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Prospect Theory in Economics: Definition & Example

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll discuss prospect theory. We'll go through a thought experiment similar to the ones the theory's developers fell for when they were vetting the idea in the late 1970s. Then, we'll look at examples of prospect theory and discuss its implications.

Prospect Theory

Imagine you have two options to choose from. Option A - you have a 50% chance of winning $5,000 and a 50% chance of losing $8,000. Option B - you have a 100% chance of losing $1,000. Which option would you choose?

If we gave 1,000 people those two options, most of them would choose Option A. You probably would choose Option A as well, right? What if I gave you those two options each day for 100 straight days? The only catch is your choice needs to stay consistent. If you choose Option A on Day 1, you need to choose Option A for all 100 days, and the same is true if Option B is your choice on Day 1. Would you still choose the same option as before?

To answer that second question, you may have done a quick expected value calculation in your head. It would have looked something like this: Option A = (50% x $5,000) + (50% x -$8,000) = -$1,500. Option B = -$1,000. For those 100 days you would have lost $150,000 if you chose Option A, and you would have lost $100,000 if you chose Option B.

Isn't that interesting! The knee jerk reaction causes you to lose $50,000 more. Even if people knew the expected value over the course of 100 days, they will still choose Option A if they are told to make the decision just once.

In this lesson, we will try to answer the question - why do we choose Option A, a clearly inferior choice? Our lesson will lead to a discussion of prospect theory, an economic theory developed by Daniel Kahneman and Amos Tversky in 1979 which won them the Nobel Prize in Economics and introduced a powerful, and yet unnerving thought: What if humans aren't as rational as we think we are.

Daniel Kahneman and Amos Tversky

Amos and Danny were psychology professors together at the Hebrew University in Israel in the 1970s. They had completely different personalities. Amos was gregarious and systems-oriented; Danny was introverted and adept at thinking up thought experiments and case studies. Despite their differences, their professional relationship flourished. They began to test their own biases with thought experiments (like the one we did earlier in the lesson). After they caught themselves acting irrationally, they would give the same thought experiment to graduate students, then other professors, economists, doctors, etc. It turns out everyone fell in the same traps.

Their most famous finding was laid out in prospect theory. I know the title sounds like something you'd read if you wanted to mine for gold. Hopefully, by the end of this lesson, you'll realize prospect theory is itself a 'nugget of gold' because it can help you limit the consequences for your own biases.

So, what is prospect theory exactly? The main argument is people don't make rational decisions where they carefully weigh probabilities and expected outcomes of the different choice. No, they make choices based on absolute gains and losses. We saw this in the intro. We were 'scared off' by the definite loss and decided to 'risk it' even though the expected value was less than the sure loss. Amos and Danny discovered that the magnitude of happiness for a $1,000 gain is less than the magnitude of a $1,000 loss. In other words, we feel more sadness for our losses than happiness for our gains. This can help explain our 'scared off' reaction to Option B in the intro. We were scared of the sure loss and decided to take risks.

The figure below is a graph in prospect theory that provides a nice visual of the concept we just talked about. Notice how the graph is asymmetrical with a sleeper slope for losses than for gains.

Prospect theory

Real World Examples

Let's see prospect theory and loss aversion through some real-world examples. Note how the individual chooses to not take the sure loss and becomes a 'risk seeker' instead.

  1. A 'rogue' trader at a large investment bank makes bigger and riskier trades to try and recoup the massive losses he has already incurred.
  2. A family breadwinner decides to not buy a life insurance policy because she doesn't want to pay the premiums.
  3. Some investors tend to sell stock investments that have appreciated in value and not sell the shares that have not appreciated. They sell the 'winners' and let the 'losers' ride, or as investor Peter Lynch put eloquently: 'investors pull out the flowers and water the weeds.'
  4. An ill patient begins an unproven treatment.

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