Economics Game Theory In Behavioral Economics Questions
Prospect theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky in 1979. It aims to explain how individuals make decisions under conditions of uncertainty or risk.
According to prospect theory, individuals do not make decisions based on the objective value of outcomes, but rather on the perceived value or utility of those outcomes. It suggests that people evaluate outcomes relative to a reference point, typically their current state or a certain outcome, and that they are more sensitive to changes in outcomes rather than absolute levels.
Prospect theory introduces the concept of value function, which describes how individuals perceive gains and losses. It suggests that individuals are risk-averse when facing gains, meaning they are more likely to choose a certain outcome over a risky one that could potentially yield higher gains. On the other hand, individuals are risk-seeking when facing losses, meaning they are more likely to choose a risky option that could potentially avoid or minimize losses.
Additionally, prospect theory introduces the concept of the framing effect, which suggests that the way a decision problem is presented or framed can significantly influence individuals' choices. People tend to be risk-averse when a problem is framed in terms of gains, but risk-seeking when the same problem is framed in terms of losses.
Overall, prospect theory contributes to our understanding of decision-making under risk by highlighting the importance of subjective perceptions and emotions in shaping individuals' choices. It provides insights into why people often deviate from rational decision-making and helps explain various phenomena observed in real-world economic and financial contexts.