Prospect Theory explained: theory including the definition and an example
Prospect Theory: this article explains the Prospect Theory by Amos Tversky and Daniel Kahneman in a practical way. Next to what is it and the definition, this article also features the Utility Theory, the risks including an example and an additional subchapter on the effect of losses and gains. Enjoy reading!
What is the Prospect Theory?
The definition of Prospect Theory
The Prospect Theory is a behavioural economic theory was that developed in the 1970s by psychologists Daniel Kahneman and Amos Tversky. It states that the preference of taking (uncertain) decisions depends on circumstances. Together they wrote “Prospect Theory: an analysis of decision under risk”, in which they explain the prospect theory as part of behavioural economics.
The Prospect Theory describes how people select alternatives where risks are involved, but in which the results are also already known. Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. The losses and gains are evaluated using facts that are available (heuristics), which have come to light through methods and/ or systems.
The prospect theory is a descriptive theory and it tries to model real-life choices rather than predict optimal decisions.
One of the criticisms of the prospects theory is that it lacks psychological explanations for the process it talks about.
The Prospect Theory was developed by Amos Tversky and Daniel Kahneman as an alternative to the expected utility hypothesis. Several scientists had shown that people do not so much look at the net result of a choice, but that they assign weight to choices. This is called the utility theory.
The Prospect Theory deals with the description of preferences in relation to the expected utility that a choice will yield. The utility theory originated dates back to 1738 and was developed by the Swiss mathematician and physicist Daniel Bernoulli. For a long time this theory was the dominant explanation for decisions of which the outcomes are uncertain.
Chances and risks are not absolute, but relative to the situation. The certainty effect plays a role in this; things that are certain outweigh possible chances. Also, many people feel that ‘losses’ outweigh ‘gains’.
Example of Prospect Theory in practice
All these theories discuss risks in detail. However, there is a distinction between risk and uncertainty where risk can be measured and uncertainty cannot be measured.
Bernoulli indicated at the time that chances are assessed differently on the basis of moral expectations. The Prospect Theory, or Loss Aversion Theory is also based on this and the example of a lottery is often cited in several theories.
For example, a ticket that costs 10 Euros will yield either nothing or the grand prize of 10,000 Euros, resulting in a weighted average of 5,000 Euros. This is also called the reference point. A very poor person may want to sell the lottery ticket for less than 5,000 Euros, while a rich person will want to buy it for 5,000 Euros.
He will accept the possibility of a risk. The utility of whether to buy or sell therefore depends on the circumstances in which a person finds himself and explains the risk avoidance behaviour of the poor man and the risk-seeking behaviour of the rich man.
Losses and gains
Kahneman and Tversky, however, did not consider the effect of losses and gains.
Their Prospect Theory shows that the value attached to losses is often greater than the value that is attached to gains. The central idea in their theory is reasoning.
When information is presented in a certain way, people are inclined to make other choices. Gain-framed information makes people more inclined to avoid risks.
In the case of adverse information in terms of ‘losses’, the opposite will happen and risk-seeking behaviour will be demonstrated. When you are aware of the influence of the information, you can prepare yourself for it so that you will not be led by this (unconsciously).
The framing effect is a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations; e.g. as a loss or as a gain.
Prospect Theory: the decision process
This theory describes the decision processes in two stages; the editing phase and the evaluation phase.
During the initial phase, the outcomes of a decision are ranked according to facts that are available (heuristics).
People determine which outcomes they consider equivalent, set a point of reference and then consider lesser outcomes as losses and greater ones as gains.
In the subsequent evaluation stage people start looking for the value (utility) that the outcome will have for them.
They base this value on the potential outcomes and the respective probabilities. Based on this information, they choose the outcomes with the highest value after which they will ultimately make a decision.
It’s Your Turn
What do you think? Is the Prospect Theory applicable in your personal or professional environment? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for good decision making?
Share your experience and knowledge in the comments box below.
- Kahneman, D., & Tversky, A. (2013). Prospect theory: An analysis of decision under risk. In Handbook of the fundamentals of financial decision making: Part I (pp. 99-127).
- Kahneman, D., & Tversky, A. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty, 5(4), 297-323.
- Wakker, P. P. (2010). Prospect theory: For risk and ambiguity. Cambridge university press.
How to cite this article:
Mulder, P. (2017). Prospect Theory explained: theory including the definition and an example. Retrieved [insert date] from Toolshero: https://www.toolshero.com/decision-making/prospect-theory/
Published on: 09/07/2017 | Last update: 03/02/2023
Add a link to this page on your website:
<a href=”https://www.toolshero.com/decision-making/prospect-theory/”>Toolshero: Prospect Theory explained: theory including the definition and an example</a>
We are sorry that this post was not useful for you!
Let us improve this post!
Tell us how we can improve this post?