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+ | '''Prospect theory''' was developed by [[Daniel Kahneman]] and [[Amos Tversky]] in [[1979]]. Starting from [[empirical]] evidence, it describes how individuals evaluate [[loss|losses]] and [[gain]]s. In the original formulation the term prospect referred to a [[lottery]]. |
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− | [[File:Daniel KAHNEMAN.jpg|thumb|180px|[[Daniel Kahneman]], who won a Nobel Prize in Economics for his work developing Prospect theory.]] |
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− | '''Prospect theory''' is a [[behavioral economic theory]] that describes decisions between alternatives that involve [[risk]], where the probabilities of outcomes are known. The theory says that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using interesting heuristics. |
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− | The model is [[descriptive]]: it tries to model real-life choices, rather than [[optimal decision]]s. The paper "Prospect Theory: An Analysis of Decision under Risk" has been called a "seminal paper in [[behavioral economics]]".<ref name=rationality>{{cite journal|coauthors=Eldar Shafir and Robyn A. LeBoeuf|title=Rationality|journal=Annual Review of Psychology|year=2002|month=February|volume=53|pages=491-517|doi=10.1146/annurev.psych.53.100901.135213|url=http://www.annualreviews.org/doi/abs/10.1146/annurev.psych.53.100901.135213|accessdate=April 23, 2012|pmid=11752494}}</ref> |
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+ | The theory is basically divided into two stages, editing and evaluation. In the first, the different choices are ordered following some [[heuristic]] so as to let the evaluation phase be more simple. The evaluations around losses and gains are developed starting from a reference point. The value function (sketched in the Figure) which passes through this point is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains ([[loss aversion]]). 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 be explained referring to the prospect theory. |
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⚫ | An important implication of prospect theory is that the way economic agents subjectively [[framing (economics)|frame]] an outcome or transaction in their mind affects the utility they expect or receive. This aspect of prospect theory, in particular, has been widely used in [[behavioural 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, intertemporal consumption and the [[endowment effect]]. |
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− | ==Model== |
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− | The theory was developed by [[Daniel Kahneman]], a professor at [[Princeton University]]'s [[Princeton University Department of Psychology|Department of Psychology]], and [[Amos Tversky]] in 1979 as a [[psychology|psychologically]] more accurate description of [[preferences]] compared to [[expected utility hypothesis|expected utility theory]]. It describes how people choose between [[probabilistic]] alternatives and evaluate potential losses and [[Gain (finance)|gain]]s. In the original formulation the term ''prospect'' referred to a [[lottery]]{{cn|date=November 2011}}. |
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⚫ | Another possible implication of prospect theory for economics is that [[utility]] might be reference based, in contrast with additive utility functions underlying much of [[neo-classical economics]]. This hypothesis is consistent with [[psychological]] research into [[happiness]] which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in wellbeing (Easterlin, 1974; Frank, 1997) |
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− | The theory describes the decision processes in two stages, editing and evaluation. In the first, outcomes of the decision are ordered following some [[heuristic]]. In particular, people decide which outcomes they see as basically identical, set a reference point and then consider lesser outcomes as losses and greater ones as gains. In the following evaluation phase, people behave as if they would compute a value ([[utility]]), based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility. |
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⚫ | 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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− | The formula that Kahneman and Tversky assume for the evaluation phase is (in its simplest form) given by |
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+ | ==Sources== |
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− | :<math>U = \sum_{i=1}^{n} w(p_i)v(x_i) = w(p_1)v(x_1)+w(p_2)v(x_2)+\dots+w(p_n)v(x_n),</math> |
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− | where <math>U</math> is the overall or expected utility of the outcomes to the individual making the decision, <math>\scriptstyle x_1,x_2,\dots</math> are the potential outcomes and <math>\scriptstyle p_1,p_2,\dots</math> their respective probabilities. <math>\scriptstyle v</math> is a so-called value function that assigns a value to an outcome. The value function (sketched in the Figure) that passes through the reference point is s-shaped and asymmetrical. Losses hurt more than gains feel good ([[loss aversion]]). This differs greatly from [[expected utility theory]], in which a rational agent is indifferent to the reference point. In [[expected utility theory]], the individual only cares about absolute wealth, not relative wealth in any given situation. The function <math>\scriptstyle w</math> is a probability weighting function and expresses that people tend to overreact to small probability events, but underreact to medium and large probabilities. |
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− | To see how Prospect Theory (PT) can be applied in an example, consider the decision to buy insurance. Assuming the probability of the insured risk is 1%, the potential loss is $1,000 and the premium is $15. If we apply PT, we first need to set a reference point. This could be the current wealth or the worst case (losing $1,000). If we set the frame to the current wealth, the decision would be either to |
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− | 1. Pay $15 for sure, which yields a PT-utility of <math>\scriptstyle v(-15)</math>, |
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− | OR |
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− | 2. Enter a lottery with possible outcomes of $0 (probability 99%) or -$1,000 (probability 1%), which yields a PT-utility of <math>\scriptstyle w(0.01) \times v(-1000)+w(0.99) \times v(0)=w(0.01) \times v(-1000)</math>. |
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− | These expressions can be computed numerically. For typical value and weighting functions, the latter expression could be larger due to the convexity of <math>\scriptstyle v</math> in losses, and hence the insurance looks unattractive. If we set the frame to −$1,000, both alternatives are set in gains. The concavity of the value function in gains can then lead to a preference for buying the insurance. |
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− | In this example, a strong overweighting of small probabilities can also undo the effect of the convexity of <math>\scriptstyle v</math> in losses: the potential outcome of losing $1,000 is overweighted. |
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− | The interplay of overweighting of small probabilities and concavity-convexity of the value function leads to the so-called ''fourfold pattern of risk attitudes'': risk-averse behavior in gains involving moderate probabilities and of small probability losses; risk-seeking behavior in losses involving moderate probabilities and of small probability gains. |
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− | ==Applications== |
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− | 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 by referring to the prospect theory. |
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− | The [[pseudocertainty effect]] is the observation that people may be risk-averse or risk-acceptant depending on the amounts involved and on whether the gamble relates to becoming better off or worse off. This is a possible explanation for why the same person may buy both an insurance policy and a lottery ticket. |
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⚫ | An important implication of prospect theory is that the way economic agents subjectively [[framing (economics)|frame]] an outcome or transaction in their mind affects the utility they expect or receive. This aspect has been widely used in [[ |
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⚫ | Another possible implication for economics is that [[utility]] might be reference based, in contrast with additive utility functions underlying much of [[neo-classical economics]] |
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− | Military historian John A. Lynn argues that prospect theory provides an intriguing if not completely verifiable framework of analysis for understanding [[Louis XIV]]'s [[foreign policy]] nearer to the end of his reign (Lynn, pp. 43–44). |
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− | ==Limits and extensions== |
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⚫ | The original version of prospect theory gave rise to violations of first-order [[stochastic dominance]]. That is, prospect |
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− | ==See also== |
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− | *[[Endowment effect]] |
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− | *[[Framing effect]] |
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− | *[[Loss aversion]] |
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− | *[[Risk aversion]] |
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− | *[[Risk seeking]] |
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− | ==Notes== |
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− | {{reflist}} |
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− | ==References== |
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* Frank, Robert H. (1997) "The Frame of Reference as a Public Good", ''The Economic Journal'' 107 (November), 1832-1847. |
* Frank, Robert H. (1997) "The Frame of Reference as a Public Good", ''The Economic Journal'' 107 (November), 1832-1847. |
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− | * Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", ''Econometrica'', |
+ | * Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", ''Econometrica'', XVLII (1979), 263-291. |

