Prospect Theory: Avioral Economic Theory

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Prospect theory is a behavioural economic theory, which describes the way people behave when given the choice between alternatives. This can involve risk, probability and uncertainty. This theory assumes that these individuals will make decisions that are based on expectations of either a loss of gain, demonstrating that people often think in terms of expected utility, relative to a reference point. For example current wealth rather than absolute outcomes, which can therefore indicate that individuals become loss averse because when they are given a choice of equal probability, they are more likely to choose to preserve their existing wealth, rather than risk the chance to increase wealth. Prospect theory therefore can explain why people exhibit…show more content…
For example, in peoples mind, it is better to not lose £10 rather than to find £10. Therefore, loss aversion can be useful in explaining the sunk cost fallacy and endowment effect. In loss aversion, the value function is often steeper for losses than for gains. Individuals can have bounded rational behaviour and rational behaviour in regards to loss aversion. Rational behaviour, in decision making, is often based on individual choices that result in the most optimal level of benefit or utility in the future whereas bounded rational behaviour refers to the idea that most consumers and businesses do no not have the sufficient information to make fully-informed judgements when making their decisions and so often opt to satisfice rather than maximise. For example, individuals that have rational behaviour are more likely to prefer to avoid losses rather than gains because it will be more advantageous and favour them, enabling them to achieve the optimal level of utility. Whereas an individual that have bounded rational behaviour, will use heuristics and so will make quick and satisfactory answers, and so are more likely satisfice because of lack of information, systematically deviating and so explains why individuals tend to be loss averse. Bounded rational behaviour differs from rational behaviour because it is less costly for firms or people to identify…show more content…
This function considers valuation of losses and gains and in the diagram, gains and losses are treated separately in order to emphasize the characteristics of loss aversion. This is shown by the value of a loss of fixed size being larger than the value of an equivalent gains. The graph shows a concave shape for gains, showing that a person is risk averse whereas a convex curve indicate losses and therefore shows a person is risk seeking. The curve kinks at the origin, which is the reference point, such as wealth or ambition, and it is usually the target where the value function is not about looking at what you have now but how it compares to the reference point. This reference point shows an individual’s behaviour at the domain of gains risk averse but show risk seeking behaviour in terms of potential

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