Economics Prospect Theory Questions Long
The reflection effect is a key concept in Prospect Theory, which is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky. It refers to the phenomenon where individuals tend to evaluate potential gains and losses differently.
According to Prospect Theory, individuals do not make decisions based on absolute outcomes, but rather on changes in their current state. The reflection effect states that people tend to be risk-averse when facing potential gains and risk-seeking when facing potential losses.
When individuals are faced with potential gains, they exhibit risk aversion. This means that they are more likely to choose a certain outcome with a smaller but guaranteed gain rather than taking a risk for a larger but uncertain gain. This behavior is driven by the diminishing marginal utility of wealth, where the additional satisfaction gained from each additional unit of wealth decreases as wealth increases. As a result, individuals are more concerned about avoiding losses and maintaining their current state of wealth.
On the other hand, when individuals are faced with potential losses, they exhibit risk-seeking behavior. This means that they are more likely to take risks in order to avoid a certain loss, even if the potential outcome is uncertain and may result in a larger loss. This behavior is driven by the concept of loss aversion, where individuals experience a stronger negative emotional response to losses compared to the positive emotional response to equivalent gains. The fear of incurring losses motivates individuals to take risks in order to avoid the negative outcome.
Overall, the reflection effect in Prospect Theory highlights the asymmetry in risk preferences between potential gains and losses. It suggests that individuals are more risk-averse when facing potential gains and more risk-seeking when facing potential losses. This behavior is driven by the diminishing marginal utility of wealth and the concept of loss aversion, which influence individuals' decision-making processes and risk preferences.