Lecture 3–4: Prospect Theory Flashcards
(12 cards)
What is Prospect Theory?
A behavioral model of decision-making under risk, where people evaluate outcomes relative to a reference point and exhibit loss aversion and probability distortions.
Who developed Prospect Theory and when?
Daniel Kahneman and Amos Tversky in 1979.
What are the 3 core components of Prospect Theory?
Reference dependence, Loss aversion, Probability weighting.
What is reference dependence?
People evaluate outcomes relative to a reference point (e.g., status quo) rather than in absolute terms.
What is loss aversion?
Losses loom larger than gains — typically, losing $100 feels worse than gaining $100 feels good.
What is the typical loss aversion coefficient found in experiments?
Around 2; losses are weighted about twice as heavily as gains.
What is probability weighting?
People overweight small probabilities and underweight large probabilities, distorting objective risk.
How does the value function in Prospect Theory look?
It is concave for gains, convex for losses, and steeper for losses — reflecting diminishing sensitivity and loss aversion.
What does the probability weighting function explain?
Why people buy both insurance and lottery tickets — overweighing small probabilities of disaster or jackpot.
How does Prospect Theory explain the Allais Paradox?
It accounts for inconsistent risk preferences by allowing nonlinear probability weighting.
What are the key differences between Prospect Theory and Expected Utility Theory?
PT uses reference points; EUT uses final wealth.
PT has loss aversion; EUT does not.
PT distorts probabilities; EUT uses objective ones.
How does Prospect Theory relate to finance?
It explains investor behavior such as the disposition effect, demand for insurance and lotteries, and framing effects in choices.
