Prospect Theory Of Decision Making

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Prospect theory Young Joon Suh Definition Prospect theory is a theory of decision making that involves risk and uncertainty. It is an economic theory with psychological elements that aims to explain how people decide between alternatives with probabilistic gains and losses. The theory is based on the premise that people make choices based upon their psychological value of potential losses and gains rather than the final outcome. Prospect theory explains why people make decisions that deviate from rational decision making by examining how the expected outcomes of alternative choices are perceived (Kahneman & Tversky, 1979). Historical background Until 1970s, the dominant theory for decision making research was Expected utility theory (Barberis,…show more content…
The first is editing phase in which decision makers edit a complicated decision into a simpler decision, usually specified in terms of gains versus losses. A key feature of this editing phase is that the way in which people edit or simplify a decision may vary from one moment to the next, depending on situational circumstances. Kahneman and Tversky referred this phenomenon as ‘reference dependent’, meaning that people evaluate losses and gains in terms of changes relative to their reference point. The status quo is often the reference point, but it can be an expected outcome or what people feel they are entitled to (Samuelson & Zeckhauser, 1988). Outcomes that are above the reference point are classed as gains, while any outcomes that are below the reference point are perceived as a loss. The second is evaluating phase in which decision makers choose between the edited options available to them. This choice is based on two dimensions, the apparent value of each attribute or option and the weight assigned to those values or options. These two features—overall value and its weight—are then combined by the decision maker, and the option with the highest combined value is chosen by the decision maker (Kahneman & Tversky, 1979). One prominent feature of the second stage is ‘loss aversion’, meaning that people dislike making a loss more than they do winning (Kahneman & Tversky, 1979). Loss aversion is robust and widely documented across experimental researches and real-life situations. It is probably an evolutionary trait because animals that see threats as more important than opportunities have a greater chance to survive and reproduce (Chen, Lakshminaryanan, & Santos,

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