Prospect Theory

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Prospect Theory is the "Study of the Choice"—the investigation of the "Psychological Discovery" (1979) that "Humans" "Do Not" "Evaluate" "Losses and Gains" "Equally." While "Classical Economics" (see Article 138) assumes we are **"Rational Actors"** (Homo Economicus), **Prospect Theory** proves we are "Irrationally Risk-Averse." From the "Loss Aversion" of **Daniel Kahneman** and **Amos Tversky** to "Framing Effects" and "Probability Weighting," this field explores the "Biases of the Mind." It is the science of "Subjective Value," explaining why "Losing $100" "Hurts More" than "Winning $100" "Feels Good"—and how "Psychology" "Rewrote" the "Laws of the Market."

Remembering

• Prospect Theory — A theory of "Decision-making" under "Uncertainty" that "Replaced" "Expected Utility Theory."
• Daniel Kahneman & Amos Tversky — The "Founders": they "Combined" "Psychology" and "Economics," leading to a "Nobel Prize."
• Loss Aversion — The "Idea" that "The Pain of Loss" is **Psychologically Twice as Powerful** as "The Joy of Gain."
• The Reference Point — People evaluate outcomes relative to their "Current State" (Status Quo) rather than an "Absolute State."
• Framing Effect — (See Article 619). The "Way" an "Option" is "Presented" (e.g., '90% Survival' vs '10% Mortality') "Changes" the "Choice."
• Diminishing Sensitivity — Each "Extra Dollar" has "Less Impact" than the one before it (for both gains and losses).
• Probability Weighting — People "Over-weight" "Small Probabilities" (e.g., 'Lottery/Plane Crashes') and "Under-weight" "High Probabilities."
• S-Shaped Value Function — The "Mathematical Curve" that "Maps" "Objective Value" to "Subjective Utility": it is "Steeper" for "Losses" than for "Gains."
• Endowment Effect — The "Bias" where people "Value" "Something they Own" "More" than the "Same Item" if they didn't own it.
• Status Quo Bias — The "Preference" for the "Current Situation" even if a "Better Alternative" exists.

Understanding

Prospect theory is understood through Loss and Relative Value.

1. The "Pain" of the Minus (Loss Aversion): Why don't we "Bet"?

• If you have a **50/50 Chance** to "Win $100" or "Lose $100," a "Rational Person" should take the bet.
• Most humans **"Refuse."**
• To "Accept" the bet, the "Possible Gain" must usually be **$200.**
• We are "Hard-wired" to **"Protect"** what we have "More" than to **"Acquire"** what we don't.
• "Survival" (see Article 146) favored "Avoiding Predators" over "Finding Extra Food."

2. The "Anchor" of the Present (Reference Points): Wealth is "Relative."

• If you "Gain $1,000" but your "Neighbor" "Gains $10,000," you feel **"Poorer."**
• Our "Brain" (see Article 163) does not care about "Absolute Dollars."
• It cares about the **"Direction of Change"** from "Right Now."
• "Happiness" is the **"Derivative"** of Wealth, not the "Integral."

3. The "Lottery" Illusion (Probability Weighting): Why do we "Buy Tickets"?

• A **1 in 100 Million** chance of winning is **"Mathematically Zero."**
• But the "Brain" "Weights" it as **"Significant."**
• Conversely, a **99% Chance** of success feels "Uncertain" to us.
• We "Fear" the "1%" "Too Much" and "Hope" for the "0.00001%" "Too Much."

Kahneman’s 'Thinking, Fast and Slow' (2011)': The "Bible" of the field. It introduced the world to **"System 1"** (Fast/Intuitive/Biased) and **"System 2"** (Slow/Logical/Lazy). It proved that "Behavioral Economics" is the "Study of how System 1 Hijacks System 2."

