How Prospect Theory Explains Risk and Human Behaviour

A major concern of behavioral economics is how individuals make risk-related decisions. Prospect theory is one of the most powerful frameworks created by Daniel Kahneman and Amos Tversky.

According to the Kahneman Tversky 1979 Prospect Theory, people will be more scared of losing than they are willing to be happy with the corresponding gains, a phenomenon referred to as loss aversion. That is why when there are gains people will not risk but when there are losses they will risk. Through this blog, we will discuss what prospect theory is and how it works, its principles, uses, and the way online assignment help may be beneficial to academic knowledge.

What is Prospect Theory?

So, what is prospect theory? Prospect Theory Kahneman Tversky 1979 elucidates that people do not make rational choices but calculate gains and losses in different ways.

Contrary to the conventional economic theories, the Kahneman Tversky 1979 prospect theory proposes that individuals tend to focus more on the minimisation of losses than on gains. For example, losing ₹50 feels more painful than the satisfaction of gaining ₹50.

This is the behaviour, as people compare the results to a reference point, not to absolute value. This makes the decisions always biased and prudent by perception as opposed to logic.

Key Concepts to know about Prospect Theory Kahneman Tversky 1979.

There are a number of concepts describing the operation of prospect theory:

• Expected Utility Theory: It is a classic theory which presupposes rationality. This is however disputed by Prospect Theory Kahneman 1979 that emphasizes on perceived gains and losses rather than absolute outcomes.

• Reference Point: A reference point is the point of reference with which results are compared. Individuals compare profits and losses in comparison to this.

• Loss Aversion: Loss aversion is a key concept in prospect theory, in which losses experience are more intense than gains of equal magnitude.

• The Framing Effect: The way decisions are framed affects the choice. A gain frame and a loss frame can result in various decisions.

• Gain Frame and Loss Frame: Gain frame is associated with people avoiding risks and loss frame is associated with people taking risks.

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

• Probability weighting Function: It is reported that people tend to overestimate the small probabilities and underestimate the large ones which make irrational decisions.

Decision Making in Uncertainty and Risk.

The Kahneman Tversky 1979 Prospect Theory describes behaviour in various situations:

• High Probability Gain (Risk Aversion): Individuals would take some gains rather than uncertain gains.

• High Probability Losses (Risk Seeking): Risk seekers avoid losses by taking risks.

• Low Probability Gains (Risk Seeking): People will take risks that have low probabilities of gaining.

• Low Probability Losses (Risk Aversion): Individuals tend to favor certainty as a way of avoiding the occurrence of rare losses.

These trends underscore the relevance of prospect theory in decision making in the real world.

Prospect Theory Uses.

Applications The Prospect Theory Kahneman Tversky 1979 has extensive applications:

• Marketing: Framing is a technique employed by businesses to determine consumer behaviour.

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

• Public Policy: Loss framing has been used to promote compliance by governments.

• Daily Decision Making: Affects decision-making such as insurance and risk-taking.

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Conclusion

The prospect theory of Kahneman Tversky 1979 is an influential theory, which describes the reason why individuals cause irrational choices in case of danger. It offers great information on human behaviour by emphasising on loss aversion and perception.

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