Economics Prospect Theory Questions Long
Prospect Theory, developed by Daniel Kahneman and Amos Tversky, is a behavioral economic theory that seeks to explain how individuals make decisions under conditions of uncertainty. One key concept within Prospect Theory is diminishing sensitivity, which refers to the idea that individuals exhibit a reduced sensitivity to changes in outcomes as the magnitude of those outcomes increases.
According to Prospect Theory, individuals evaluate outcomes relative to a reference point, often the status quo or their initial endowment. The theory suggests that people are more sensitive to changes in outcomes when they are near the reference point, but this sensitivity diminishes as the outcomes move further away from the reference point.
Diminishing sensitivity has important implications for decision-making. Firstly, it implies that individuals are risk-averse when facing gains and risk-seeking when facing losses. This is because the diminishing sensitivity effect leads individuals to be less sensitive to additional gains as they move further away from the reference point. As a result, individuals are more likely to take risks to try to recover from losses, as the potential gains are perceived as more significant.
Secondly, diminishing sensitivity affects the way individuals evaluate probabilities. Prospect Theory suggests that individuals overweight small probabilities and underweight large probabilities. This is because the diminishing sensitivity effect leads individuals to perceive small probabilities as more significant than they actually are, while large probabilities are perceived as less significant. This bias in probability evaluation can lead to suboptimal decision-making, as individuals may overestimate the likelihood of rare events and make choices based on these overestimated probabilities.
Furthermore, diminishing sensitivity also influences the framing effect, which refers to how the presentation of information can influence decision-making. Prospect Theory suggests that individuals are more sensitive to losses than gains, and this sensitivity asymmetry can be exploited through framing. For example, presenting a decision as a potential loss rather than a gain can lead individuals to make different choices due to the varying levels of sensitivity associated with gains and losses.
In summary, diminishing sensitivity is a key concept in Prospect Theory that explains how individuals' sensitivity to changes in outcomes decreases as the magnitude of those outcomes increases. This effect has significant implications for decision-making, leading individuals to be risk-averse when facing gains and risk-seeking when facing losses. It also influences the evaluation of probabilities and the framing effect, potentially leading to biases and suboptimal choices. Understanding the concept of diminishing sensitivity is crucial for comprehending the complexities of decision-making under uncertainty in the field of economics.