Prospect Theory is a concept in psychology and economics that explains how people decide between alternatives that involve risk and uncertainty. It challenges the traditional Expected Utility Theory, which suggests people always make logical, rational choices that maximize their benefits.Think of it like choosing between a guaranteed $50 or a 50% chance to win $100. Expected Utility Theory says people will always choose the option that gives them the most money on average. But in real life, people don't always make decisions based purely on math. They are influenced by the fear of losing and the excitement of winning, and they often value certain gains more than uncertain ones, even if the uncertain option has a higher average value.Prospect Theory shows that people's choices often violate the strict rules of rational decision-making proposed by traditional theories. It takes into account things like how much we fear losses more than we value gains, and how we perceive probabilities - we might overestimate small chances (like winning the lottery) and underestimate large chances.In simple terms, Prospect Theory acknowledges that when it comes to risk, human decision-making is often more complex and less predictably 'rational' than traditional economic models suggest.
The Value Function An essential feature of the present theory is that the carriers of value are changes in wealth or welfare, rather than final states. This assumption is compatible with basic principles of perception and judgment. Our perceptual apparatus is attuned to the evaluation of changes or differences rather than to the evaluation of absolute magnitudes. When we respond to attributes such as brightness, loudness, or temperature, the past and present context of experience defines an adaptation level, or reference point, and stimuli are perceived in relation to this reference point . Thus, an object at a given temperature may be experienced as hot or cold to the touch depending on the temperature to which one has adapted. The same principle applies to non-sensory attributes such as health, prestige, and wealth. The same level of wealth, for example, may imply abject poverty for one person and great riches for another-depending on their current assets.
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The emphasis on changes as the carriers of value should not be taken to imply that the value of a particular change is independent of initial position. Strictly speaking, value should be treated as a function in two arguments: the asset position that serves as reference point, and the magnitude of the change (positive or negative) from that reference point. An individual's attitude to money, say, could be described by a book, where each page presents the value function for changes at a particular asset position. Clearly, the value functions described on different pages are not identical: they are likely to become more linear with increases in assets. However, the preference order of prospects is not greatly altered by small or even moderate variations in asset position. The certainty equivalent of the prospect (1,000, .50), for example, lies between 300 and 400 for most people, in a wide range of asset positions. Consequently, the representation 277 278
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D. KAHNEMAN AND A. TVERSKY of value as a function in one argument generally provides a satisfactory approximation.
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Many sensory and perceptual dimensions share the property that the psychological response is a concave function of the magnitude of physical change. For example, it is easier to discriminate between a change of 30 and a change of 60 in room temperature, than it is to discriminate between a change of 130 and a change of 160. We propose that this principle applies in particular to the evaluation of monetary changes. Thus, the difference in value between a gain of 100 and a gain of 200 appears to be greater than the difference between a gain of 1,100 and a gain of 1,200. Similarly, the difference between a loss of 100 and a loss of 200 appears greater than the difference between a loss of 1,100 and a loss of 1,200, unless the larger loss is intolerable. Thus, we hypothesize that the value function for changes of wealth is normally concave above the reference point (v"(x) < 0, for x > 0) and often convex below it (v"(x) > 0, for x < 0). That is, the marginal value of both gains and losse
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