Prospect Theory Explained: Meaning, Examples, and Applications

Elucidating the decision-making process of people under risk is an important area of behavioral economics. Prospect theory is one of the most influential models, which was created by Daniel Kahneman and Amos Tversky.

The Prospect Theory Kahneman Tversky 1979 emphasizes the fact that people are more afraid of losses than they appreciate similar gains, which is called loss aversion. This is the reason why individuals shun risks when handling gains but take risks to shun off losses. This blog discusses the concept of the prospect theory, its principles, and applications, and the role of online assignment help in aiding academic knowledge.

What is Prospect Theory?

So, what is prospect theory? According to the Prospect Theory Kahneman Tversky 1979, people compare gains and losses not in a purely rational manner but make a decision.

Contrary to the conventional economic theories, the Kahneman Tversky 1979 prospect theory holds that individuals tend to focus on avoiding losses, rather than making gains. To illustrate, the experience of losing ₹50 is worse than the pleasure of earning ₹50.

This behaviour can be explained by the fact that people evaluate the results based on a reference point and not absolute value. Consequently, decisions tend to be biased and driven by perceptions, instead of by logic.

Main ideas to be acquainted with Prospect Theory Kahneman Tversky 1979.

There are a number of concepts that describe the operation of prospect theory:

• Expected Utility Theory: It is a conventional theory that presupposes rational decision-making. But Prospect Theory Kahneman Tversky 1979 does not agree since it emphasizes perceived gains and losses, rather than absolute results.

• Reference Point: A reference point is a standard upon which results are compared. Individuals evaluate profits and losses based on this point.

• Loss Aversion: The Loss aversion is a major concept of prospect theory, according to which losses are more important than gains with an equivalent value.

• The Framing Effect: The presentation of choices affects the decisions. There can be a gain frame and a loss frame, which can result in various decisions.

• Gain Frame and Loss Frame: In gain frames, people risk nothing whereas in loss frames, they risk everything.

• Diminishing Sensitivity: The effect of gains and losses diminishes with the magnitude of the gains and losses.

• Probability weighting Function: This type of probability is commonly known to overestimate small probabilities and underestimate large ones which results in irrational decisions.

Making Decisions in the presence of risk and uncertainty.

The Kahneman Tversky 1979 Prospect Theory is a description of behaviour in various circumstances:

• High Probability Gains (Risk Aversion): Individuals tend to favor some gain as opposed to uncertain gain.

• High Probability Losses (Risk Seeking): Individuals engage in risk in order to be able to evade losses.

• Low Probability Gains (Risk Seeking): People make risky choices that have unattainable possible rewards.

• Low Probability Losses (Risk Aversion) Individuals are risk-averse to prevent uncommon losses.

These trends point out the contribution of prospect theory on the way people make decisions in the real world.

Prospect Theory Uses.

The Prospect Theory Kahneman Tversky 1979 has wide applications:

• Marketing: Framing is a technique used by businesses to change consumer behaviour.

• Finance: Discusses investor biases such as holding losses and selling gains early.

• Public Policy: Loss framing is employed by the governments to stimulate compliance.

• Daily Decision Making: Affects the decisions such as insurance, risk-taking.

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Conclusion

The prospect theory proposed by Kahneman Tversky 1979 is a strong model explaining the irrational decision making in cases of risks. It offers excellent information about human behaviour by addressing the issue of loss aversion and perception.

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