How does the prospect theory explain economic decision making?

The Prospect Theory explains economic decision-making as a process influenced by perceived gains and losses, rather than final outcomes.

Developed by psychologists Daniel Kahneman and Amos Tversky, the Prospect Theory challenges the traditional economic theory that people make rational decisions based on maximising utility. Instead, it suggests that people make decisions based on the potential value of losses and gains, not the final outcome. This is often why people's decisions can appear irrational or inconsistent.

The theory is built on two main ideas: reference dependence and loss aversion. Reference dependence suggests that individuals evaluate outcomes in relation to a reference point, which is usually their status quo. Any change from this reference point is perceived as a gain or a loss. For example, if you were expecting a £10 discount but only received £5, you would perceive this as a loss, even though you are still better off than before.

Loss aversion, the second principle, suggests that people feel the pain of losing more intensely than the pleasure of gaining. In other words, losses loom larger than gains. This can lead to risk-averse behaviour when individuals face potential losses, and risk-seeking behaviour when they face potential gains. For instance, people might buy insurance to avoid the potential loss of their property, even if the probability of the event is low.

The Prospect Theory also introduces the concept of 'diminishing sensitivity', which means that the perceived difference between £0 and £1000 is greater than between £1000 and £2000. This can explain why people are willing to travel further to save £10 on a £20 purchase, but not on a £200 purchase.

In conclusion, the Prospect Theory provides a more nuanced understanding of economic decision-making by considering how people perceive gains and losses. It highlights that people's decisions are not always rational or consistent, but are influenced by their perceptions and emotions. This has significant implications for areas such as behavioural economics, finance, and policy-making, where understanding human behaviour is crucial.