What is Prospect Theory?
cartoon via XKCD.com
text via Behaviouralfinance.net
Prospect theory has probably done more to bring psychology into the heart of economic analysis than any other approach. Many economists still reach for the expected utility theory paradigm when dealing with problems, however, prospect theory has gained much ground in recent years, and now certainly occupies second place on the research agenda for even some mainstream economists. Unlike much psychology, prospect theory has a solid mathematical basis — making it comfortable for economists to play with. However, unlike expected utility theory which concerns itself with how decisions under uncertainty should be made (a prescriptive approach), prospect theory concerns itself with how decisions are actually made (a descriptive approach).
Prospect theory was created by two psychologists, Kahneman and Tversky, who wanted to build a parsimonious theory to fit a number of violations of classical rationality that they (and others) had uncovered in empirical work. Prospect theory bears more than a passing resemblance to expected utility theory.” Montier (2002) p 20 READ MORE
text via Wikipedia
Some behaviors observed in economics, like the disposition effect (PDF) or the reversing of risk aversion/risk seeking in case of gains or losses (termed the reflection effect), can also be explained referring to the prospect theory.
An important implication of prospect theory is, that the way economic agents subjectively frame an outcome or transaction in their mind, affects the utility they expect or receive. This aspect has been widely used in behavioral economics and mental accounting. Framing and prospect theory has been applied to a diverse range of situations which appear inconsistent with standard economic rationality; the equity premium puzzle, the status quo bias, various gambling and betting puzzles, intertemporal consumption and the endowment effect.
Another possible implication for economics is that utility might be reference based, in contrast with additive utility functions underlying much of neo-classical economics. This means people consider not only the value they receive, but also the value received by others. This hypothesis is consistent with psychological research into happiness, which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in the standard of living (Easterlin, 1974; Frank, 1997). READ MORE
RELATED WRITINGS (by Raphie Frank)
Synchronicities of the Happily Converging Road
The Mathematics of Opportunity
Introducing “Trickle Up Economics” (aka “The One Song”)
1 Comment »