Prospect Theory
Prospect Theory, proposed by Daniel Kahneman and Amos Tversky in 1979, is a theory in behavioral economics that explains how people make decisions involving risk. Unlike traditional economic theories that assume rational decision-making, Prospect Theory demonstrates that people often make irrational decisions.
Key Concepts of Prospect Theory
Value Function: The value function shows how people evaluate gains and losses. Prospect Theory has the following characteristics:
Loss Aversion
: People are more psychologically affected by losses than gains of the same amount. For example, the pain of losing $100 is felt more strongly than the joy of gaining $100.
Reference Dependence
: People evaluate value based on changes from a specific reference point rather than absolute amounts.
Probability Weighting Function: People tend to subjectively distort probabilities rather than evaluating them objectively.
Overestimation of Small Probabilities
: People overestimate the likelihood of very low-probability events.
Underestimation of Medium to High Probabilities
: People underestimate the likelihood of medium to high-probability events.
Key Points of Prospect Theory
Reference Point: The reference point, which serves as the basis for decision-making, is crucial. Gains and losses are evaluated against this reference point, which varies among individuals and situations.
Loss Aversion: The concept of loss aversion shows that losses have a stronger psychological impact than gains of the same amount, leading people to take risks to avoid losses.
Framing Effect: The framing effect demonstrates that the presentation of information (framing) can lead to different decisions. For example, "90% success rate" and "10% failure rate" represent the same fact but can influence people differently.
Applications of Prospect Theory
Financial Investment: Investors may choose high-risk investments to avoid losses and react more strongly to the possibility of losses than gains, potentially missing out on selling opportunities.
Marketing: When presenting the value of products or services, marketers can use the psychology of loss aversion to influence consumer decisions. For example, messages like "Don't miss out on this sale" can increase consumer purchasing intent.
Health Behavior: Framing effects can be used to promote health behaviors by presenting risks and benefits effectively. For example, "Continuing to smoke reduces your lifespan" is more effective than "Quitting smoking extends your lifespan."
Advantages and Challenges of Prospect Theory
Advantages:
Realistic Understanding of Decision-Making
: Helps to understand how people actually make decisions.
Wide Range of Applications
: Applicable in various fields such as finance, marketing, and health behavior.
Challenges:
Model Complexity
: While intuitive, the mathematical model of Prospect Theory is complex and can be difficult to apply to actual data.
Individual Differences
: Reference points and attitudes toward risk vary among individuals, making generalization difficult.
Summary
Prospect Theory, proposed by Daniel Kahneman and Amos Tversky, explains how people make irrational decisions involving risk. It provides a different perspective from traditional expected utility theory by introducing concepts such as loss aversion and subjective probability evaluation. Prospect Theory is applied in various fields, including finance, marketing, and health behavior. Understanding Prospect Theory enables the construction of more realistic decision-making models and the design of effective strategies.