Applying

Modeling 'The Loss Aversion' (Predicting 'Bet Acceptance'): <syntaxhighlight lang="python"> def evaluate_gamble(potential_win, potential_loss, win_prob):

   """
   Shows why 'Homo Economicus' would bet, but 'Humans' won't.
   """
   # Expected Value (Rational)
   ev = (potential_win * win_prob) - (potential_loss * (1 - win_prob))
   
   # Prospect Value (Human - Loss is weighted 2.2x)
   prospect_v = (potential_win * win_prob) - (potential_loss * 2.2 * (1 - win_prob))
   
   if prospect_v > 0:
       return f"RESULT: ACCEPT BET. (EV: {ev}, Prospect: {round(prospect_v, 2)})."
   else:
       return f"RESULT: REJECT BET. (Rational EV is {ev}, but it FEELS like {round(prospect_v, 2)})."

1. Case: A 'Fair' bet ($110 win vs $100 loss)

print(evaluate_gamble(110, 100, 0.5))

1. Case: A 'Great' bet ($250 win vs $100 loss)

print(evaluate_gamble(250, 100, 0.5)) </syntaxhighlight>

Economic Landmarks

The 'Mug' Experiment (Thaler) → Proving the **Endowment Effect**: students who were "Given a Mug" "Demanded" **$7** to sell it, while those who "Didn't have one" only "Offered" **$3** to buy it.

The 'Asian Disease' Problem → Proving **Framing**: when a choice was "Framed as 'Saving 200 lives'," people chose the "Certainty." When "Framed as '400 people dying'," people "Gambled."

Mental Accounting (Thaler) → The "Bias" where people "Treat Money Differently" depending on its "Category" (e.g. 'Bonus money' vs 'Salary').

Hyperbolic Discounting → The "Bias" where we "Value" "Now" "Way More" than "Tomorrow," "Explaining" why we "Fail" to "Save for Retirement" or "Diet."

Analyzing

Neoclassical vs. Behavioral Economics

Feature	Neoclassical (The Math)	Behavioral (The Psychology)	Human Model	"Homo Economicus" (Rational)	"Homo Sapiens" (Emotional/Biased)
Goal	"Utility Maximization"	"Satisfaction / Loss Avoidance"
Preferences	"Stable / Consistent"	"Context-Dependent / Fluid"
Focus	"The Market Equilibrium"	"The Individual Choice"
Analogy	A 'Computer'	A 'Primate'

The Concept of "Bounded Rationality": Analyzing "The Constraint." Herbert Simon (see Article 514) argued that we "Aren't Lazy"—we just have **"Limited Brainpower"** and **"Limited Time."** We don't "Optimize" (Find the best); we **"Satisfice"** (Find 'Good Enough'). "Prospect Theory" is the "Map" of our "Satisficing Shortcuts."

Evaluating

Evaluating Prospect Theory:

1. Universality: Does "Loss Aversion" apply to "Professional Traders"? (Or can you 'Learn' to be 'Rational'?).
2. Marketing: Is it "Ethical" to use "Prospect Theory" to "Trick" people into "Buying"? (e.g. 'Limited time offer!').
3. Policy: (See Article 620). Should "Governments" "Frame" "Taxes" as "Losses" or "Contributions"?
4. Impact: Why did "Behavioral Economics" "Fail" to "Predict" the **2008 Financial Crisis**?

Creating

Future Frontiers:

1. Personalized 'Bias' AI: An "App" that "Tracks your Spending" and "Alerts you" when your "Loss Aversion" is "Making a Bad Choice."
2. Neurological 'Market' Design: A "Stock Exchange" that "Adjusts" "Rules" (see Article 602) to "Cancel Out" "Human Biases," "Preventing" "Bubbles."
3. Global 'Utility' Credits: A "New Currency" based on "Subjective Well-being" (see Article 118) rather than "Dollars," "Optimizing" for "Human Happiness."
4. Direct 'Brain' Economics: Using "fMRI" (see Article 127) to "Measure" "Utility" "Directly in the Neurons," "Ending" the "Need" for "Prices" entirely.