Prospect theory is a psychological theory that explains how people make decisions involving uncertainty and risk. It was formulated by psychologists Daniel Kahneman and Amos Tversky in 1979 and has had a significant impact on the field of behavioral economics. Prospect theory challenges the traditional economic theory of rational decision-making and offers insights into how people evaluate and respond to potential gains and losses.
Key concepts of prospect theory include the following.
Value Function
Prospect theory proposes that people do not evaluate outcomes in an absolute sense but rather in terms of changes from a reference point. This reference point is often the individual’s current state or situation. The value function describes how people perceive and evaluate gains and losses relative to this reference point. It suggests that losses are felt more strongly than gains of the same magnitude.
Loss Aversion
One of the central tenets of prospect theory is the principle of loss aversion. Loss aversion refers to the idea that losses have a greater psychological impact than equivalent gains. In other words, people are more averse to losses than they are motivated by gains of the same size. This bias can influence decision-making, leading individuals to take risks to avoid losses and to be cautious when pursuing gains.
S-Shaped Value Function
The value function in prospect theory is often depicted as an S-shaped curve. It indicates that as the magnitude of outcomes increases, the perceived value of gains decreases, and the perceived value of losses increases, but these changes are not linear. This non-linear valuation leads to behaviors like risk-seeking in the domain of losses (to potentially mitigate losses) and risk-averse behavior in the domain of gains (to secure gains).
Risk Attitudes
Prospect theory introduces the concept of risk attitudes, which describes how individuals perceive and react to uncertainty. People tend to be risk-averse when dealing with gains, meaning they prefer certain gains over uncertain ones. However, they may become risk-seeking when facing potential losses, preferring uncertain losses over certain losses.
Framing Effects
Another important aspect of prospect theory is the impact of framing on decision-making. The way information is presented or framed can significantly influence how decisions are made. People’s choices can change depending on whether options are framed in terms of potential gains or potential losses, even if the underlying probabilities and outcomes remain the same.
Conclusion
Prospect theory has been widely studied and applied in various fields, including economics, psychology, marketing, finance, and public policy. It provides a more accurate understanding of how people make decisions in real-world situations where uncertainty and risk are involved, and it highlights the role of psychological biases in shaping our choices.
