Prospect Theory: A Cognitive Analysis of Decision Making under Risk
Abstract
This article provides an overview of Prospect Theory, a cognitive analysis of decision making under risk developed by Kahneman and Tversky in 1979. It outlines the core components of the theory, which include a non-linear utility function, a reference point, and a risk-aversion coefficient. It also explores how Prospect Theory has been applied to different research areas, including finance, economics, and psychology. Finally, it provides a summary of the implications of Prospect Theory for decision makers.
Introduction
Decision making is a central aspect of human behavior and is often characterized by risk. In 1979, Kahneman and Tversky proposed a novel cognitive analysis of decision making under risk called Prospect Theory. The theory has since been applied to many different research areas, including finance, economics, and psychology. This article provides an overview of Prospect Theory, focusing on its core components and implications.
Core Components
Prospect Theory proposes that individuals make decisions by constructing a mental representation of a decision problem that includes a non-linear utility function, a reference point, and a risk-aversion coefficient. The utility function is a function that assigns a numerical value to each outcome of a decision problem. The reference point is the point at which an individual is indifferent between the outcomes of a decision problem. The risk-aversion coefficient is a measure of an individual’s willingness to take risks.
Applications
Prospect Theory has been applied to many different research areas, including finance, economics, and psychology. In finance, Prospect Theory has been used to explain various stock market behaviors, such as the disposition effect and the equity premium puzzle. In economics, it has been used to explain the effects of taxation on consumer behavior. In psychology, Prospect Theory has been used to explain the effects of framing on decision making.
Implications
The implications of Prospect Theory are far-reaching. It suggests that individuals are risk averse and that their decisions are influenced by their reference point. It also suggests that individuals tend to overweight small probabilities and underweight large ones. Furthermore, it suggests that framing effects can have a significant impact on decision making. By taking into account these factors, decision makers can make more informed decisions in a variety of contexts.
Conclusion
In conclusion, Prospect Theory provides a cognitive analysis of decision making under risk. It suggests that individuals are risk averse and that their decisions are influenced by a reference point and a risk-aversion coefficient. Prospect Theory has been applied to a variety of research areas, including finance, economics, and psychology, and its implications are far-reaching.
References
Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291.
Tversky, A., & Kahneman, D. (1992). Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty, 5(4), 297-323.
Kahneman, D., & Tversky, A. (2000). Choices, Values, and Frames. American Psychologist, 45(4), 341-350.
Barberis, N., & Thaler, R. (2003). A Survey of Behavioral Finance. In G. Constantinides, M. Harris, & R. Stulz (Eds.), Handbook of the Economics of Finance (Vol. 1, pp. 1053-1128). Amsterdam: North-Holland.
Lopes, L. L. (1987). Between Hope and Fear: The Psychology of Risk. Advances in Experimental Social Psychology, 20, 255-295.