Prospect theory

Welcome to the second episode of our Behavioral Economics course. This episode introduces **Prospect Theory**, the Nobel Prize-winning framework developed by Daniel Kahneman and Amos Tversky that revolutionized how we understand decision-making under risk. We will explore how this theory challenges traditional economic models by showing that people don't make choices based on final outcomes, but on potential gains and losses relative to a reference point. You'll learn about the theory's core components: the S-shaped value function that explains our changing attitudes to risk, and the concept of probability weighting that shows how we misjudge likelihoods.

Check your understanding

These are the same multiple-choice questions you will see in the Quiz section after you listen to the episode. Use them here to preview or review the answers.

What is a core principle of Prospect Theory that distinguishes it from traditional Expected Utility Theory?

  1. People always make rational decisions to maximize their final wealth.
  2. People evaluate outcomes as gains and losses relative to a reference point.
  3. People's decisions are based on their final state of wealth, not on changes to it.
  4. People are only concerned with the probability of an outcome, not its value.
  5. Decisions are evaluated based on changes from a neutral starting point.

According to Prospect Theory's S-shaped value function, why do people often become risk-seeking when faced with a choice between a sure loss and a risky loss?

  1. Because the value function is concave for losses.
  2. Because of diminishing sensitivity to losses, making a larger potential loss feel less incrementally painful.
  3. Because the value function for losses is convex.
  4. Because people enjoy losing money.
  5. Because they overestimate the probability of avoiding the loss entirely.

The concept of 'diminishing sensitivity' in Prospect Theory suggests that:

  1. The difference between gaining $0 and $100 feels about the same as gaining $1000 and $1100.
  2. The subjective impact of an additional $100 gain is greater for someone who is already wealthy.
  3. The difference between gaining $0 and $100 feels much more significant than the difference between gaining $1000 and $1100.
  4. People are equally sensitive to gains and losses of the same magnitude.
  5. The pain of losing $1100 is only slightly worse than the pain of losing $1000.

How does Prospect Theory describe the way people typically handle probabilities?

  1. People assess all probabilities with perfect objectivity.
  2. People tend to ignore probabilities completely.
  3. People tend to overweight small probabilities, like the chance of winning a lottery.
  4. People tend to underweight moderate and high probabilities.
  5. People place a special premium on certainty (a 100% probability).

What is the role of a 'reference point' in Prospect Theory?

  1. It is the maximum possible gain in a gamble.
  2. It is the final amount of wealth a person will have after a decision.
  3. It is the neutral starting point from which outcomes are judged as either gains or losses.
  4. It is always equal to zero dollars.
  5. It can be influenced by one's current state or expectations.

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