Economics Prospect Theory Questions
The key concepts of Prospect Theory are as follows:
1. Reference Point: Prospect Theory suggests that individuals evaluate outcomes based on a reference point, which is typically their current state or a certain expectation. They perceive gains and losses relative to this reference point.
2. Loss Aversion: Prospect Theory states that individuals are more sensitive to losses than gains. The pain of losing is felt more intensely than the pleasure of gaining. As a result, people tend to take more risks to avoid losses rather than to achieve gains.
3. Value Function: The value function in Prospect Theory describes how individuals subjectively evaluate outcomes. It is typically concave for gains, indicating diminishing sensitivity to increasing gains, and convex for losses, indicating increasing sensitivity to increasing losses.
4. Probability Weighting: Prospect Theory suggests that individuals do not evaluate probabilities objectively. Instead, they apply subjective weights to probabilities, overweighting low probabilities and underweighting high probabilities. This leads to risk-seeking behavior for low-probability events and risk-averse behavior for high-probability events.
5. Framing Effect: The framing effect refers to how the presentation or framing of a decision problem can influence individuals' choices. Prospect Theory suggests that people are influenced by the way options are presented, even if the underlying outcomes are the same.
6. Mental Accounting: Prospect Theory recognizes that individuals mentally categorize and separate their financial resources into different accounts. This can lead to irrational behavior, such as treating gains and losses from different accounts differently.
Overall, Prospect Theory provides insights into how individuals make decisions under uncertainty and how they deviate from rational behavior predicted by traditional economic theory.