Prospect Theory
Prospect theory was developed in 1979 as
a psychologically realistic alternative to expected utility theory.
It allows one to describe how people make choices in situations where
they have to decide between alternatives that involve risk, e.g. in
financial decisions. Prospect theory is a theory that describes decisions
between alternatives that involve risk, i.e. alternatives with uncertain
outcomes, where the probabilities are known. The model is descriptive:
it tries to model real-life choices, rather than optimal decisions.
Starting from empirical evidence, the theory describes how individuals
evaluate potential losses and gains. In the original formulation the
term prospect referred to a lottery.
Some behaviors observed
in economics, like the disposition effect or the reversing of risk aversion/risk
seeking in case of gains or losses (termed the reflection effect), can
also be explained referring to the prospect theory.
An important implication
of prospect theory is, that the way economic agents subjectively frame
an outcome or transaction in their mind, affects the utility they expect
or receive. This aspect has been widely used in behavioral economics
and mental accounting.
Framing and prospect theory
has been applied to a diverse range of situations which appear inconsistent
with standard economic rationality; the equity premium puzzle, the status
quo bias, various gambling and betting puzzles.
The original version of
prospect theory gave rise to violations of first-order stochastic dominance.
That is, one prospect might be preferred to another even if it yielded
a worse outcome with probability one.
The editing phase overcame
this problem, but at the cost of introducing intransitivity in preferences.
A revised version, called cumulative prospect theory overcame this problem
by using a probability weighting function derived from Rank-dependent
expected utility theory. Cumulative prospect theory can also be used
for infinitely many or even continuous outcomes (e.g. if the outcome
can be any real number).
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