Prospect theory, a pioneering concept in behavioral economics and decision-making, was developed by psychologists Daniel Kahneman and Amos Tversky in 1979. This theory revolutionized traditional economic models by demonstrating that people’s decisions are not purely rational and based on maximizing gains, as previously believed. Let’s delve into the core aspects of prospect theory and how it reshaped our understanding of human decision-making.
1. Departure from Traditional Economics:
Classical economic theory assumed that individuals make rational decisions based on maximizing utility and expected value. However, in real-world scenarios, people often make decisions based on heuristics, emotions, and the perception of gains and losses.
2. Gains and Losses:
Prospect theory posits that individuals evaluate potential outcomes not in terms of final states of wealth but in terms of gains and losses from a specific reference point. This reference point is typically the individual’s current situation or a recent experience.
3. Value Function:
The value function in prospect theory illustrates how individuals perceive gains and losses. It is S-shaped, reflecting that losses loom larger than gains. The emotional impact of losing $100 is greater than the joy of gaining $100, highlighting the concept of loss aversion.
4. Loss Aversion:
Loss aversion is a fundamental element of prospect theory, demonstrating that losses have a more substantial psychological impact than equivalent gains. Individuals are willing to take more risks to avoid losses than to achieve gains.
5. Diminishing Sensitivity:
Prospect theory also introduces diminishing sensitivity, suggesting that the incremental emotional impact of gains and losses diminishes as the magnitude of the gain or loss increases. This explains why people are risk-averse for large gains but risk-seeking for large losses.
6. Reflection Effect:
The reflection effect is another key principle of prospect theory. It emphasizes that risk attitudes for gains and losses are asymmetric. Individuals tend to be risk-averse for gains (preferring a certain gain over a risky one) and risk-seeking for losses (preferring a risky loss over a certain loss).
7. Framing Effect:
The way choices are presented or framed influences decision-making. The same information presented positively (as gains) or negatively (as losses) can lead to different choices due to the psychological impact of framing.
8. Real-world Applications:
Prospect theory has been applied in various fields, including finance, marketing, and public policy. Understanding how individuals perceive gains and losses helps in designing strategies to nudge behavior and influence decision-making.
Irrational Choices
Prospect theory unravels the psychological intricacies that shape how we perceive gains and losses, challenging the assumption of purely rational decision-making. By recognizing the impact of emotions and framing on our choices, we can design better strategies to guide individuals towards more informed and favorable decisions. It’s a valuable tool for economists, policymakers, and anyone seeking a deeper understanding of decision-making dynamics.
