Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, revolutionized the field of economics and psychology by introducing a realistic way of understanding how people make decisions under risk and uncertainty. This theory contrasts with the classical economic theory of expected utility, which assumes that individuals act rationally and are risk-neutral. Prospect Theory suggests that people value gains and losses differently, leading to inconsistent and sometimes irrational decision-making.
Key to Prospect Theory is the concept of value function, which is defined on deviations from a reference point (usually the status quo or expected outcome) rather than final wealth. This function is concave for gains, reflecting risk aversion, and convex for losses, indicating risk-seeking behaviour in the face of losses. Additionally, it illustrates that losses loom larger than gains, a principle known as loss aversion.
Another important component of Prospect Theory is the weighting function, which describes how people disproportionately weigh the probability of different outcomes. People tend to overestimate small probabilities and underestimate large probabilities, leading to preference anomalies like the lottery paradox and insurance purchase.
Prospect Theory has profound implications across various fields, including economics, finance, marketing, and public policy. It provides insights into consumer behaviour, investment decisions, and the design of economic and health policies, among others. Kahneman’s work on Prospect Theory and related research on judgment and decision-making under uncertainty earned him the Nobel Prize in Economic Sciences in 2002.
This ground breaking theory underscores the complexity of human decision-making, challenging the assumption of human rationality in economic models and highlighting the psychological factors that influence choices.
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