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 uncertainty. The theory suggests that people do not always make rational decisions based on expected utility theory, but rather their choices are influenced by psychological factors such as framing and reference points. The key components of the value function in Prospect Theory are as follows:
1. Reference Point: The value function in Prospect Theory starts with a reference point, which is the starting point or the status quo against which individuals evaluate potential gains or losses. This reference point can be subjective and varies from person to person. People tend to evaluate outcomes relative to this reference point rather than in absolute terms.
2. Loss Aversion: Prospect Theory suggests that individuals are more sensitive to losses than to gains. The value function is concave for gains and convex for losses, meaning that the marginal utility of gains decreases as the amount of gain increases, while the marginal disutility of losses increases as the amount of loss increases. This implies that individuals are more averse to losses and are willing to take more risks to avoid losses than to achieve gains.
3. Diminishing Sensitivity: The value function in Prospect Theory also incorporates the concept of diminishing sensitivity. This means that individuals are less sensitive to changes in outcomes as they move away from the reference point. For example, the difference between gaining $100 and gaining $200 is perceived as larger than the difference between gaining $1,000 and gaining $1,100. This diminishing sensitivity to changes in outcomes affects decision-making and risk preferences.
4. Probability Weighting: Another key component of the value function is probability weighting. Prospect Theory suggests that individuals do not evaluate probabilities objectively but rather subjectively. People tend to overweight small probabilities and underweight large probabilities. This means that individuals are more risk-averse when facing high-probability gains or losses and more risk-seeking when facing low-probability gains or losses.
5. Losses loom larger than gains: Prospect Theory also highlights the phenomenon that losses loom larger than gains. Individuals tend to place more weight on potential losses than on potential gains of the same magnitude. This asymmetry in the evaluation of gains and losses influences decision-making and risk preferences.
Overall, the value function in Prospect Theory incorporates the concepts of reference point, loss aversion, diminishing sensitivity, probability weighting, and the asymmetry between gains and losses. These components help explain how individuals evaluate and make decisions under uncertainty, deviating from the assumptions of rationality in traditional economic theory.