PROSPECT

THEORY

Q1 Q2 Q3 Q4

Prospect theory is a behavioral model that shows how people decide between alternatives that
involve risk and uncertainty (e.g. % likelihood of gains or losses). It demonstrates that people think
in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute
outcomes.
DEVELOPMENT OF PROSPECT THEORY
1. EXPECTED UTILITY THEORY

• Given by Daniel Bernoulli,1738

• Dominant theory until the mid 20th century
• Three important concepts:
Utility(psychological value)
Wealth (current state)
Rational choice model
UTILITY

• Utility does not increase proportionately with the amount of money.

• Example: The first pound extra is worth more than the 10th or the 100th
• A gamble should be assessed by its expected utility , not by expected absolute value.
WEALTH

• Utility is dependent on the current state of wealth

• Example:₹10 is worth more to someone who only has ₹10 than to someone who has
₹100, a₹1000 or ₹100000
• Wealth is included when calculating the best option.
MODEL OF RATIONAL CHOICE

• The utility of potential outcomes is weighted by the probability of its occurrence.

• Example : 1) 60% chance of +₹10= ₹6
2) 50% chance of +₹10= ₹5
• People are expected to choose the best option.
ISSUES WITH EXPECTED UTILITY THEORY

• Although we could make decisions based on rational cost- benefit analyses , we often
don’t for two reasons :
1. People have a irrational tendency to be less willing to gamble with profits than losses →
prospect theory
2. We use mental shortcuts instead of calculating all possible options → heuristics(snap
decision making)
2. PROSPECT THEORY

• Given by Kahneman & Tversky in 1979

• People do not always make rational decision because they value gains and losses
differently
• Centred around loss aversion – we like winning but we don’t like losing.
• “A bird in the hand is worth two in the bush”- it is better to hold onto something one
has than to risk losing it by trying to get something better.
We experience stronger emotions during loss than during gain
→ Loss aversion
People are risk – seeking
wen faced with potential
loss , while they are risk
averse and prefer certainty
for gains.
When ever people are faced
with gaining something they
like to keep this gain so they
are going to be risk averse
Whenever people are faced
with potential losses they
don’t like loosing so they are
more risk seeking to try to
avoid having loses
EXAMPLE – ASIAN FLU

• There are 2 programs to battle a disease

1) In program A, 200 people will be saved
2) In program B, there is a 1/3 probability that 600 people will be saved , and a 2/3 probability that no
one will be saved.
 Absolute outcome is the same
• In expected utility theory we expect people to not have a preference for program A or B because
outcome is same.
• Prospect theory explains that these conditions matter
• People will have a preference for program A and as they prefer 200 people being saved over the chance
of maybe no one will be saved.(showing the risk averse nature while gaining something)
EXAMPLE (2)

• There are 2 programs to battle a disease

• 1) in program C, 400 people will die
• 2) in program D, there is a 1/3 probability that no one will die , and 2/3 probability that 600 people will
die.
 Absolute outcome is the same
• According to the expected utility theory we don’t expect a difference we expect people to have similar
preference of program c and program d
• But people prefer to choose program d and they actually would like to take risk. As the people are likely
to die , this is a loss situation and people don’t like losing so they prefer risking to avail the chance to
save everyone. Thus people are risk seeking when facing potential loss.
 CONCLUSION

• People do not always make a rational choice of the best option.

• Experiments show that people deviate from rationality in a consistent , predictable manner.
Reason being that they value gains and losses differently
• “ It ain’t what you say , but the way you say it”
DEEPER ANALYSIS
1.REFERENCE POINT
A 1995 study of Olympic winners found that bronze medal winners seemed
happier than silver medal winner.
The reason has to do with perceived gains or losses around a reference point
1.The silver medallist
focused on almost
winning gold with any
other outcome
considered a loss.
2.The bronze medallist
focused down towards
fourth place and not
winning a medal at all .So
any outcome above not
winning a medal is a
again.
3.The silver medallist
should be happy at being
second best in the world
rather than being the
first loser .
4. Prospect theory
explains that people
process information in an
illogical way by valuing
gains and losses
differently .
Expressing in financial terms consider 2 situations:-
1. Gain of ₹ 50
2. Gain of ₹100 and then loss of ₹50
Both situation result in a net gain of ₹ 50 but people view single gain more favourable than the gained and
lost scenario because the feeling of pain is two to three times greater than the joy felt from an equivalent
gain.
2.VALUE FUNCTION
Value Function – represents how people
value things.
• People don’t weight gains and losses
linearly.
• Origin – point of reference (probably
present wealth)
• When people have gains , there is
diminishing value and vice versa.
• Kink at origin- explains people are very
conscious of little changes in their
wealth.
• Even for a small loss the value drops
drastically , which shows that people
are spooked and deterred by losses and
they are less and less encouraged by
small gains.
3. WEIGHTING FUNCTION
Weighting Function- represents how people
infer or deal with probabilities.
• Very low probabilities are Rounded off to
0 and very high are rounded to 1.
• It explains that people are not capable of
analysing probabilities. And they exist
only three cases 1) can’t happen
2) may be
3) will occur
• Example – The probability of an airplane
crash are very less , so most people in
their minds say it is 0 but there are some
who blow out all proportions in their
mind and exaggerate .
• The Airplane Insurance companies tries to
manipulate this personality characteristic
and they target people who exaggerate
and charge them outrageous prices.
THANK YOU

Made by – Rahul Nandwani (2498)