Prospect Theory
Introduction
Prospect Theory, developed by psychologists Daniel Kahneman and Amos Tversky, is a behavioral economic theory that describes how people make decisions when faced with risk. It is a descriptive model of decision making under uncertainty, contrasting with the normative expected utility theory. The theory was developed to explain various empirical anomalies observed in human decision-making behavior.
History and Development
The development of Prospect Theory was motivated by empirical observations that challenged the expected utility theory, which was the prevailing model of decision making under risk at the time. Kahneman and Tversky began their work on Prospect Theory in the late 1960s and published their seminal paper, "Prospect Theory: An Analysis of Decision under Risk," in the journal Econometrica in 1979.
Theoretical Framework
Prospect Theory is based on two main ideas: reference dependence and loss aversion.
Reference Dependence
Reference dependence implies that individuals evaluate outcomes relative to a reference point, rather than in absolute terms. The reference point is usually the status quo, but it can also be affected by expectations, recent experiences, and the framing of the decision problem.
Loss Aversion
Loss aversion refers to the observation that individuals are more sensitive to losses than to gains of the same magnitude. This is reflected in the value function of Prospect Theory, which is steeper for losses than for gains.
Mathematical Representation
The value function v(x) in Prospect Theory is defined over gains and losses relative to the reference point, and it is typically represented as follows:
v(x) = {
x^α if x ≥ 0, -λ(-x)^β if x < 0,
}
where α, β < 1 reflect the diminishing sensitivity to both gains and losses, and λ > 1 reflects loss aversion.
Empirical Evidence
There is a vast body of empirical evidence supporting Prospect Theory. This evidence comes from experiments in the lab and field, as well as from real-world data. For example, it has been shown that people's choices in gambling tasks, insurance decisions, and consumer behavior are consistent with the predictions of Prospect Theory.
Applications
Prospect Theory has been applied in various fields, including economics, finance, marketing, political science, and health. In economics and finance, it has been used to explain phenomena such as the equity premium puzzle and the disposition effect. In marketing, it has been used to study consumer behavior and pricing strategies. In political science, it has been used to analyze voting behavior and international relations. In health, it has been used to understand medical decision making and health behaviors.
Criticisms and Limitations
Despite its success, Prospect Theory has also faced criticisms and limitations. Some critics argue that it is not a true theory, but rather a descriptive model that lacks predictive power. Others point out that it does not provide a unified explanation for all decision-making behavior under risk. Moreover, the parameters of the value function (α, β, λ) are not uniquely determined, which makes the theory somewhat flexible and open to interpretation.