Prospect Theory

Definition

Prospect Theory is a behavioral economic theory that describes how people make decisions based on perceived gains and losses rather than the final outcome. This theory highlights the fact that individuals tend to value losses more heavily than equivalent gains, leading to risk-averse behavior when faced with potential gains and risk-seeking behavior when facing potential losses. It challenges the traditional rational choice model by illustrating how psychological factors and cognitive biases affect decision-making processes.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by Daniel Kahneman and Amos Tversky in 1979, and it introduced the concept of value functions that are defined over gains and losses.
2. The theory suggests that people exhibit risk aversion when considering potential gains but will take risks to avoid losses, highlighting inconsistent decision-making.
3. A key element of Prospect Theory is the S-shaped value function, which is concave for gains and convex for losses, indicating diminishing sensitivity as outcomes increase.
4. The probability weighting function in Prospect Theory shows that individuals tend to overestimate small probabilities and underestimate large probabilities when making choices.
5. Prospect Theory has significant implications for public policy, especially in areas such as health care, finance, and risk management, by understanding how people perceive risks and rewards.

Review Questions

• How does Prospect Theory challenge the traditional rational choice model in decision-making?
  • Prospect Theory challenges the rational choice model by demonstrating that people's decisions are not solely based on objective outcomes but are heavily influenced by subjective perceptions of gains and losses. While the rational choice model assumes individuals act to maximize utility consistently, Prospect Theory reveals that emotions and cognitive biases lead to inconsistencies in choices. For instance, individuals may avoid a gamble with a positive expected outcome due to fear of losing what they have, illustrating behavior that diverges from pure rationality.
• Discuss how loss aversion is a key component of Prospect Theory and its impact on individual decision-making.
  • Loss aversion is a fundamental aspect of Prospect Theory, emphasizing that losses are felt more intensely than gains of the same size. This principle drives individuals to make decisions that prioritize avoiding losses rather than achieving equivalent gains, which can lead to risk-averse behavior when faced with potential profits. As a result, loss aversion impacts various real-world decisions such as investing, insurance purchasing, and even voting behavior, where individuals might resist change out of fear of losing what they already have.
• Evaluate the implications of Prospect Theory for public policy design, particularly in managing risk-related behaviors.
  • Evaluating the implications of Prospect Theory for public policy reveals how understanding human psychology can enhance effective interventions. Policymakers can design programs that account for loss aversion by framing information in ways that highlight potential losses from inaction rather than just emphasizing potential gains. For example, public health campaigns might stress the dangers of unhealthy behaviors rather than just promoting healthy alternatives. By leveraging insights from Prospect Theory, policies can better motivate individuals to engage in desired behaviors and improve overall outcomes in areas like health care and financial planning.

Related terms

Loss Aversion: Loss aversion refers to the psychological phenomenon where individuals prefer to avoid losses rather than acquiring equivalent gains, influencing their decision-making.

Framing Effect: The framing effect describes how people's decisions are influenced by the way information is presented or 'framed,' which can lead to different choices based on context.

Utility Theory: Utility theory is an economic principle that models how individuals make rational choices to maximize their satisfaction or utility from available options.