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
Kahneman’s article is an analysis of intuitive thinking and how it guides our decision-making. Although primarily aimed at the field of psychology, it is an interdisciplinary article with applications in economic theorising. Kahneman attempts to differentiate between two systems of thought, one of intuition (system 1) and one of reasoning (system 2), and argues that many judgements and choices are made intuitively, rather than with reason (a slower and more deliberate process). Intuitive decision making, which encompasses heuristics, although generally more efficient and rapid, makes the agent potentially subject to errors due to framing effects or violations of dominance. The analysis of the studies and theoretical situations also provides criticism of the commonly held model of the rational agent within economics. The article also further conceptualises Kahneman’s theory, the Prospect Theory (Kahneman & Tversky, 1979), which has descriptive applications of people’s choice in decision-making situations involving risk and known probability of outcomes. These situations are typically unexplained by the more normative rational agent model.
3. Risk acceptance is especially useful for the risks with low likelihood. For a smaller
The Law of diminishing returns states that if one factor of production is increased while the others remain constant, the overall returns will relatively decrease after a certain point. The total fixed cost is the same regardless of the output; the total variable costs will change with the level of output resulting in the total cost as the sum of the fixed cost and variable cost at each level of output. Over the 0 to 4 range of output, the TVC and TC curves slope upward. They reflect a decreasing rate due to the increasing minor returns. The slopes curves will increase due to these diminishing marginal returns.
17. Environments exist when decision makers lack complete certainty regarding the outcomes of various courses of action, but they are aware of the probabilities associated with their occurrence
According to ASC 450-20-25-1, “When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. As indicated in the definition of contingency, the term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly
6. [LO 2] What does it mean to characterize a gain or loss? Why is characterizing a gain or loss important?
This paper will cover two criminological theories and they will be applied to two types of criminality. The two theories chosen for the paper were developmental theory and rational choice theory. The two types of crimes that were chosen were organized crime, specifically focusing on gangs, and terrorism. Then the crimes will be compared and contrasted. Finally, the developmental theory will be applied to organized crime to explain why and how it happens. The rational choice theory will be applied to terrorism to explain what compels individuals to attempt this form of criminality.
\noindent Now we will compare the risk measure determined by Corollary \ref{4-cl3} with other risk measures in literature.
Ritter (2003, p.429), describes behavioural finance is based on psychology which suggests that human decision processes are subject to several cognitive illusions. These illusions are divided into two groups as illusions caused by heuristic decision process and illusions rooted from the adoption of mental frames grouped in the prospect theory (Waweru et al., 2008, p.27)
In today’s economy, decision-making skills vary for each household; however, the bottom-line goal for every individual is to get the most for their money. In order to do this, there are 4 principles of individual decision-making: facing trade-offs, evaluating what one is giving up to obtain their goal, thinking at the margin, and responding to incentives.
Rational choice theory accepts that all individuals attempt to effectively expand their preference in any circumstance and in this way reliably attempt to minimize their misfortunes. The hypothesis depends on the possibility that all people construct their choices in light of sound figuring’s, act with discernment when picking, and intend to increment either delight or benefit. Rational choice theory likewise stipulates that all unpredictable social wonders are driven by individual human activities. Accordingly, if a business analyst needs to clarify social change or the activities of social organizations, he needs to take a look at the balanced choices of the people that make up the entirety.
2. Compares the returns of the asset to the market over a period of time (Beta)
4. Excess Return was obtained from the difference between Actual and Expected Return. Excess Return = Actual Return – Expected Return
3) Based on the data in Exhibit 7 and the definition of operating income gains given
Classical decision making theory based on the orientation of the decision makers, such as, economics or market conditions values. A “rational choice” is one which is based on relatively fixed preferences and follows a logic of consequence, by which current actions are dictated by anticipation of the value associated with future outcomes (March, 1994). After finding and gathering info and fact, decision makers are assumed to choose among alternatives by some values (minimizing bad consequence and regret, maximazing profits). However,