Background
Prospect theory is a prominent theory within behavioral economics that provides an alternative to the traditional expected utility theory. Developed by Daniel Kahneman and Amos Tversky in 1979, prospect theory investigates how people decide between probabilistic alternatives that involve risk and uncertainty.
Historical Context
Introduced in the seminal paper “Prospect Theory: An Analysis of Decisions Under Risk”, this theory emerged from observed real-world behaviors that conflicted with the predictions of expected utility theory. Kahneman and Tversky’s work has been pivotal in understanding decision-making processes and has earned Kahneman the Nobel Memorial Prize in Economic Sciences in 2002.
Definitions and Concepts
Prospect theory’s core concepts include:
- Reference Dependence: Outcomes are evaluated relative to a reference point.
- Loss Aversion: Losses have a greater psychological impact than commensurate gains.
- Probability Weighting: People tend to overestimate small probabilities and underestimate large probabilities.
- Value Function: This is typically concave for gains and convex for losses, indicating diminishing sensitivity.
Major Analytical Frameworks
Classical Economics
Classical economics does not traditionally account for the psychological nuances captured by prospect theory, adhering instead to the rational actor model.
Neoclassical Economics
Similar to classical economics, neoclassical economics focuses on utility maximization and rational decision-making, often overlooking behavioral insights like those highlighted by prospect theory.
Keynesian Economics
While Keynesian economics emphasizes the role of psychology in economics—particularly in terms of investor behavior—prospect theory provides a more granular framework for understanding decision-making under risk.
Marxian Economics
Marxian economics primarily addresses class relations and dynamics of economic systems, which doesn’t typically employ the micro-level analytical lens provided by prospect theory.
Institutional Economics
Institutional economics examines the broader social and institutional influences on economic behavior, often aligning with the behavioral insights emphasized by prospect theory.
Behavioral Economics
Prospect theory is a cornerstone of behavioral economics, directly challenging the rationality assumption of orthodox economic theories and incorporating psychological factors into economic modeling.
Post-Keynesian Economics
This framework takes into account broader socio-economic factors and acknowledges psychological elements, aligning with the tenets of prospect theory.
Austrian Economics
Austrian economics, with its focus on the subjective nature of value, somewhat intersects with prospect theory, although it doesn’t systematize psychological biases in individual decision-making to the same extent.
Development Economics
Development economics can integrate insights from prospect theory to understand behaviors in varying economic contexts, especially in policy design to mitigate poverty and improve economic decision-making.
Monetarism
Monetarist theories focus on macroeconomic factors like the role of government and central banking, traditionally less concerned with individual decision-making quirks highlighted by prospect theory.
Comparative Analysis
Prospect theory contrasts with expected utility theory by emphasizing psychological and cognitive biases in decision-making under risk. This model aligns better with empirical findings where human behavior diverges from the predictions of expected utility theory.
Case Studies
Several case studies in financial markets, consumer behavior, and policy-making effectively demonstrate prospect theory’s application. Studies show that investors are risk-averse regarding gains but risk-seeking concerning losses, emphasizing loss aversion and probability weighting.
Suggested Books for Further Studies
- “Thinking, Fast and Slow” by Daniel Kahneman
- “Misbehaving: The Making of Behavioral Economics” by Richard H. Thaler
- “Nudge: Improving Decisions About Health, Wealth, and Happiness” by Richard H. Thaler and Cass R. Sunstein
Related Terms with Definitions
- Expected Utility Theory: A theory positing that individuals choose between risky options to maximize their expected utility.
- Behavioral Economics: A field that combines insights from psychology with economics to explore how people actually behave in economic situations.
- Loss Aversion: A concept within prospect theory that suggests losses are more psychologically impactful than equivalent gains.
