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Decision-making is essential to our lives, but it is not always straightforward. Psychological and emotional factors often influence our choices, leading us to deviate from what is considered rational and logical. Prospect theory is a behavioral economic theory that explains how people make decisions when faced with uncertainty or risk.
Prospect theory was introduced by Nobel Prize-winning psychologists Daniel Kahneman and Amos Tversky in 1979. It suggests that our decisions are not always driven by logic and that we often make inconsistent choices with classical economic theory. The theory states that people’s preferences are unstable and that their choices depend on how the problem is framed.
One of the key insights of prospect theory is that people value potential losses differently from potential gains. In other words, people are more sensitive to losses than equivalent gains. This phenomenon is known as loss aversion, a central idea in prospect theory. For example, people would rather avoid a loss of $100 than make a gain of $100. This means the pain of losing $100 is greater than the pleasure of gaining $100. I must admit, I have difficulty wrapping my head around this.
Another important aspect of prospect theory is that it considers the framing effect. The framing effect refers to the way in which a problem is presented that affects the decision-making process. For example, if a person is presented with two options, one framed as a loss and the other as a gain, they are more likely to choose the option framed as a gain, even if both options lead to the same outcome.
Prospect theory also suggests that people tend to be overconfident in their decisions. This means they often overestimate the likelihood of positive outcomes and underestimate the likelihood of negative outcomes. This can lead to poor decision-making and result in suboptimal outcomes.