Prospect theory Flashcards
prospect theory has been advanced as an alternative to utility theory to describe how people make decisions. discuss the main differences of these approaches
prospect theory and utility theory are both approaches that aim to describe how people make decisions . however, they differ in a number of ways.
utility theory is based on the assumption that people make decisions by maximising their utility, or happiness. it assumes that people have consistent preferences and that they will make decisions that will maximise their utility.
prospect theory on the other hand is based on the observation that people either make decisions that are inconsistent with the assumption of utility theory. it takes into account the fact that people are often risk-averse or risk seeing and that they place different weights on gains and losses.
prospect theory is based on the idea that people evaluate choices using a reference point, such as their current wealth.
utility theory is based on the fact that people make decisions based on the absolute value of a potential outcome.
another difference is that prospect theory is accounts for the framing effect, which is the tendency for people to make decisions depending on how the options are presented to them.
highlight the benefits of using prospect theory
it can help to better understand and predict real-world decision making. it can also provide a more accurate description of how people make decisions when faced with risky decisions.
comment on extensions of the original prospect theory
what is prospect theory
Prospect theory is a concept in behavioral finance that explains how people make decisions under uncertainty and risk. The theory proposes that people do not always behave rationally when faced with potential gains and losses, and that they are more sensitive to losses than to gains of the same magnitude. This leads to a number of biases and heuristics that can affect decision-making, such as the tendency to take more risks to avoid losses than to realize gains.
