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Prospect theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky in 1979. It seeks to explain deviations from rational behavior by examining how individuals make decisions under uncertainty and risk.
According to prospect theory, individuals do not always make decisions based on expected utility theory, which assumes that people are rational and always make choices that maximize their expected utility. Instead, prospect theory suggests that individuals evaluate potential gains and losses relative to a reference point, typically their current state or a certain outcome.
The theory proposes that individuals perceive gains and losses differently and that their decision-making is influenced by two main components: the value function and the decision weighting function.
The value function describes how individuals perceive gains and losses. It suggests that individuals are more sensitive to losses than gains, meaning that the psychological impact of losing a certain amount is greater than the impact of gaining the same amount. This is known as loss aversion. As a result, individuals are more likely to take risks to avoid losses rather than to pursue gains.
The decision weighting function, on the other hand, explains how individuals assess probabilities and make decisions under uncertainty. Prospect theory suggests that individuals tend to overweight small probabilities and underweight large probabilities. This means that individuals are more risk-averse when facing high probabilities of gains and more risk-seeking when facing high probabilities of losses.
Overall, prospect theory explains deviations from rational behavior by highlighting the role of cognitive biases and heuristics in decision-making. It suggests that individuals' preferences are influenced by their subjective perceptions of gains and losses, rather than solely based on objective probabilities and expected values. These biases and heuristics can lead to systematic deviations from rational behavior, such as the tendency to avoid losses, overweight small probabilities, and underweight large probabilities.
In conclusion, prospect theory provides a framework for understanding how individuals make decisions under uncertainty and risk. By considering the value function and the decision weighting function, it explains deviations from rational behavior by highlighting the role of cognitive biases and heuristics in decision-making.