Making decisions is something that people do every day, knowingly or unknowingly. It is not surprising, that the topic of Decision-Making is shared by many disciplines, from Mathematics, Economics and Political Science, to Sociology and Psychology.

Analyses of Decision-Making usually discriminate between risky and riskless choices.

For instance, a risky choice would be leaving the house without taking the charger of your mobile phone, and have the risk to end up with an empty battery. The riskless choice, though, would be to think in advance and get your charger, thus eliminating the risk of an empty battery.

History

The choice of an act can be defined as a gamble that can yield various outcomes with different probabilities. The traditional finance theory assumes that investors try to maximize expected utility of wealth when they are making decisions under uncertainty. Daniel Bernoulli (1738), first published the theory of Expected Utility Theory, in an attempt to explain why people are generally averse to risk and why risk aversion decreases with increasing wealth.

Many studies have shown that the underlying assumptions of the traditional theory do not accurately describe how people actually behave when choosing among risky alternatives. We do not always process information in a rational way.

As a result, a theory was created in 1979 and it was further developed in 1992 by Daniel Kahneman and Amos Tversky and was awarded the Nobel Prize in Economics in 2002. This theory was a critique of expected utility theory as a descriptive model of decision making under risk. As a result, they developed an alternative theory, as a psychologically more accurate description of decision making, called Prospect Theory.

Prospect Theory

Prospect Theory is a Behavioural Economics theory which assumes that losses and gains are valued differently. Thus, investors make decisions based on perceived gains instead of perceived losses. So, if an individual has the opportunity to choose between two equal choices, one expressed in terms of possible gains and the other in terms of possible losses, he/she will choose the former.

The theory is also known as “loss aversion” theory. Simply put, people tend to prefer avoiding losses to acquiring equivalent gains. Tversky and Kahneman (1984) support the idea that losses cost psychologically more in comparison to equivalent gains. For example, the majority of people would regret much more if they would lose 50 euros that if they won 50 euros.

Prospect theory vs Expected Utility theory

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, although prospect theory has gained much ground in recent years, because of its mathematical basis which makes it easier for economists. Expected utility theory concerns itself with how decisions should be made, whereas prospect theory concerns itself with how decisions are actually made.

Conclusions

Prospect theory explains many biases where people rely when making decisions. Understanding these biases can help to persuade people to take action but also to be used in contexts such as advertising, ecology and charity.

Can we have a better understanding of our data using models based on psychologically realistic assumptions? What do you think?

Your opinion matters! Leave your feedback!

Natasha Karatza, Growth Strategist & Researcher for Nudge Unit Greece
~Explaining Behavioral Economics Simply~

Sources

Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American psychologist, 39(4), 341.

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica: Journal of the econometric society, 263-291.