Prospect theory is a fundamental concept in behavioral economics that explains how people make decisions under uncertainty. Developed by Daniel Kahneman and Amos Tversky in 1979, the theory challenges traditional economic assumptions that individuals always act rationally. Instead, it shows that people evaluate potential gains and losses differently, often making irrational choices based on perception rather than logic.
Key Principles of Prospect Theory
- Loss Aversion – One of the most significant aspects of prospect theory is that losses hurt more than equivalent gains feel good. For example, losing ₹1,000 feels more painful than the pleasure of gaining ₹1,000. This bias can lead people to make overly cautious or risk-seeking decisions.
- Framing Effect – The way a choice is presented influences decision-making. For example, people are more likely to opt for surgery if they are told there’s a 90% survival rate rather than a 10% death rate, even though both statements mean the same thing.
- Diminishing Sensitivity – The impact of a gain or loss decreases as its size increases. For instance, the joy of winning ₹500 is much greater than the additional joy of winning ₹1,000 instead of ₹500. Similarly, the pain of losing ₹500 feels stronger than the difference between losing ₹5,000 and ₹5,500.
- Risk Preferences in Gains and Losses –
- When faced with gains, people tend to avoid risks and prefer a sure but smaller profit over a potentially higher but uncertain one.
- When dealing with losses, people become risk-seeking, preferring a risky bet to avoid a definite loss, even if it leads to greater losses in the long run.
Real-World Applications of Prospect Theory
- Stock Market Behavior – Investors often hold onto losing stocks for too long, hoping to recover their losses, even when selling would be a wiser decision. This is known as the disposition effect.
- Gambling & Insurance – People buy insurance to avoid potential losses, even if the probability of the event occurring is low. On the other hand, they gamble despite low winning chances, driven by the hope of a big gain.
- Marketing & Pricing Strategies – Businesses use prospect theory by offering discounts framed as “saving ₹500” rather than “spending ₹1,500,” making the deal more appealing.
Prospect theory provides a deep understanding of human decision-making, showing that people are not always rational but are influenced by psychological biases. Recognizing these biases can help individuals make better financial choices, avoid common investment pitfalls, and make smarter decisions in daily life.
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