− | * Lynn, John A. (1999) ''The Wars of Louis XIV 1667-1714''. United Kingdom: Pearson Education Ltd. |
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− | * McDermott, Rose, [[James H. Fowler]], and Oleg Smirnov. "On the Evolutionary Origin of Prospect Theory Preferences." ''Journal of Politics'', forthcoming (April 2008) Paper available at SSRN: http://www.ssrn.com/abstract=1008034 |
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− | * Post, Thierry, Van den Assem, Martijn J., Baltussen, Guido and Thaler, Richard H., "Deal or No Deal? Decision Making Under Risk in a Large-Payoff Game Show." American Economic Review, March 2008. Paper available at SSRN: http://www.ssrn.com/abstract=636508 |
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− | ==External |
+ | ==External link== |

* [http://www.econport.org/econport/request?page=man_ru_advanced_prospect An introduction to Prospect Theory] |
* [http://www.econport.org/econport/request?page=man_ru_advanced_prospect An introduction to Prospect Theory] |
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− | * [http://prospect-theory.behaviouralfinance.net/ Prospect Theory] |
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− | {{DEFAULTSORT:Prospect Theory}} |
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− | [[Category:Behavioral finance]] |
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+ | [[category:Marketing]] |
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− | [[Category:Behavioral economics]] |
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+ | [[category:Finance theories]] |
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− | [[Category: |
+ | [[Category:Motivation]] |

− | [[Category: |
+ | [[Category:Psychological theories]] |

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− | [[Category:Decision theory]] |
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+ | **** |
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− | [[Category:1979 introductions]] |
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+ | **** |
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− | [[Category:Framing (social sciences)]] |
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− | [[Category:Prospect theory| ]] |
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− | [[es:Teoría de las perspectivas]] |
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− | [[ko:전망이론]] |
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− | [[it:Teoria del prospetto]] |
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− | [[ja:プロスペクト理論]] |
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− | [[pl:Teoria perspektywy]] |
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