Prospect theory and decision-making under risk

Prospect Theory:

The phenomenon of prospect theory branches out of the field of economics and mainly explains the business decisions that are made in relation to taking risks to gain certain rewards. These risks that are part of prospect theory are ones where the end results after application can be measured and the probabilities of the impacts of these results are well-known (Lyon, 1999). Prospect theory mainly states that the individuals involved in the decision making process usually takes the business decision based on a few integral issues, in this case, the overall probable value gains and losses as opposed to the end results or the impacts of the decision. They do so by utilizing the criteria of heuristics and ensuring that the model used in one that is descriptive, focuses on real life patterns and decisions as opposed to those that might be regarded corporately important (Kahneman, 2003).

The theory was first coined by Professor Daniel Kahneman who worked at Princeton University, employed at the Department of Psychology there. A colleague of his, Amos Tversky, helped him in pioneering this theory back in the year 1979. They both asserted that prospect theory was a far more accurate explanation, in psychological terms, of human inclinations in a risky situation than the phenomenon of expected utility theory that existed previously (Kahneman, 2003). In this way, Prospect Theory is a descriptive model as opposed to the more commonly available normative models.

Before the end of the 1970s, irrational behavior was considered to be unsuited and chaotic for modeling. The most common and suitable method for approximating descriptive behavior was the normative expected utility theory. The emergence and development of prospect theory provided a major breakaway from the normative expected utility model. This is mainly because the model was the first descriptive theory to clearly incorporate irrational behavior in an empirically logical way (Wakker, 2010, p. 2). This model achieved this while being systematic and tractable at the same time. Actually, it's considered as the first rational theory of irrational behavior through the empirically realistic means.

As gains and losses are examined from a subjective reference point, prospect theory was developed by Tversky and Kahneman to explain and understand framing effects. Traditionally, the net effects of gains and losses that are involved in every choice are pooled in order to present an overall examination of whether the choice is attractive. Generally, academics tend to use utility as a means for describing pleasure and argue that people prefer instances that capitalize on utility. Based on this model, individuals value a certain gain over a probable gain with similar or greater expected value. The vice-versa is true for losses because the function associating with the biased value and corresponding losses is steeper than the one for gains (McKeown, 2000). Consequently, the dissatisfaction associated with losses is usually greater than the pleasure associated with similar amounts of gain. Depending on whether the options or choices are framed on the basis of gains or losses, people respond differently. According to the theory, losses tend to have increased emotional impact than the same emotional impact of gains.

The two most common framing effects associated with the prospect theory are bi-directional and unidirectional effects. Bi-directional framing effects incorporate the preference reversal from mainly risk averse to mostly risk seeking or vice-versa because of the dichotic impact of the framing of the choice results. As a result, this effect is characterized by more risk-averse choices based on positive framing and more risk-seeking choices based on negative framing. On the contrary, the unidirectional effect involves no preference reversal like the bidirectional framing effects but rather incorporates the shift towards a more extreme risk preference. When the major preference is uni-directionally risk averse on both of the framing conditions, it's a more risk averse on the positive frame than a negative frame and vice versa.

In economics, the phenomenon of expected utility hypothesis is primarily a notion where the utility of a certain action is based on the overall 'betting' inclinations of the individuals involved especially when dealing where the probable result is either uncertain or risky. These inclinations are thus presented by a series of reimbursements (monetary or products/goods), the likelihood of repetition of incidence, the potential to evade further risks or uncertainties as well as the use of the same utility to people sharing different dynamics, capital as well as inclinations (Cynkar, 2007).