Economics Prospect Theory Questions Medium
Probability weighting is a key concept in Prospect Theory, which is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky. It suggests that individuals do not evaluate probabilities in a rational and objective manner, but rather subjectively and with biases.
In Prospect Theory, individuals tend to overweight small probabilities and underweight large probabilities. This means that they assign higher subjective weights to low-probability events and lower subjective weights to high-probability events. This phenomenon is known as probability weighting.
The theory proposes that people tend to be risk-averse when facing gains and risk-seeking when facing losses. When evaluating potential gains, individuals overweight small probabilities, which leads them to perceive a higher likelihood of winning than what objective probabilities suggest. This tendency explains why individuals are often willing to take risks in situations where the probability of winning is low.
On the other hand, when evaluating potential losses, individuals underweight small probabilities, which leads them to perceive a lower likelihood of losing than what objective probabilities suggest. This tendency explains why individuals are often risk-averse when facing potential losses, as they are more concerned about avoiding losses than maximizing gains.
Probability weighting plays a crucial role in shaping individuals' decision-making under uncertainty. It highlights the importance of subjective perceptions and biases in how individuals assess and respond to probabilities. By understanding probability weighting, economists and policymakers can gain insights into how individuals make choices and design interventions to promote better decision-making.