Prospect Theory - Explained
What is Prospect Theory?
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Table of ContentsWhat is Prospect Theory?How does Prospect Theory Work?
What is Prospect Theory?
The prospect theory is a theory that believes that people make certain decisions and exhibit certain behaviors when faced with choices that involve probability.
As an economic theory, the prospect theory maintains that individuals value losses and profits differently and often base their decisions on perceived gains rather than losses.
More specifically, individuals have a higher tendency of choosing potential gains instead of minimizing losses when given two options.
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How does Prospect Theory Work?
The prospect theory was first formulated in 1979 before it was later developed and improved upon by Amos Tversky and Daniel Kahneman in 1992.
This theory is a branch in behavioral economics that describes the decision-making habits of individuals when faced with two choices, involving different risks and different benefits.
It studies the psychology behind the accuracy of decisions made by individuals in risk conditions. According to this theory, if two options, one of the losses and the other of gains are presented to individuals, they would choose the option with gains over the one with losses.
This also explains the loss aversion attributes of humans in which the probability of gain is preferred and chosen over the probability of loss.
According to the proponents of the prospect theory, losses trigger more emotions than equivalent gains, when these options are presented with the same result, an individual will pick the potential gain over the perceived losses.
This shows that individuals select the more favorable option, Regardless of what the underlying risks might be.