- Also called:
- loss-aversion theory
- Related Topics:
- decision making
prospect theory
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What is prospect theory in psychology?
Prospect theory, crafted by psychologists Daniel Kahneman and Amos Tversky, is a psychological model that explains decision-making under risk.
Prospect theory has two phases:
* Editing Phase In this phase, individuals frame their options, showcasing how choices can be swayed by presentation—order, method, or wording.
* Evaluation Phase During this phase, there are two components at play. The first is the value function, where people become more risk-averse when presented with opportunities for gains. Conversely, in the realm of potential losses, they exhibit risk-seeking behavior. The second component is the weighting function, where individuals attribute greater significance to outcomes they perceive as certain, while also overemphasizing low-probability events.1 Britannica SourceCreated from Britannica articles using AI. AI can make mistakes, so verify using Britannica articles. -
Who developed prospect theory and why was it created?
Daniel Kahneman and Amos Tversky developed prospect theory, a psychological model explaining decision-making under risk, which they initially published in 1979.
Prospect theory emerged from empirical experiments on human choice behavior, aiming to provide an accurate model of decision-making. It posits that decisions rely on choices among options influenced by individual biases. Kahneman and Tversky built upon their earlier work regarding biases that come with assessments of probability. Judgments involve evaluating the external world, while decisions involve internal choices across values.
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How does prospect theory explain how people make decisions under risk?
Prospect theory describes decision-making under risk, suggesting choices depend on biased judgments. Developed by Daniel Kahneman and Amos Tversky, it includes an editing phase, where framing affects choices, and an evaluation phase with a value function and a weighting function.
The value function shows people are more risk-averse when expecting gains and risk-seeking when trying to avoid losses. People feel the pain of a loss more than the pleasure of an equivalent gain. The weighting function indicates that people overemphasize certain or impossible outcomes, and they give too much weight to low-probability events. Though initially focused on financial decisions, prospect theory now applies to political science, explaining seemingly irrational risks in international relations and comparative politics.
1 Britannica SourceCreated from Britannica articles using AI. AI can make mistakes, so verify using Britannica articles. -
What is the difference between how people view gains and losses in prospect theory?
Prospect theory describes how people make decisions, especially under risk, and includes an editing phase and an evaluation phase. In the evaluation phase, the value function shows that people react differently to gains versus losses.
People tend to avoid risks when considering potential gains, but they become more risk-seeking when trying to avoid losses. This means that when things are going well, people are less likely to gamble, but when facing losses, they are more likely to take risks to recover. Also, the theory recognizes that the pain of a loss is greater than the pleasure of an equivalent gain. People usually need to be offered much more than the potential loss to be willing to risk a chance of gaining something.
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What is loss aversion according to prospect theory?
In prospect theory, loss aversion is the tendency for people to feel the pain of a loss more strongly than the pleasure of an equivalent gain. In the evaluation phase of prospect theory, the value function demonstrates how individuals respond to loss. People tend to be more willing to take risks to avoid losses than they are to achieve gains. Studies have shown that people generally need to be offered twice as much in gains to be willing to take a risk for a chance of a gain.
2 Britannica SourcesCreated from Britannica articles using AI. AI can make mistakes, so verify using Britannica articles. -
How does prospect theory challenge traditional economic theory about decision-making?
Prospect theory, developed by Daniel Kahneman and Amos Tversky, challenges traditional economic theory by presenting a more descriptively accurate model of human decision-making under risk. Traditional models often assume individuals make rational choices to maximize benefits, but prospect theory posits that decisions are influenced by psychological factors, such as how choices are framed.
Prospect theory consists of two phases: In the editing phase, individuals characterize options for choice, and framing effects demonstrate how the presentation of choices affects decisions. In the evaluation phase, people are more risk-averse when considering gains and more risk-seeking when trying to avoid losses. People tend to overweight small-probability events, leading to counterintuitive choices.
1 Britannica SourceCreated from Britannica articles using AI. AI can make mistakes, so verify using Britannica articles.
prospect theory, psychological theory of decision-making under conditions of risk, which was developed by psychologists Daniel Kahneman and Amos Tversky and originally published in 1979 in Econometrica. The model has been imported into a number of fields and has been used to analyze various aspects of political decision-making, especially in international relations.
