Prospect theory

Prospect conviction is a opinion of behavioral economics as well as behavioral finance that was developed by Daniel Kahneman in addition to Amos Tversky in 1979. the theory was cited in a decision to award Kahneman the 2002 Nobel Memorial Prize in Economics.

Based on results from controlled studies, it describes how individuals assess their waste and make-up perspectives in an asymmetric classification see loss aversion. For example, for some individuals, the pain from losing $1,000 could only be compensated by the pleasure of earning $2,000. Thus, contrary to the expected service theory which models the decision that perfectly rational agents would make, prospect theory aims to describe the actual behavior of people.

In the original formulation of the theory, the term prospect target to the predictable results of a lottery. However, prospect theory can also be applied to the prediction of other forms of behaviors and decisions.

Model

The theory describes the decision processes in two stages:

The formula that Kahneman and Tversky assume for the evaluation phase is in its simplest make-up given by:

where is the overall or expected utility of the outcomes to the individual devloping the decision, are the potential outcomes and their respective probabilities and is a function that attaches a value to an outcome. The value function that passes through the address point is s-shaped and asymmetrical. Losses hurt more than gains feel good loss aversion. This differs from expected utility theory, in which a rational agent is indifferent to the acknowledgment point. In expected utility theory, the individual does not care how the outcome of losses and gains are framed. The function is a probability weighting function and captures the idea that people tend to overreact to small probability events, but underreact to large probabilities. let denote a prospect with outcome with probability and outcome with probability and nothing with probability . if is aprospect i.e., either , or , or , then:

However, whether and either or , then:

It can be deduced from the number one equation that and . The value function is thus defined on deviations from the reference point, loosely concave for gains and ordinarily convex for losses and steeper for losses than for gains. If is equivalent to then is non preferred to , but from the number one equation it follows that , which leads to , therefore:

This means that for a constant ratio of probabilities the decision weights are closer to unity when probabilities are low than when they are high. In prospect theory, is never dominates prospect , which means that , therefore:

As , , but since , it would imply that must be linear; however, dominated alternatives are brought to the evaluation phase since they are eliminated in the editing phase. Although direct violations of a body or process by which power to direct or develop or a particular part enters a system. never happen in prospect theory, it is possible that a prospect A dominates B, B dominates C but C dominates A.