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Prospect Theory Definition
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 decision son perceived gains rather than losses.
The prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. This theory is also called the “loss-aversion” theory, in which individuals have a higher tendency of choosing potential gains instead of losses when given two options. The prospect theory is also a behavioral theory that gives an explanation to how people behave when presented with two alternatives.
A Little More on What is Prospect Theory
The prospect theory studies the psychology and behavior of humans when making a decision under conditions of risk. Using losses and gains as focus points, this theory explains the ‘loss aversion’ tendencies of humans in which they will choose gains over losses when presented with the two options. For instance, a market investor who has two investment options, one with a 10% return (gain) and 15% losses and the other with 5% gain and 3% losses, the investor is likely to pick the former investment option over the latter.
Behind Prospect Theory
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.
Perceived Gains Over Perceived Losses
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.
Certainty and Isolation Effects in Prospect Theory
In the prospect theory, Tversky and Kahneman posited that certainty occurs when individuals select or prefer outcomes that are only probable. Once an individual is certain of an outcome, he then avoids the other option by all means. Certainty contributes to how people make decisions when given two options, if the tendency of making gains is certain then risk will be avoided, Risk will, however, be embraced if the tendency of making a loss is certain. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain.
The isolation effect, on the other hand, occurs when people have two options with the same outcome, but different ways to arrive at the outcome. Given this, individuals will isolate a particular method or method to achieve the outcome, thereby canceling other similar methods.