Prospect Theory

Prospect theory has done more to bring psychology into the heart of economic analysis than any other approach. Prospect theory, developed by Kahneman and Tversky (1979)48 and Tversky and Kahneman (1974, 1981)49 was proposed as a best practice alternative to conventional wisdom. Prospect theory is a theory of average behaviour. It theorizes how an individual or group of individuals behaves, on average, in a world of uncertainty.

The prospect theory is proposed by Daniel Kahneman and Tversky. They describe how people frame and value decision involving uncertainty. According to Prospect theory, people look at choices in terms of potential gains or losses in relation to specific reference point, which is often a purchase price. People feel more strongly about the pain from loss then the pleasure from equal gain.

Prospect theory is a representation of the statistical average of individual behaviours. Thus, there will be deviations from the mean. For example, a subsample of individuals behaving in a consistently deviant fashion can help explain important aspects of choice behaviour, whether or not such behaviour is consistent with the conventional wisdom or prospect theory. Nevertheless, the underlying empirics of prospect theory with regard to average choice behaviour have been well documented.

As Tversky and Kahneman (1981)50 write:

“Prospect theory and the scales [used in this theory] should be viewed as an approximate, incomplete, and simplified description of the evaluation of risky prospects. Although the properties of v and n summarize a common pattern of choice, they are not universal: the preferences of some individuals are not well described by an S-shaped value function and a consistent set of decision weights.”

Fig shows value function- this is prospect theory’s equivalent of classical economic utility function. However, it is defined over gains and losses around a reference point. The reference point is determined by the subjective feelings of the individual. It is the individuals’ point of reference, the benchmark against which all comparison is made. Value function is concave for gains and convex for losses. This means that value function is steeper for losses than for gains- this is referred as loss aversion.

Three unique features of prospect theory:

• Prospect theory assumes that choice decisions are based upon a subjectively determined reference point independent of the decision maker’s state of wealth.
• Subjective reference points introduce a frame to a prospect, which affects choice behaviour.
• A kink exists at the reference point of prospect theory’s value function, assuming individuals weight losses at above twice that of gains.

Individuals tend to think in terms of gains and losses rather than a state of wealth. For example, if there are two people, one of them learns that his wealth has gone from 1 million to 1.3 million while other one learns that his wealth gone down from 5 million to 4.5 million. Most of the people will say that the first guy is happier. However if we look in terms of finance, the second person should be better pay off in terms of total wealth.

The Prospect theory explains that people focus on the outcomes of their decisions. This is in contrast to Bernoulli’s expected utility theory that looked at the utility of the state of wealth. TheProspect Theory of Kahneman and Tversky follow value functions. Reference points serve to frame the decision parameters. Thus, gain and losses are evaluated both separately and relatively, as opposed to simultaneously and in terms of absolute values of state of wealth.