Prospect Theory: Leading Theories Of Human Decision Making

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One of the leading theories of human decision making is Prospect Theory (Kahneman & Tversky, 1979). It is a more psychologically accurate approach to describing human decision making, compared to the expected utility theory. In particular, an important element of prospect theory, reference-dependent preferences, is based on the main idea that an individual’s assessment of an outcome, is not only determined by the outcome itself but how the outcome compares to a reference point. In doing so, it typically assumes that outcomes relative to the reference point; are evaluated by an S-shaped value function – capturing two key components: loss aversion (suggesting losses hurt more than gains feel good) and diminishing sensitivity (by being convex in losses, but concave in gains) (Kahneman & Tversky, 1984). A leading theory of reference-dependence developed by Köszegi and Rabin (2006) assumes reference points are based on expectations, formed by the beliefs an individual held in the recent past. The intuition being that if the expectations of an individual fail to match their outcome, their utility is lowered by the lack of fulfillment of these expectations. While it can be difficult to define and observe reference points in the field, recent papers aiming to find evidence of (expectation-based) reference-dependence and loss aversion take advantage of professional sports tournaments (Pope et al., 2011; Grund & Gürtler, 2005; Bartling et al., 2015). Professional sports provide an

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