Economics Prospect Theory Questions Medium
In Prospect Theory, the concept of reference point refers to a psychological benchmark or point of comparison that individuals use to evaluate potential gains and losses. It serves as a reference against which individuals assess the desirability or utility of different outcomes.
The reference point can vary depending on the individual and the context. It can be based on past experiences, expectations, or social norms. For example, if an individual's reference point is their current wealth level, they may perceive a gain of $100 as positive if it increases their wealth above the reference point, but they may perceive a loss of $100 as negative if it decreases their wealth below the reference point.
The reference point also influences the way individuals perceive and react to gains and losses. Prospect Theory suggests that individuals tend to be risk-averse when outcomes are framed as gains relative to the reference point. In this case, individuals are more likely to take a sure gain rather than risk losing it. On the other hand, when outcomes are framed as losses relative to the reference point, individuals tend to be risk-seeking. They are more willing to take risks in the hope of avoiding or minimizing the losses.
Moreover, the reference point can shift over time or due to changes in circumstances. For instance, if an individual experiences a significant gain, their reference point may shift upwards, leading them to perceive smaller gains as less significant. Similarly, if an individual experiences a loss, their reference point may shift downwards, making smaller losses seem less severe.
Overall, the concept of reference point in Prospect Theory highlights the importance of individuals' subjective evaluations and comparisons when making decisions involving gains and losses. It helps explain why individuals' risk preferences can vary depending on the framing of outcomes and the reference point used for evaluation.