Prospect theory

Daniel Kahneman (3283955327) (cropped)

Prospect Theory is a behavioral economics theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory was developed by Daniel Kahneman and Amos Tversky in 1979 and is considered a foundational work in behavioral economics, challenging the classical utility theory which suggests that individuals act rationally to maximize their utility. Prospect theory introduces concepts such as loss aversion, the endowment effect, and the framing of decisions, which demonstrate that people think in terms of potential gains and losses, rather than final outcomes.

Overview

Prospect theory can be divided into two stages: the editing phase and the evaluation phase. In the editing phase, individuals simplify available prospects. In the evaluation phase, they choose the prospect that holds the highest utility, which is calculated differently from the expected utility theory. The theory posits that people value gains and losses differently, leading to inconsistent choices, depending on how a question or problem is framed.

Key Concepts

Loss Aversion

One of the most critical insights from prospect theory is loss aversion, the idea that losses loom larger than gains. This means that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. People are more likely to act to avert a loss than to achieve a gain.

Reference Points

Prospect theory also introduces the concept of reference points, where the utility of a certain outcome is dependent on a reference point rather than the absolute outcome. This means that the same outcome can be perceived differently by different individuals, depending on their reference points.

Diminishing Sensitivity

The theory describes diminishing sensitivity to both gains and losses, which means that the difference in utility between $100 and $200 is more significant than between $1,100 and $1,200, even though both involve a gain of $100.

Applications

Prospect theory has wide-ranging applications across various fields such as economics, finance, psychology, and political science. It has been used to explain various phenomena such as the equity premium puzzle in finance, the status quo bias in decision-making, and the framing effects in voting behavior.

Criticism and Development

While prospect theory has been influential, it has also faced criticism, particularly regarding its empirical testing and the subjective nature of its psychological assumptions. Despite this, it has spurred further research and development, leading to the creation of cumulative prospect theory and other models that seek to refine and expand upon Kahneman and Tversky's original ideas.

See Also

• Behavioral Economics
• Utility Theory
• Daniel Kahneman
• Amos Tversky
• Loss Aversion
• Endowment Effect