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Prospect theory is a theory of behavioral economics, judgment and decision making that was developed by Daniel Kahneman and Amos Tversky in 1979. [1] The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics .
In mental accounting theory, the framing effect defines that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect. [11] The concept of framing is adopted in prospect theory , which is commonly used by mental accounting theorists as the value function in their analysis (Richard Thaler ...
The main modification to prospect theory is that, as in rank-dependent expected utility theory, cumulative probabilities are transformed, rather than the probabilities themselves. This leads to the aforementioned overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events.
The theory also incorporates evidence that small deviations from a reference point tend to be over-valued. So, based on prospect theory, pricing something only a few cents under a whole dollar could be beneficial to the seller. This theory works well because of how the reference point is established by the consumer.
Reference dependence is a central principle in prospect theory and behavioral economics generally. It holds that people evaluate outcomes and express preferences relative to an existing reference point, or status quo. It is related to loss aversion and the endowment effect. [1] [2]
Prospect theory and loss aversion suggests that most people would choose option B as they prefer the guaranteed $920 since there is a probability of winning $0, even though it is only 1%. This demonstrates that people think in terms of expected utility relative to a reference point (i.e. current wealth) as opposed to absolute payoffs.
It is an idea introduced in prospect theory. Normally a reduction in the probability of winning a reward (e.g., a reduction from 80% to 20% in the chance of winning a reward) creates a psychological effect such as displeasure to individuals, which leads to the perception of loss from the original probability thus favoring a risk-averse decision.
In prospect theory, the pseudocertainty effect is the tendency for people to perceive an outcome as certain while it is actually uncertain in multi-stage decision making. The evaluation of the certainty of the outcome in a previous stage of decisions is disregarded when selecting an option in subsequent stages.