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 uncertainty and how they evaluate potential gains and losses.
Traditional expected utility theory assumes that individuals are rational and make decisions based on maximizing their expected utility. It suggests that individuals assign subjective probabilities to different outcomes and calculate the expected utility of each option to make a decision. This theory assumes that individuals are risk-averse and that their preferences are consistent and stable.
On the other hand, Prospect Theory challenges the assumptions of expected utility theory by introducing the concept of loss aversion and framing effects. According to Prospect Theory, individuals are more sensitive to potential losses than potential gains. They experience losses more intensely than gains of the same magnitude, leading to risk-seeking behavior when facing potential losses and risk-averse behavior when facing potential gains.
Additionally, Prospect Theory suggests that individuals evaluate outcomes relative to a reference point, which can be influenced by the way options are presented or framed. The framing effect refers to the idea that individuals' choices can be influenced by the way information is presented, even if the underlying outcomes are the same. For example, individuals may be more willing to take risks to avoid losses when a situation is framed as a potential loss rather than a potential gain.
Overall, Prospect Theory provides a more realistic and descriptive model of decision-making under uncertainty compared to traditional expected utility theory. It takes into account the psychological biases and heuristics that individuals exhibit when evaluating potential gains and losses, highlighting the importance of framing and loss aversion in decision-making.