What is the theory of prospects?
The theory of prospects is an economic behavior theory that attempts to explain people's decisions when they face situations that include a risk. According to theory, people evaluate potential profits and losses as changes in their current state rather than as an independent situation in the future and try to avoid losses more than they try to seek wins. People perceive the likelihood of an event inaccurately, especially when the probability is close to zero or one. The theory of prospects explains seemingly irrational decisions in situations such as gambling and insurance purchases. The proposal of the theory of the prospect was helpful in establishing a new area: behavioral economics. This study area mixes the principles of economics and psychology. In 2002, Kahneman shared the Nobel Prize in Economics with Vernon L. Smith for their work.
Most economic theory is descriptive; This means trying to explain human behavior by simplifyingthe teaching models. If the real world does not show the behavior that the model predicts, the model needs to be revised. This was the case of the expected usefulness theory that predicted that people would accurately assess the probability and payouts to make a rational choice in the face of the risk. This means that the person should be indifferent to 50 % of the chances of winning 1,000 and a guaranteed payment of 500. Experiment led by Maurice Allais, French economist, in 1953 questioned the expected usefulness theory.
The experiment represented a number of options between lotteries and respondents chose which set of payouts and probabilities that preferred. Allais found that respondents did not always choose lotteries that expected the theory of use and its findings became known as the paradox of Allais. Kahneman and TVersky made an Allais experiment and gained similar results. For example, most respondents preferred a guaranteed payout of 3,000 to 80 % chance to receive 4,000, although the secondThe possibility has an expected value that is 200 higher than the expected value of the first.
Kahneman and TVersky tried to explain the paradox Allais by exploring the processes of human decision -making. They suggested that every economic agent, or a person who made an economic decision, has two relevant functions in the face of the risk: the value and function of the weight of the decision -making. When calculating his expected tools, the agent uses more payouts and probabilities from these functions rather than from the numbers.
The value of the value assigns the payout value. Unlike the predictions of the expected usefulness theory, the size of the negative positive payout is not the same - the negative part of the value of value is steeper than the positive part, so the absolute value of the loss is greater than the absolute value of the equivalent victory. This is where the theory of the prospect gets its name: the agent perceives every lottery as a prospect of change from its current position. In case of 300 versus guaranteed50 % chance of winning 1,000 and 50 % chance of losing 400, the expected usefulness theory would say that the lottery is equivalent because both are expected to be 300. Within the theory of the prospect, a potential loss of 400 could predominate to a potential profit of 1,000, so the agent could prefer guaranteed 300.
Dear Dear Settings describes how agents treat probability. Within the expected usefulness theory, agents multiply the exact probability of its occurrence. The theory of prospects acknowledges that agents have an imperfect understanding of the meaning of probability. Ghting's Weifunction describes the probability that agents use in their calculations or decision -making weight for each level of probability. The weight of decision -making tends to be lower than the specified probability, except for the ends of the function: agents consider probabilities that are almost zero as zero, treat little probabilities as larger than they actually are, and treat the probability téme 100 percent for security.
The theory of the prospect applies to any situation in which agents must make a decision on the basis of an evaluation of payout and probability. Agents could buy insurance if the bonus is higher than the expected value of their potential losses because they tend to overestimate little probability. Similarly, they could overestimate the chance to win a lottery and buy tickets that are not worthwhile. This theory allows economists to evaluate the reasons for these decisions rather than written as irrational.