Prospect Theory Quiz

Decisions involving potential gains and losses with unknown outcomes, where probabilities are assigned to each outcome.

A phenomenon where individuals feel the pain of a loss more strongly than the pleasure of an equivalent gain.

An attitude towards risk where individuals are willing to accept a higher risk for a potential larger reward.

Theories that explain how individuals make decisions under risk and uncertainty, often based on the concept of expected utility.

A theory of decision-making under risk that assumes individuals are rational and maximize their expected utility.

Deviations from the predictions of Expected Utility Theory, suggesting that individuals may not always make rational decisions.

A behavioural economic theory that incorporates psychological insights into decision-making under risk, focusing on loss aversion and framing effects.

A key concept in Prospect Theory, where individuals value losses more heavily than equivalent gains.

The psychological tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain.

An individual's willingness to take on greater risk for the potential of a larger reward, often due to the prospect of avoiding a significant loss.

Prospect Theory replaces the EUT utility function with a value function that accounts for reference points, loss aversion, and diminishing marginal sensitivity.

The coefficient of loss aversion, represented by the Greek letter lambda (λ), reflects the relative weight given to losses compared to gains.

The impact of a probability on the overall value of a prospect is not linear, reflecting how humans tend to overestimate the impact of low probabilities and underestimate the impact of high probabilities.

Prospect Theory models this process in two steps: editing and evaluation. In the editing phase, individuals frame outcomes in terms of gains and losses relative to a reference point.

The editing phase involves how we perceive the choices and outcomes, while the evaluation phase involves calculating the value of each prospect based on the perceived gains and losses.

The idea that people do not value gains and losses linearly. This means that the difference between $10 and $20 seems smaller than the difference between $100 and $110. Loss aversion is a significant part of this nonlinearity.

A way to represent how people perceive probabilities. Instead of being linear, it involves a curve where small probabilities are overestimated, and large probabilities are underestimated.

The assumption that individuals prefer more wealth to less wealth, regardless of their current level of wealth, and that this preference is reflected in their utility function.

The stage in Prospect Theory where individuals simplify and refine their choices, potentially using heuristics or mental shortcuts, before making their final decision.

The second stage in Prospect Theory where individuals evaluate the potential outcomes of their choices based on their sensitivity to losses and gains, often exhibiting loss aversion and framing effects.

In decision-making, people often exhibit risk-seeking behavior when facing potential losses. This means they are more willing to take risks to avoid a loss, even if the potential reward is small.

People's reactions to probabilities are not always linear. They may overweight small probabilities and underweight large probabilities, leading to biased decisions.

Prospect Theory (PT) suggests that people don't always make decisions based on expected utility. Instead, they frame decisions in terms of potential gains and losses, using a non-linear probability scale.