particularly when it comes to encouraging healthier lifestyle choices. By understanding that individuals are more motivated by the fear of losses rather than the promise of equivalent gains, policymakers can design campaigns that frame health-related decisions in terms of avoiding negative outcomes. For example, messaging that emphasizes the health risks associated with poor lifestyle choices (loss framing) may be more effective than promoting the benefits of healthy behaviors (gain framing). Additionally, integrating reference points within interventions can help shape individual perceptions about what constitutes healthy behavior and motivate positive change.

Related terms

Loss Aversion: The principle that losses have a greater emotional impact on individuals than an equivalent amount of gains, leading to risk-averse behavior.

Reference Point: The baseline or starting point from which individuals evaluate potential gains and losses; this point can greatly influence decision-making.

Utility Theory:

A theory in economics that models how individuals make choices to maximize their satisfaction or utility based on preferences and available options.