Economics Prospect Theory Questions Medium
Prospect Theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky in 1979. It seeks to explain how individuals make decisions under conditions of uncertainty and risk. The theory challenges the traditional economic assumption that individuals are rational and always seek to maximize their utility.
The key concepts and components of Prospect Theory are as follows:
1. Reference Point: Prospect Theory suggests that individuals evaluate outcomes relative to a reference point, which is often their current state or a certain level of expectation. This reference point serves as a baseline against which gains and losses are assessed.
2. Value Function: The theory proposes that individuals do not evaluate outcomes in absolute terms, but rather in terms of changes from the reference point. The value function describes how individuals perceive and weigh gains and losses. It suggests that individuals are more sensitive to losses than gains, meaning that the psychological impact of losing a certain amount is greater than the impact of gaining the same amount.
3. Loss Aversion: Prospect Theory emphasizes the concept of loss aversion, which refers to the tendency of individuals to strongly prefer avoiding losses over acquiring equivalent gains. Loss aversion implies that individuals are willing to take on more risk to avoid losses, even if the potential gains are higher.
4. Probability Weighting: According to Prospect Theory, individuals do not accurately assess probabilities when making decisions. Instead, they apply subjective weights to probabilities, overweighting low probabilities and underweighting high probabilities. This leads to risk-seeking behavior in the domain of losses and risk-averse behavior in the domain of gains.
5. Diminishing Sensitivity: The theory suggests that individuals exhibit diminishing sensitivity to changes in outcomes as the magnitude of those changes increases. This means that the psychological impact of a gain or loss decreases as the size of the gain or loss increases.
6. Framing Effects: Prospect Theory highlights the influence of framing on decision-making. The way a decision is presented or framed can significantly impact individuals' choices. People tend to be risk-averse when options are framed in terms of gains, but risk-seeking when options are framed in terms of losses.
Overall, Prospect Theory provides a comprehensive framework for understanding how individuals make decisions under uncertainty and risk. It highlights the importance of reference points, value functions, loss aversion, probability weighting, diminishing sensitivity, and framing effects in shaping decision-making behavior.