Risks and Uncertainties are parts of our daily life. To do something big we always have to take risks. But how to make decisions under Risk and Uncertainty? Should we depend on our fate? To act better in such situations, we must self introspect. Yeah, you read it right! We have to know how our brain works. One such theory that helps us understand the basic human nature when it comes to making decisions under risk and uncertainty is the Prospect Theory.
WHAT’S IN IT
What is Prospect Theory
According to Behavioral economics, Prospect theory is a conduct model that shows how individuals settle on options that include hazard and vulnerability (for example % probability of gain or loss). It shows that individuals think in terms of expected utility relative to a reference point as opposed to absolute results.
Prospect theory was proposed by Daniel Kahneman and Amos Tversky in 1979 and was developed in 1992. Kahneman won the Nobel prize in economic sciences in 2002 for changing modern Economics forever by suggesting the Prospect Theory.
Kahneman wrote “Thinking Fast and Slow” a book on Economics that was recognized by the New York Times in 2011, as a bestseller, his book discusses decision making.
However, before we talk about prospects, we have to first discuss its predecessor, Utility Theory. Utility Theory was proposed in 1738 by the Swiss mathematician Daniel Bernoulli. It was known as a moral expectation opposing the theory of mathematical expectation until the mid 20th century.
This theory explains why most people are risk-averse when it comes to making decisions that could result in a loss, especially in situations such as gambling. This theory is based on the assumption that everyone is rational and all the decisions that they will make.
For example, suppose you have a choice to flip a coin. If it’s head you will get Rs 100, and if it’s tail you will get Rs 0. Another choice you have is Just taking Rs 50 without flipping the coin.
According to Utility theory, people are more likely to choose to gain Rs 50 instead of choosing the uncertainty, although there was a chance to win more.
Utility theory focuses on the aspect of how useful the money is to you. A gain of Rs 1 means more to you than if you had Rs 1 crore and you gained Rs 1. Going back to the example of why people choose the option of getting Rs 50? because it has the highest utility since it carries no risk rather than the possibility of receiving double or nothing with a gamble.
Prospector theory uses the same core concepts as Utility theory however, it includes an individual’s reference point in regards to decision making, for example of gambling.
Therefore, happiness can be determined by the recent change in their wealth due to their reference point. Reference points are important for later comparisons of their current and past wealth.
Prospect Theory is all about the individual’s gains and losses rather than the utility of their wealth. It indicates that we dislike losing more than we like winning.
This is a graphical representation of the Prospect Theory. The curve in the upper right represents some gains, and the curve in the lower left represents losses. Looking at the curves on either side of the graph, we can see the decline on the left is steeper than the incline on the right. This indicates that losses are more salient than gains.
Examples of Prospect Theory
In our regular life, we see a lot of examples of the Prospect Theory. Let me show some of them.
The silver medal winner is never that happy because they lost the gold medal, but the bronze medalist is happy because they made it to the top three.
The key difference between Prospect Theory and Utility Theory
Now that we’ve gone over the general ideas of both utility and prospect theories, we’d like to highlight some of the key differences between the Prospect Theory and the Utility Theory.
First Utility Theory does not account for where you started from and how it will feel to shift from that point of view. For example, if you have Rs 1 crore and your friend has Rs 9 crore, and tomorrow you both have Rs 5 crore, how happy you both would be?
According to Utility Theory, both you and your friend will be equally happy tomorrow because you both have Rs 5 crore.
However, if you look at the numbers, you can see that you will be much happier than your friend. Prospect Theory can predict this as it takes into consideration that you have gained Rs 4 crore, while your friend has lost Rs 4 crore.
Prospect Theory takes into account that people are not entirely rational. They do not make their choices based solely upon which choice has more utility but upon which choice is less aversive or causes them the least loss.
Utility theory was used in Economics for over 3 centuries. Prospect theory has replaced it and changed the modern economy. This theory is applied today in fields like Politics, Software development, Business management, etc.
Also you can Read Blog on How the Decision Cycle helps to make decisions