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The Prospect Theory, A Behavioral Economic Theory

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Prospect theory is a Behavioural Economics Theory which tries to understand how people take decisions in terms of two alternatives, which have a probabilistic nature. These decision making processes and their respective outcomes also involve risk. An important point of the Prospect Theory is that it considers the fact that the outcomes of the alternatives are known. The basic idea behind the theory is that people base their decisions on potential gains and losses, rather than thinking about the final outcome. The theory is of the idea that people make such decisions about gains and losses with the help of heuristics. The theory has been very critical in its application as it tries to bring forth a model which is much more realistic in nature, …show more content…

In the equation, xi refers to the total number of possible outcomes and pi shows the probability of those respective outcomes. In the equation w is referred to as the weighing function for the probabilities which therefore shows that people tend to overreact to certain situations of smaller probability as compared to larger probabilities.

MAJOR FEATURES

1) The coefficients of values are just gains and losses which are not to be confused with final wealth. 2) The model is able to represent greater sensitivity towards losses as compared to gains.
3) The function is convex for losses that would occur out of the possible outcomes and concave for any sort of gain.
4) Weighing function helps to overweigh smaller probabilities.

APPLICATIONS OF PROSPECT THEORY

Barberis (2013) paper is a review of the applications of Prospect Theory. As some argue that the Prospect Theory only works well under a laboratory setting, the author has other ideas to share. According to Barberis, Prospect Theory is just not well made to be directly applied. The paper is able to trace down the various advancements that have come up in terms of Prospect

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