Economics Prospect Theory Questions Medium
The reflection effect in Prospect Theory refers to the tendency of individuals to evaluate gains and losses differently. According to Prospect Theory, individuals are more sensitive to losses than gains, and the reflection effect explains how this sensitivity influences decision-making.
When faced with potential gains, individuals tend to be risk-averse and prefer certain gains over uncertain ones. This means that they are more likely to choose a smaller but guaranteed gain rather than taking a risk for a potentially larger gain. This behavior is known as the "certainty effect."
On the other hand, when confronted with potential losses, individuals become risk-seeking and are more willing to take risks to avoid losses. They are more likely to choose uncertain options that offer a chance to avoid losses, even if the potential outcome is worse than the certain loss. This behavior is referred to as the "probability effect."
The reflection effect impacts decision-making by influencing individuals to make choices that deviate from rational decision-making principles. It suggests that individuals are not solely motivated by maximizing their expected utility, but rather by their subjective evaluation of gains and losses. This can lead to suboptimal decisions, as individuals may be overly cautious when it comes to gains and overly willing to take risks to avoid losses.
Understanding the reflection effect is crucial in various economic contexts, such as investment decisions, insurance choices, and policy-making. It highlights the importance of framing and how the presentation of options can significantly impact individuals' decision-making processes.