Behavioral Economics Quiz: Test Your Knowledge of Finance

Theory of Behavioral Economics and Behavioral Finance

Prospect theory is a theory of behavioral economics and behavioral finance.
It was developed by Daniel Kahneman and Amos Tversky in 1979.
The theory describes how individuals assess their loss and gain perspectives in an asymmetric manner.
For some individuals, the pain from losing $1,000 could only be compensated by the pleasure of earning $2,000.
Prospect theory aims to describe the actual behavior of people.
It challenges the expected utility theory developed by John von Neumann and Oskar Morgenstern in 1944.
The theory stems from Loss aversion, where the observation is that agents asymmetrically feel losses greater than that of an equivalent gain.
Decisions are made in relativity not in absolutes.
Prospect theory describes the decision processes in two stages.
The formula that Kahneman and Tversky assume for the evaluation phase is given by a function that assigns a value to an outcome.
Losses hurt more than gains feel good (loss aversion).
This differs from expected utility theory, in which a rational agent is indifferent to the reference point.Understanding Prospect Theory
Prospect theory is a behavioral economic theory that seeks to explain how people make decisions under uncertainty.
The theory suggests that people do not make decisions based on absolute outcomes, but rather on changes in outcomes relative to a reference point.
The value function in prospect theory is generally concave for gains and commonly convex for losses and steeper for losses than for gains.
The decision weights in prospect theory are never linear and are closer to unity when probabilities are low than when they are high.
In the case that x>y>0, p>p', and p+q=p'+q'<1, prospect (x,p;y,q) is preferred to prospect (y,p'q';x,pr).
It can be deduced from the first equation that ν(y)+ν(-y)>ν(x)+ν(-x) and ν(-y)+ν(-x)>ν(x)+ν(-x).
The value function is defined on deviations from the reference point and is generally concave for gains and commonly convex for losses and steeper for losses than for gains.
The decision weights in prospect theory are never linear and are closer to unity when probabilities are low than when they are high.
Prospect theory suggests that people do not make decisions based on absolute outcomes, but rather on changes in outcomes relative to a reference point.
In the case that x>y>0, p>p', and p+q=p'+q'<1, prospect (x,p;y,q) is preferred to prospect (y,p'q';x,pr).
The value function in prospect theory is generally concave for gains and commonly convex for losses and steeper for losses than for gains.
It can be deduced from the first equation that ν(y)+ν(-y)>ν(x)+ν(-x) and ν(-y)+ν(-x)>ν(x)+ν(-x).Summary of Prospect Theory and Its Application
Prospect theory is a model for decision-making under uncertainty, which suggests that people evaluate potential losses and gains differently.
Prospect theory proposes that people choose between prospects (uncertain outcomes) rather than final outcomes.
The theory introduces the concepts of value function and reference point, which influence the evaluation of prospects.
The value function is S-shaped, meaning that people are more sensitive to losses than to gains.
The reference point is the starting point for evaluating prospects and can be set by various factors, such as current wealth or worst-case scenario.
Prospect theory suggests that people overweight low-probability events and underweight high-probability events.
The theory also introduces the concept of editing phase, where people simplify the decision problem by combining or eliminating prospects.
In prospect theory, dominance is a criterion for eliminating prospects, where one prospect is considered better than another in all respects.
The violation of dominance is not common in prospect theory, but it is possible.
Prospect theory can be applied to various decision-making scenarios, such as buying insurance.
The application of prospect theory involves setting a reference point and evaluating the prospects based on the value function and probability weighting.
The comparison between probabilities and values can lead to different decisions, depending on the reference point and the editing phase.Prospect Theory: Understanding Decision Making Under Uncertainty
Prospect theory explains how people make decisions under uncertainty by assessing potential losses and gains in relation to a reference point.
Losses are weighted more heavily than gains of equal magnitude, and people become less sensitive to changes in wealth as their wealth increases.
Overweighting of small probabilities and concavity-convexity of the value function leads to the fourfold pattern of risk attitudes: risk-averse behavior when gains have moderate probabilities or losses have small probabilities; risk-seeking behavior when losses have moderate probabilities or gains have small probabilities.
Myopic loss aversion (MLA) is the propensity for people to focus on short-term losses and gains and to weigh them more heavily than long-term losses and gains, causing people to make worse decisions.
MLA can result in people placing greater magnitude on their short-term gains and losses instead of their overall earnings.
Narrow framing is a derivative result of prospect theory where people evaluate new gambles in isolation, ignoring other relevant risks.
Prospect theory can explain several empirical regularities observed in the context of auctions, which are difficult to reconcile with standard economic theory.
Prospect theory is applied extensively in the context of political decision-making.
Scholars have employed prospect theory to shed light on a number of issue areas in politics, such as collective action problems, political party behavior, and terrorism.
Prospect theory provides the ability for researchers and policymakers to create interventions that help people make more informed choices and attain their long-term goals.
Digital age has brought the implementation of prospect theory in software.
Prospect theory has implications for the way economic agents subjectively frame an outcome or transaction in their mind, which affects the utility they expect or receive.