Economics Prospect Theory Questions Long
Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, is a behavioral economic theory that seeks to explain how individuals make decisions under conditions of uncertainty. One of the key concepts in Prospect Theory is probability weighting, which refers to the systematic biases individuals exhibit when evaluating and weighting probabilities.
In traditional economic theory, individuals are assumed to make decisions based on the expected utility theory, which assumes that individuals are rational and make decisions by maximizing expected utility. However, Prospect Theory challenges this assumption by suggesting that individuals do not always make decisions based on objective probabilities and expected values.
According to Prospect Theory, individuals tend to overweight small probabilities and underweight large probabilities. This means that individuals assign more weight to low-probability events than they should, and assign less weight to high-probability events. This bias is known as the probability weighting function.
The probability weighting function can be represented by an S-shaped curve, where the subjective weight assigned to probabilities is concave for gains and convex for losses. This means that individuals are more risk-averse when facing gains and more risk-seeking when facing losses. For example, individuals may perceive a 10% chance of winning $100 as more attractive than a 90% chance of winning $10, even though the expected value is the same.
The effects of probability weighting on decision-making under uncertainty are significant. Firstly, it leads to risk aversion in the domain of gains and risk-seeking behavior in the domain of losses. This implies that individuals are more willing to take risks to avoid losses than to pursue gains. For instance, individuals may be more likely to gamble in an attempt to recover a loss rather than to secure a gain.
Secondly, probability weighting can lead to the phenomenon of the certainty effect. This effect suggests that individuals tend to overweight outcomes that are certain, even if the expected value is lower than uncertain outcomes. This can result in individuals choosing a certain outcome with a lower expected value over a risky outcome with a higher expected value.
Thirdly, probability weighting can also influence the framing effect. The framing effect refers to the phenomenon where individuals' choices are influenced by how options are presented or framed. Prospect Theory suggests that individuals are more risk-averse when options are framed in terms of gains, and more risk-seeking when options are framed in terms of losses. This highlights the importance of how information is presented in decision-making.
In conclusion, probability weighting is a fundamental concept in Prospect Theory that explains how individuals deviate from rational decision-making under uncertainty. The biases introduced by probability weighting, such as risk aversion in gains, risk-seeking in losses, the certainty effect, and the framing effect, have significant implications for understanding and predicting human decision-making behavior.