Prospect theory explained

It challenges traditional economic theories that assumed individuals act in a purely rational manner when making choices. Instead, Prospect Theory introduces the idea that people value potential losses and gains differently, leading to decisions that deviate from rational expectations.

Key Concepts of Prospect Theory

Prospect Theory is based on several key ideas that explain how people make decisions involving risks. The central concept revolves around loss aversion, reference points, and the value function. These concepts suggest that people's choices are often not based on absolute outcomes but rather how those outcomes compare to a reference point, which is usually their current situation or expectations.

Loss Aversion

One of the most groundbreaking aspects of Prospect Theory is the idea of loss aversion. Kahneman and Tversky found that people tend to experience the pain of losing something more intensely than the pleasure of gaining the same thing. In other words, a loss of $100 feels more psychologically impactful than the pleasure of gaining $100. This asymmetry in how people perceive gains and losses leads to decision-making that is not purely rational.

The phenomenon of loss aversion explains many everyday behaviors, such as why people are often unwilling to sell a stock that has decreased in value, hoping it will recover, even though selling would minimize their losses. Similarly, it can explain why people may hold on to a losing bet longer than is rational.

Reference Points

Prospect Theory asserts that decisions are evaluated based on reference points. A reference point is the status quo or a baseline from which gains and losses are assessed. People evaluate outcomes as gains or losses relative to their reference point, not in terms of absolute wealth or value.

For example, if someone receives a $50 bonus, it may be perceived as a gain if their reference point is a salary without any bonus. However, if their reference point is a $200 bonus they received last year, the $50 might be perceived as a loss. This reference-dependent evaluation helps explain why people may make different choices based on their expectations or past experiences, rather than purely on the objective value of the outcome.

The Value Function

The value function in Prospect Theory is S-shaped and asymmetric. It shows how people evaluate potential outcomes, with the steepest slopes occurring for losses. This means that the negative emotional impact of losses is felt more strongly than the positive emotional impact of gains.

The value function is concave for gains and convex for losses. In simpler terms, it implies that people are risk-averse when facing gains but risk-seeking when facing losses. For instance, individuals are more likely to avoid risky options when they stand to gain something but might take on risky behavior when trying to avoid a loss.

The value function is typically steeper for losses than for gains, reflecting the principle of loss aversion. For example, the difference between losing $100 and losing $200 feels much greater than the difference between gaining $100 and gaining $200, even though the numerical difference is the same.

Diminishing Sensitivity

Another component of the value function is diminishing sensitivity. This principle suggests that as the size of the gain or loss increases, the psychological impact of that gain or loss decreases. For example, a person may feel a substantial difference between gaining $10 and $100, but the difference between gaining $1,000 and $1,100 will feel less significant, even though the monetary difference is the same.

Framing Effect

The framing effect is a key implication of Prospect Theory. It refers to the idea that the way choices are presented or framed can significantly influence decisions. A loss framed as a potential gain will often lead to a different decision than the same loss framed as an actual loss.

For example, people are more likely to choose a medical treatment that has a "90% survival rate" than one that has a "10% mortality rate," even though the two phrases convey the same information. This demonstrates how framing can alter perceptions and decision-making.

Applications of Prospect Theory

Prospect Theory has had a wide-ranging impact on economics, psychology, and other fields, offering insights into behavior that traditional economic models had not been able to explain. Some of the areas where Prospect Theory has been particularly influential include:

Behavioral Economics

Traditional economic models assume that individuals make decisions rationally, maximizing their utility. However, Prospect Theory introduced behavioral economics, which takes into account psychological factors, such as loss aversion and reference points, that lead to irrational behavior. This has led to a better understanding of consumer behavior, including why people often make suboptimal financial choices, such as holding on to losing investments or buying items on sale that they do not need.

Finance and Investing

Investors are not always rational when making investment choices, and Prospect Theory helps explain many phenomena in finance, such as why individuals are risk-averse when it comes to gains but risk-seeking when facing potential losses. This asymmetry can lead to behaviors like holding onto losing stocks for too long (hoping to avoid realizing a loss) or overreacting to small gains.

Public Policy and Marketing

The insights from Prospect Theory have also been applied in areas like public policy, marketing, and consumer behavior. For example, policies that highlight potential losses (such as a tax penalty for non-compliance) are often more effective than those that emphasize potential gains (such as tax credits). Similarly, marketers use framing techniques to emphasize the gains consumers could get from a product or the losses they would face by not purchasing.

Conclusion

Prospect Theory has significantly changed how we understand human decision-making under risk and uncertainty. By highlighting how people evaluate outcomes based on gains and losses relative to a reference point and how they exhibit loss aversion, the theory challenges traditional economic models that assumed people always acted rationally. Its applications in behavioral economics, finance, marketing, and policy continue to shape how we understand and influence decision-making in various domains.