The Basics
- Simple definition: A behavioral economic theory describing how people make decisions under uncertainty, emphasizing that losses hurt more than equivalent gains feel good.
- Core idea: We evaluate outcomes relative to a reference point, not final wealth, and we hate losing.
- Think of it as: Losing Rs. 1,000 feels worse than gaining Rs. 1,000 feels good – loss aversion.
What It Actually Means
Developed by Kahneman and Tversky (Nobel Prize), prospect theory replaces expected utility theory. Key features: reference dependence (outcomes judged as gains/losses from a reference point), loss aversion (losses about twice as painful as gains pleasurable), diminishing sensitivity (marginal impact decreases), and probability weighting (overweight small probabilities, underweight large). Explains many anomalies – why people buy lottery tickets (overweight small win chance) and insurance (overweight small loss chance).
Example
A Pakistani investor faces a sure loss of Rs. 10,000 or a 50% chance to lose Rs. 20,000, 50% chance to lose nothing. Expected loss is the same, but prospect theory predicts many gamble (hope to avoid loss) – loss aversion makes sure loss painful. Different from rational predictions.
Why It Matters
Prospect theory explains financial behavior, insurance purchase, marketing (framing as gain vs loss), and policy design. It’s foundational to behavioral economics.
See also
Behavioral Economics • Loss Aversion • Expected Utility • Framing Effect • Endowment Effect
Read more about this with MASEconomics:
Behavioral Economics article (coming soon)