This lesson introduces prospect theory and explains why people often respond differently to gains and losses of the same size.
Developed by Daniel Kahneman and Amos Tversky in 1979, prospect theory is a behavioral account of judgment and decision-making under risk. It was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economic Sciences. The theory was built from controlled experiments and is intended to describe how people actually choose, rather than how perfectly rational agents would choose.
All flashcards
What is prospect theory?
A behavioral account of how people make choices under risk, including how they evaluate gains and losses.
What is a reference point?
A baseline against which a person judges an outcome as a gain or a loss.
What is loss aversion?
The tendency for losses to have greater psychological impact than equivalent gains.
What is a decision weight?
The subjective influence assigned to an objective probability during evaluation.
What is myopic loss aversion?
Loss aversion combined with a short evaluation horizon that makes short-term outcomes salient.
Quiz questions
In prospect theory, what is the primary role of the editing phase?Answer: To organize and simplify possible outcomes before evaluation
What shape is the value function commonly described as having for losses?Answer: Convex, consistent with greater willingness to risk avoiding a sure loss
What does the probability-weighting function do in prospect theory?Answer: Transforms objective probabilities into subjective decision weights
Which combination defines myopic loss aversion?Answer: Loss aversion combined with a short evaluation horizon
How does cumulative prospect theory address a key problem of the original formulation?Answer: It uses rank-dependent probability weighting to address stochastic-dominance violations
Based on the Wikipedia article Prospect theory, licensed CC BY-SA 4.0. Adapted into a summary, flashcards and quizzes.