Economics Game Theory In Behavioral Economics Questions Long
Prospect theory is a behavioral economic theory that seeks to explain how individuals make decisions under conditions of uncertainty, particularly in the context of financial decision-making. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as an alternative to the traditional expected utility theory.
According to prospect theory, individuals do not make decisions based on the expected value of outcomes alone, but rather on the perceived value or utility of those outcomes. The theory suggests that people evaluate potential gains and losses relative to a reference point, typically their current wealth or status quo. This reference point serves as a baseline against which individuals assess the desirability of different outcomes.
Prospect theory also introduces the concept of diminishing sensitivity, which states that individuals are less sensitive to changes in wealth as they move away from their reference point. This means that the perceived value of gains and losses diminishes as they become larger or smaller relative to the reference point. For example, the emotional impact of losing $100 is greater when an individual's wealth is $200 compared to when their wealth is $10,000.
Another key aspect of prospect theory is the distinction between gains and losses. It suggests that individuals are more averse to losses than they are attracted to equivalent gains. This is known as loss aversion and implies that the pain of losing $100 is greater than the pleasure of gaining $100. As a result, individuals tend to be risk-averse when faced with potential losses and risk-seeking when faced with potential gains.
Prospect theory also introduces the concept of framing, which refers to how choices are presented or framed to individuals. The way a decision is framed can influence individuals' preferences and choices. For example, individuals may be more willing to take risks when a decision is framed in terms of potential gains rather than potential losses.
In the context of financial decision-making, prospect theory suggests that individuals may deviate from rational decision-making by being influenced by their emotions, reference points, and the way choices are presented. For example, individuals may be more likely to hold onto losing investments in the hope of recovering their losses (known as the "break-even effect") or may be more willing to take on risky investments when they have experienced recent gains.
Overall, prospect theory provides insights into how individuals make decisions under uncertainty and helps explain the biases and deviations from rationality observed in financial decision-making. By understanding these behavioral tendencies, economists and policymakers can design interventions and strategies to improve decision-making and promote better financial outcomes.