and challenge traditional economic models by incorporating psychological factors into decision-making under uncertainty. These concepts explain why people often make choices that seem irrational, like overvaluing losses compared to equivalent gains.
Understanding prospect theory helps us grasp real-world economic behaviors, from consumer choices to financial markets. It's crucial for designing effective policies, marketing strategies, and incentives that account for how people actually make decisions, not just how they "should" in theory.
Prospect Theory vs Expected Utility
Key Principles and Differences
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Prospect theory describes decision-making under uncertainty incorporating psychological factors
Evaluates outcomes relative to a reference point rather than in absolute terms like expected utility theory
Introduces a concave for gains and convex for losses reflecting
Uses decision weights instead of probabilities accounting for overweighting low probabilities and underweighting high probabilities
Accounts for framing effects where choice presentation influences decisions unlike expected utility theory
Explains the overvaluing certain outcomes compared to probable ones contradicting expected utility assumptions
Value Function and Decision Weights
Value function shape reflects risk aversion in gains and behavior in losses
Decision weights capture tendency to overweight unlikely events and underweight likely ones
function typically inverse S-shaped (overweight small probabilities, underweight large ones)
Value function steeper for losses than gains illustrating loss aversion
Examples:
Lottery tickets (overweighting small chance of winning)
Insurance (overweighting small chance of large loss)
Loss Aversion and Decision-Making
Psychological Impact and Behavioral Effects
Loss aversion psychological impact of loss typically twice as strong as equivalent gain
Leads to valuing owned items higher than identical unowned items
Results in disposition effect in investing holding losing stocks too long and selling winners too quickly
Contributes to preferring current state to avoid potential losses from change
Examples:
Reluctance to sell house below purchase price even if market value declined
Holding onto underperforming investments hoping for recovery
Implications for Marketing and Policy
Influences marketing strategies framing offers as avoiding losses rather than acquiring gains
Crucial for policymakers designing incentives or implementing changes perceived as potential losses
Affects pricing strategies emphasizing savings or loss prevention
Impacts public policy communication focusing on preventing negative outcomes
Examples:
"Don't miss out on this limited-time offer" (loss framing in marketing)
Emphasizing potential tax savings rather than refunds in tax policy
Reference Points and Gains vs Losses
Influence on Decision-Making
Reference points basis for evaluating outcomes as gains or losses
Often current state or status quo but influenced by expectations aspirations or social comparisons
Changes in reference points alter outcome perception from gain to loss or vice versa
Adaptation shifts reference points over time (hedonic treadmill effect)
Examples:
Salary expectations based on industry averages
Judging investment performance against market indices
Framing and Manipulation
Reference points manipulated through framing effects influencing chosen reference point
Crucial for predicting behavior in various economic contexts
Impacts financial markets with purchase prices or historical highs influencing investor behavior
Affects consumer choices and policy responses
Examples:
Framing a 1000bonusas500 twice a year vs $1000 once (different reference points)
Anchoring effect in negotiations setting initial offer as reference point
Prospect Theory in Economic Applications
Consumer Behavior and Financial Markets
Explains sunk cost fallacy continuing investment in losing propositions to avoid realizing losses
Informs insurance product design as people pay premiums to avoid potential losses even with negative expected value
Provides insights into investor behavior market anomalies and effectiveness of investment strategies
Examples:
Continuing to attend concerts after purchasing season tickets despite not enjoying them
Preference for low-deductible insurance plans despite higher overall costs
Labor Markets and Policy Design
Explains worker resistance to nominal wage cuts more than demand for raises influencing wage rigidity
Informs tax policy design explaining preference for tax refunds over lower withholding
Guides incentive structure design in employee compensation and public health initiatives
Helps frame policy choices like presenting energy conservation as avoiding losses rather than achieving gains
Examples:
Framing pay cuts as "temporary salary adjustments" to reduce resistance
Presenting health initiatives as avoiding future illness rather than gaining better health