- Prospect theory
**Prospect theory**is a theory that describes decisions between alternatives that involverisk , i.e. alternatives with uncertain outcomes, where the probabilities are known. The model isdescriptive : it tries to model real-life choices, rather than optimal decisions.**Model****Prospect theory**was developed byDaniel Kahneman , professor atPrinceton University 's Department of Psychology, andAmos Tversky in1979 as a psychologically realistic alternative to expected utility theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g. in financial decisions.Starting fromempirical evidence, the theory describes how individuals evaluate potential losses and gains. In the original formulation the term "prospect" referred to alottery .The theory describes such decision processes as consisting of two stages, editing and evaluation. In the first, possible outcomes of the decision are ordered following some

heuristic . In particular, people decide which outcomes they see as basically identical and they set a reference point and consider lower outcomes as losses and larger 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.The formula that Kahneman and Tversky assume for the evaluation phase is (in its simplest form) given by$U=w(p\_1)v(x\_1)+w(p\_2)v(x\_2)+dots,$where $x\_1,x\_2,dots$ are the potential outcomes and $p\_1,p\_2,dots$ their respective probabilities. $v$ is a so-called value function that assigns a value to an outcome.The value function (sketched in the Figure) which passes through the reference 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 ). In contrast to Expected Utility Theory, it measures losses and gains, but not absolute wealth. The function $w$ is called a probability weighting function and expresses that people tend to overreact to small probability events, but underreact to medium and large probabilities.To see how Prospect Theory (PT) can be applied in an example, consider a decision about buying an insurance policy. Let us assume the probability of the insured risk is 1%, the potential loss is $1000 and the premium is $15. If we apply PT, we first need to set a reference point. This could be, e.g., the current wealth, or the worst case (losing $1000). If we set the frame to the current wealth, the decision would be to either pay $15 for sure (which gives the PT-utility of $v(-15)$) or a lottery with outcomes $0 (probability 99%) or $-1000 (probability 1%) which yields the PT-utility of $w(0.01)\; imes\; v(-1000)+w(0.99)\; imes\; v(0)=w(0.01)\; imes\; v(-1000)$. These expressions can be computed numerically. For typical value and weighting functions, the former expression could be larger due to the convexity of $v$ in losses, and hence the insurance looks unattractive. If we set the frame to $-1000, both alternatives are set in gains. The concavity of the value function in gains can then lead to a preference for buying the insurance.

We see in this example that a strong overweighting of small probabilities can also undo the effect of the convexity of $v$ in losses: the potential outcome of losing $1000 is overweighted.

The interplay of overweighting of small probabilities and concavity-convexity of the value function leads to the so-called "four-fold 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. This is an explanation for the fact that people, e.g., simultaneously buy lottery tickets and insurances, but still invest money conservatively.

**Applications**Some behaviors observed in

economics , like thedisposition effect or the reversing ofrisk aversion /risk seeking in case of gains or losses (termed the "reflection effect"), can also be explained by referring to the prospect theory.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 orworse off. This is a possible explanation for why the same person may buy both aninsurance policy and alottery ticket.An important implication of prospect theory is that the way economic agents subjectively frame an outcome or transaction in their mind affects the utility they expect or receive. This aspect has been widely used in

behavioral economics andmental accounting . Framing and prospect theory has been applied to a diverse range of situations which appear inconsistent with standard economic rationality; theequity premium puzzle , thestatus quo bias , various gambling and betting puzzles,intertemporal consumption and theendowment effect .Another possible implication for economics is that

utility might be reference based, in contrast with additive utility functions underlying much ofneo-classical economics . This means people consider not only the value they receive, but also the value received by others. This hypothesis is consistent withpsychological research intohappiness , which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in the standard of living (Easterlin, 1974; Frank, 1997).Military historian John A. Lynn argues that prospect theory provides an intriguing if not completely verifiable framework of analysis for understanding

