Prospect Theory: A Theory of Decision-Making Under Risk

A comprehensive exploration of Prospect Theory, which explains how people decide between probabilistic alternatives involving risk, where the probabilities of outcomes are uncertain.

Prospect Theory is a foundational concept in behavioral economics that describes how individuals make choices when faced with risky options. Developed by Daniel Kahneman and Amos Tversky in 1979, this theory provides a descriptive account of how people evaluate potential losses and gains. It stands as an alternative to the traditional expected utility theory, offering insights into human biases and irrationality.

Historical Context

• Origin: Daniel Kahneman and Amos Tversky introduced Prospect Theory in their seminal 1979 paper “Prospect Theory: An Analysis of Decision under Risk.”
• Influence: The theory revolutionized the field of economics and psychology, contributing significantly to behavioral economics.
• Nobel Prize: Kahneman was awarded the Nobel Prize in Economics in 2002 for his work on Prospect Theory.

Key Components of Prospect Theory

1. Value Function:

   • Relative Gains and Losses: The value function is defined over changes in wealth or welfare, not absolute wealth.
   • Concavity and Convexity: The value function is concave for gains (diminishing sensitivity) and convex for losses (increasing sensitivity), reflecting loss aversion.

       graph TD
   	    A[Gain]
   	    B[Loss]
   	    C[Reference Point]
   	    A -->|Concave| C
   	    B -->|Convex| C
   

2. Loss Aversion:

   • Greater Sensitivity to Losses: Individuals tend to feel the pain of losses more acutely than the pleasure of equivalent gains.
   • Mathematical Representation: If v(x) represents the value function, typically v(-x) > -v(x), indicating stronger negative impact from losses.

3. Probability Weighting:

   • Overweighting of Small Probabilities: Individuals tend to overemphasize low probability events.
   • Underweighting of High Probabilities: Conversely, they often underweight events of high probability.

       pie
   	    title Probability Weighting Function
   	    "Small Probabilities": 35
   	    "Medium Probabilities": 20
   	    "High Probabilities": 45
   

Importance and Applicability

• Behavioral Economics: Prospect Theory has become a cornerstone of behavioral economics, highlighting systematic deviations from rational decision-making.
• Policy Making: Policymakers use insights from Prospect Theory to design better interventions and predict public responses.
• Finance and Investment: Investors’ risk aversion and decision-making anomalies can be better understood and managed through this theory.

Examples and Considerations

Example

Consider a choice between a sure gain of $100 or a 50% chance to gain $250. According to Prospect Theory, many individuals might prefer the certain $100, demonstrating risk aversion for gains.

Conversely, given a choice between a sure loss of $100 or a 50% chance to lose $250, individuals might gamble, showing risk-seeking behavior for losses.

Related Terms

• Expected Utility Theory: A framework where individuals choose the option with the highest expected utility, assuming rational decision-making.
• Behavioral Finance: A field studying the influence of psychology on the behavior of financial practitioners.
• Risk Aversion: The tendency to prefer certainty over a gamble with a higher or equal expected value.

Interesting Facts and Inspirational Stories

• Nobel Recognition: Daniel Kahneman’s Nobel Prize underscores the theory’s profound impact on economic thought.
• Widespread Application: Prospect Theory’s principles have been applied across various fields including marketing, politics, and health economics.

Famous Quotes

• “People tend to overweight low probabilities and underweight high probabilities.” - Daniel Kahneman
• “Losses loom larger than gains.” - Popularization of the core concept of loss aversion in Prospect Theory

Proverbs and Clichés

• “A bird in the hand is worth two in the bush.”: Reflects risk aversion similar to the sure gain preference in Prospect Theory.
• “Better safe than sorry.”: Aligns with the preference for certainty.

Jargon and Slang

• “Nudge”: Slight changes in the way choices are presented to influence decision-making.
• [“Framing Effect”](https://financedictionarypro.com/definitions/f/framing-effect/ ““Framing Effect””): People’s choices influenced by how a situation is presented (gain vs. loss framing).

FAQs

What is the main difference between Prospect Theory and Expected Utility Theory?

While Expected Utility Theory assumes rational decision-making based on utility maximization, Prospect Theory accounts for actual human behavior, which includes biases like loss aversion and probability weighting.

How does Prospect Theory explain investment behavior?

It suggests that investors are risk-averse for gains and risk-seeking for losses, explaining why they might hold onto losing stocks and sell winning ones prematurely.

What role does the reference point play in Prospect Theory?

The reference point is crucial as gains and losses are assessed relative to it. It can be influenced by past experiences, expectations, or social comparisons.

References

1. Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291.
2. Thaler, R. H. (2016). Misbehaving: The Making of Behavioral Economics. W. W. Norton & Company.
3. Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus and Giroux.

Summary

Prospect Theory offers a nuanced understanding of decision-making under risk, accounting for human tendencies to overweight low probabilities and be more sensitive to losses than gains. This theory has broad applications, enriching fields such as behavioral economics, finance, and public policy, while challenging traditional economic models of rational behavior.

By appreciating the intricacies of human judgment and choices illuminated by Prospect Theory, we can foster better decision-making frameworks and interventions across various domains.