Prospect theory was based on a series of experimental empirical demonstrations of actual human choice behavior; it was developed to present a descriptively accurate model of human decision-making. Nevertheless, the domain in which prospect theory explored human decision-making was primarily based on choices among a series of financial bets and gambles. It was not originally intended to provide wider generalization beyond that domain, although it has subsequently been used to explain a wide variety of phenomena across many fields, including law, political science, and economics.
Prospect theory states that decision-making depends on choosing among options that may themselves rest on biased judgments. Thus, it built on earlier work conducted by Kahneman and Tversky on judgmental heuristics and the biases that can accompany assessments of frequency and probability. Such judgments involve evaluations of the external world; decisions involve more fundamentally internal choices across values. Thus, the essence of decision-making involves a trade-off between values.
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The two phases of prospect theory
Prospect theory encompasses two distinct phases: (1) an editing phase and (2) an evaluation phase. The editing phase refers to the way in which individuals characterize options for choice. Most frequently, these are referred to as framing effects. Framing effects demonstrate the way in which the substance of a person’s choice can be affected by the order, method, or wording in which it is presented. The classic demonstration of this effect took place in the so-called Asian disease paradigm, in which people were asked to make a choice among public policy plans for responding to a disease outbreak. Although the actual statistical probabilities remained identical, the percentage of people supporting a given plan changed dramatically based on whether or not the outcomes were presented in terms of the number of people who would live versus the number of people who would die. In perhaps the most dramatic demonstration of this effect, real-world patients suffering from cancer made different choices of whether to undergo surgery or chemotherapy for treatment of their illness based on whether the outcome percentages were presented in terms of survival or mortality. Once people are presented with both choices side by side, they can easily see that the substance of the decision remains the same, even if the psychic pull to perceive them differently remains.
Once choices are framed for decision, prospect theory enters its second, evaluation phase. This phase involves two component elements. The first element is graphically represented by the value function. This function differs from standard normative models by including a left-hand side to the graph that represents how people respond to loss. In this way, prospect theory differs from standard economic models that always encourage prudence as the better part of valour. Regardless of the normative imprimatur of such advice, this does not accurately characterize how most people make decisions. There are three important aspects to the value function that effectively distinguish it from expected utility in particular. First, the model examines the way in which value is related to the original reference point, or the start of action or choice. In most situations, this reference point is assumed to refer to the person’s current status quo position, but this is not necessarily required within the confines of the model. Rather, the operative reference point can be defined by some future level of aspiration or some kind of social comparison. But the key insight of the model is that the hedonic value of choice options is assessed by the way in which people evaluate change, movement, distance, or difference between where they are, or where they want to be, and the outcome offered by a particular choice. In other words, relative outcomes matter more than absolute outcomes.
The second important insight offered by the value function relates to the central prediction of the model. People tend to be more risk-averse when in a domain of gains, where things are going well and appear to be likely to continue to improve or where actors confront primarily opportunities for gains. Simultaneously, actors tend to be much more risk-seeking in the realm of losses, where they are much more likely to take risks in order to recoup previous losses or to recover from a loss in order to revert to a previous position.
The last important element of the value function recognizes that losses hurt more than equal gains please. Loss-aversion has indeed become the most robust finding in the entire model. In general, people have to be offered about two and a half times as much as a loss in order to prove willing to take a risk for the chance of a gain.
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The second element of the evaluation phase is characterized by the weighting function. This function contains two critical insights. First, people treat outcomes that are deemed to be either certain or impossible very differently than those whose changes take place in the midrange of probability. In other words, people simply assign more psychological weight and importance to outcomes that they can characterize with greater certainty. While this is not justifiable from a normative perspective, most people treat quite unlikely events as though they were impossible and quite likely events as though they were certain to occur. Second, people tend to attribute more importance than normatively justified to low-probability events. They simultaneously apply less psychological weight to medium- and high-probability outcomes than are normatively warranted.
The interaction of the value function and the weighting function lead to some very interesting and counterintuitive explanations and predictions for phenomena such as insurance (taking a sure loss against the small possibility of a larger loss) and lotteries (taking a sure loss against the even smaller possibility of a large gain). Because people overweight small-probability events, the main prediction of prospect theory reverses close to the reference point as individuals become risk-seeking in gains (lotteries) and risk-averse in losses (insurance).