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Concept
Prospect theory
Summary
Prospect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics.
Based on results from controlled studies, it describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion). For example, for some individuals, the pain from losing 2,000. Thus, contrary to the expected utility theory (which models the decision that perfectly rational agents would make), prospect theory aims to describe the actual behavior of people.
In the original formulation of the theory, the term prospect referred to the predictable results of a lottery. However, prospect theory can also be applied to the prediction of other forms of behaviors and decisions.
Prospect theory challenges the expected utility theory developed by John von Neumann and Oskar Morgenstern in 1944 and constitutes one of the first economic theories built using experimental methods.
Prospect theory stems from Loss aversion, where the observation is that agents asymmetrically feel losses greater than that of an equivalent gain. It centralises around the idea that people conclude their utility from "gains" and "losses" relative to a certain reference point. This "reference point" is different for each person and relative to their individual situation. Thus, rather than making decisions like a rational agent (i.e using expected utility theory and choosing the maximum value), decisions are made in relativity not in absolutes.
Consider two scenarios;
100% chance to gain 1000
100% chance to lose 1100
Prospect theory suggests that;
When faced with a risky choice leading to gains agents are risk averse, preferring the certain outcome with a lower expected utility (concave value function).
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Behavioral economics
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors in the decisions of individuals or institutions, and how these decisions deviate from those implied by classical economic theory. Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory. The study of behavioral economics includes how market decisions are made and the mechanisms that drive public opinion.
Decision-making
In psychology, decision-making (also spelled decision making and decisionmaking) is regarded as the cognitive process resulting in the selection of a belief or a course of action among several possible alternative options. It could be either rational or irrational. The decision-making process is a reasoning process based on assumptions of values, preferences and beliefs of the decision-maker. Every decision-making process produces a final choice, which may or may not prompt action.
Expected utility hypothesis
The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion. The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities).