What Is Prospect Theory In Behavioral Economics?

Prospect theory is a psychological theory that describes how people make decisions when faced with uncertainty or risk. The theory proposes that people tend to value gains and losses differently, and that they are more sensitive to losses than to gains of the same magnitude. This means that people may be more willing to take risks to avoid losses than to obtain gains, and that they may be more likely to choose a certain option that offers a smaller reward over an uncertain option that offers a larger potential reward. Prospect theory also suggests that people have a tendency to overweight small probabilities and to underestimate large probabilities, and that they are more influenced by the potential for extreme outcomes than by the average or expected outcomes of a situation. Overall, prospect theory provides a framework for understanding how people make decisions when faced with uncertainty or risk, and can be used to predict and explain people’s choices in a variety of situations.

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