A Review Of Prospect Theory
Introduction (Via SSRN)
Prospect theory is a descriptive theory of how individuals choose among risky alternatives. The theory challenged the conventional wisdom that economic decision makers are rational expected utility maximizers. We present a number of empirical demonstrations that are inconsistent with the classical theory, expected utility, but can be explained by prospect theory. We then discuss the prospect theory model, including the value function and the probability weighting function. We conclude by highlighting several applications of the theory.
Excerpts (Via SSRN)
The objective of prospect theory is to describe how people make decisions when there is uncertainty about the consequences of their choices. Decision theorists distinguish between: decision under risk, situations in which the likelihood of events are known or objective such as a spin of a roulette wheel); and decision under uncertainty, situations in which the decision maker must assess the probability of the uncertain events and hence the likelihood of events are subjective (such as the outcome of a sports game) . Although prospect theory applies to both risk and uncertainty we will focus on risk here for simplicity.
Example (Via SSRN)
In Situation 1, you are first given $1,000. You must now choose between two options. If you choose A, you will receive an additional $500 for sure. If you choose B, there is an equal chance that you will receive either an additional $1,000 or nothing.
Now consider Situation 2. This time you are first given $2,000. Again, there are two options. Perhaps you would like C, a sure loss of $500? Or, maybe you would prefer D, a 50% chance at losing $1,000 and a 50% chance at losing $0?
When confronted with Situation 1, most people prefer A, the sure $500, to the gamble B. On the other hand, when posed with a choice between C and D, most choose D, the uncertain loss, over the sure loss C. While both choices seem reasonable in isolation, Situation 1 and 2 are identical in terms of final consequences, reducing to a choice between $1,500 for sure (A and C), and a lottery that offers an even chance at $1,000 or $2,000 (B and D).