How does Prospect Theory explain the phenomenon of loss aversion?

Prospect Theory explains the phenomenon of loss aversion by suggesting that individuals tend to weigh potential losses more heavily than potential gains when making decisions. Loss aversion refers to the tendency of people to strongly prefer avoiding losses over acquiring equivalent gains. According to Prospect Theory, individuals evaluate outcomes relative to a reference point, typically their current state or a certain reference level.

Loss aversion occurs because the negative psychological impact of a loss is generally greater than the positive psychological impact of an equivalent gain. In other words, the pain of losing $100 is typically felt more intensely than the pleasure of gaining $100. This asymmetry in the way losses and gains are perceived leads individuals to be more risk-averse when faced with potential losses.

Prospect Theory also suggests that individuals exhibit diminishing sensitivity to gains and losses as the magnitude of the outcome increases. This means that the emotional impact of a $100 loss is greater than the emotional impact of a $100 gain, but the difference in emotional impact between a $1,000 loss and a $1,000 gain is relatively smaller. As a result, individuals become more risk-seeking when faced with potential gains of larger magnitudes.

Overall, Prospect Theory explains loss aversion as a cognitive bias that influences decision-making by emphasizing the importance of avoiding losses and the asymmetrical psychological impact of losses and gains.