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The prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. Starting from empirical evidence, it describes how individuals evaluate losses and gains. In the original formulation the term prospect referred to a lottery. The theory is basically divided into two stages, editing and evaluation. In the first, the different choices are ordered following some heuristic so as to let the evaluation phase be more simple. The evaluations around losses and gains are developed starting from a reference point. The value function which passes through this point is s-shaped and as it is asymmetric implies, given the same variation in absolute value, a bigger impact of losses than of gains ( loss aversion). Some behaviors observed in economics, like the disposition effect or the reversing of risk aversion/ risk seeking in case of gains or losses (termed the reflection effect), can 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 of prospect theory, in particular, has been widely used in behavioural 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 puzzleThe equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are higher, by approximately 6%, than returns on government bonds. Economists expect arbitrage opportunities would reduce the difference in returns on, the status quo biasStatus quo bias is cognitive bias for the status quo; in other words, people like things to stay relatively the same. The finding has been observed in many fields, including political science, economics and question framing. Kahneman, Thaler and Knetch cr, various gambling and betting puzzles, intertemporal consumption and the endowment effectThe endowment effect is a hypothesis that people value a good (object) more once their property right to it has been established. In other words, people value something more as soon as they own it. In one experiment, people demanded a higher price for a c.
Another possible implication of prospect theory for economics is that utilityThis article is about "utility" in economics and in game theory. For utility companies and similar concepts, see public utility. For utilities in computers, see computer software. In economics, utility is a measure of the happiness or satisfaction gained might be reference based, in contrast with additive utility functions underlying much of neo-classical economics. This hypothesis is consistent with psychological research into happinessThis article is about an emotion. Happiness is also a 1998 U. film written and directed by Todd Solondz. See also Joy for the disambiguation of that term. Happiness pleasure or joy is the emotional state of being happy . The definition of happiness is one which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in wellbeing (Easterlin, 1974; Frank, 1997)
- Kahneman, Daniel, and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk" Econometrica, XVLII (1979), 263-291.
Economics