Louis XIV 'sforeign policy nearer to the end of his reign. As he briefly explains the theory, it "argues that individuals choose actions or objects not simply by rationally weighing their intrinsic utility. The theory states this by arguing that people measure utility by some variable reference point, not by some immutable scale. . . Tests show that people place higher value on things that they already regard as their own than on comparable things that they do not possess." Applied to Louis XIV's foreign policy, it promises to explain his actions that helped lead to theNine Years War and theWar of the Spanish Succession . Lynn elaborates, asserting that " [a] ccording to prospect theory, it would be entirely reasonable for Louis to invest great effort and accept high risk in the name of defending his old territories and new acquisitions. Here extreme behavior would be the natural product of a defensive mentality and not of an acquisitive drive." (Lynn, pp. 43-44)**Limits and extensions**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 introducingintransitivity in preferences. A revised version, calledcumulative prospect theory overcame this problem by using a probability weighting function derived fromRank-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 anyreal number ).Recently, scholars have connected prospect theory to

optimal foraging theory , noting that survival thresholds might be responsible for the origin of prospect theory preferences in humans (McDermott et al. 2008).**ources*** Easterlin, Richard A. (1974) "Does Economic Growth Improve the Human Lot?" in Paul A. David and Melvin W. Reder, eds., "Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz", New York: Academic Press, Inc.

* Frank, Robert H. (1997) "The Frame of Reference as a Public Good", "The Economic Journal" 107 (November), 1832-1847.

* Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", "Econometrica", XLVII (1979), 263-291.

* Lynn, John A. (1999) "The Wars of Louis XIV 1667-1714". United Kingdom: Pearson Education Ltd.

* 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

* 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" (April 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://www.ssrn.com/abstract=636508

* http://prospect-theory.behaviouralfinance.net/**External links*** [

*http://www.econport.org/econport/request?page=man_ru_advanced_prospect An introduction to Prospect Theory*]

*Wikimedia Foundation.
2010.*

### Look at other dictionaries:

**Prospect Theory**— Die Prospect Theory, im Deutschen auch Neue Erwartungstheorie genannt, wurde 1979 von Daniel Kahneman und Amos Tversky als eine psychologisch realistischere Alternative zu der Erwartungsnutzentheorie vorgestellt.[1] Sie erlaubt die Beschreibung… … Deutsch Wikipedia**Prospect theory**— Die Prospect Theory, im Deutschen auch Neue Erwartungstheorie genannt, wurde 1979 von Daniel Kahneman und Amos Tversky als eine psychologisch realistischere Alternative zu der Erwartungsnutzentheorie vorgestellt.[1] Sie erlaubt die Beschreibung… … Deutsch Wikipedia**Prospect Theory**— A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in… … Investment dictionary**prospect theory**— A theory, developed by the economists Daniel Kahneman and Amos Tversky, that seeks to explain how individuals make decisions when faced with uncertainty. It is central to the growing area of research known as behavioural finance, which posits… … Big dictionary of business and management**Cumulative prospect theory**— Daniel Kahneman Cumulative prospect theory (CPT) is a model for descriptive decisions under risk which was introduced by Amos Tversky and Daniel Kahneman in 1992 (Tversky, Kahneman, 1992). It is a further development and variant of prospect… … Wikipedia**Theory of conjoint measurement**— The theory of conjoint measurement (also known as conjoint measurement or additive conjoint measurement) is a general, formal theory of continuous quantity. It was independently discovered by the French economist Gerard Debreu (1960) and by the… … Wikipedia**Prospect Park Zoo**— Infobox zoo zoo name = Prospect Park Zoo logo caption = Logo of Prospect Zoo, part of the Wildlife Conservation Society logo width = 207px location = 450 Flatbush Avenue, Brooklyn, New York, USA 11225, in Prospect Park date opened = 1890 (a… … Wikipedia**Prospect High School (Illinois)**— Infobox Secondary school name = Prospect High School logo = motto = established = 1957 (Arlington HS) 1958 (Prospect HS) principal = type = Public secondary grades = 9–12 city = 801 W. Kensington Rd. Mt. Prospect state = Illinois country = USA… … Wikipedia**prospect**— A potential customer. ► “The more that is learned about customers and prospects, the less they fit into the normally distributed theory.” (Journal of Direct Marketing, Winter 1995, p. 5) … American business jargon**Optimal foraging theory**— Ants dismember a larger insect. Optimal foraging theory predicts these insects will forage in such a way as to maximize their colony s energy intake per unit time. Optimal foraging theory is an idea in ecology based on the study of foraging… … Wikipedia