Prospect Theory

Definition

Prospect Theory is a behavioral economic theory that describes how people make decisions involving risk and uncertainty. It suggests that individuals evaluate potential losses and gains differently, often being more sensitive to losses than to equivalent gains, which can lead to irrational decision-making. This theory highlights the importance of framing options in a certain way, as the perception of outcomes significantly affects choices, especially when creating and evaluating options.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979, challenging the traditional expected utility theory by showing that people do not always act rationally.
2. According to Prospect Theory, individuals tend to overweight small probabilities, meaning they might overvalue unlikely events like winning a lottery compared to more probable outcomes.
3. The theory introduces the value function, which is concave for gains and convex for losses, indicating diminishing sensitivity as outcomes move further from the reference point.
4. In negotiations, understanding prospect theory can help in crafting options that minimize perceived losses for all parties involved, leading to better outcomes.
5. Prospect Theory has practical implications in various fields including finance, marketing, and policy-making, influencing how choices are structured and presented.

Review Questions

• How does Prospect Theory explain the tendency of individuals to make decisions under risk differently compared to traditional economic theories?
  • Prospect Theory illustrates that individuals do not always make rational decisions based on maximizing utility as traditional theories suggest. Instead, it shows that people are often influenced by how choices are framed and have a stronger aversion to losses compared to the pleasure derived from equivalent gains. This leads to behaviors such as risk-seeking in loss situations and risk-averse behavior when considering potential gains, highlighting a more complex decision-making process.
• Discuss how the concept of loss aversion within Prospect Theory can impact the way options are created in negotiation scenarios.
  • Loss aversion indicates that people fear losing what they already have more than they desire equivalent gains. In negotiations, this can influence how options are crafted; if negotiators present outcomes in terms of avoiding losses rather than achieving gains, they may motivate better acceptance of proposals. By framing options that emphasize security and risk mitigation, negotiators can align with this psychological tendency and encourage agreement.
• Evaluate the implications of Prospect Theory on strategic decision-making in high-stakes negotiations, considering both individual and collective outcomes.
  • Prospect Theory emphasizes that decision-making in high-stakes negotiations involves psychological biases that can skew rational assessments of risks and benefits. As negotiators become aware of their own tendencies toward loss aversion or the framing effects of proposals, they can strategically design offers that resonate emotionally with counterparts. This approach can lead to more favorable agreements for both parties by minimizing perceived threats while enhancing perceived benefits. Ultimately, understanding these dynamics can enhance collective outcomes by fostering collaboration rather than competition.

Related terms

Loss Aversion:

A principle within Prospect Theory that states people prefer to avoid losses rather than acquiring equivalent gains, leading to a stronger emotional response to losses.

Framing Effect:

The phenomenon where the way information is presented influences decision-making, illustrating how choices can be swayed by context rather than just the content.

Utility Theory: A traditional economic theory suggesting that individuals make rational choices based on maximizing utility, often contrasted with Prospect Theory's findings on human behavior.