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The value function that passes through the reference point is s-shaped and asymmetrical. The value function is steeper for losses than gains indicating that losses outweigh gains. Prospect theory stems from loss aversion, where the observation is that agents asymmetrically feel losses greater than that of an equivalent gain. It centralises ...
A typical value function in Prospect Theory and Cumulative Prospect Theory. It assigns values to possible outcomes of a lottery. The value function is asymmetric and steeper for losses than gains indicating that losses outweigh gains. A typical weighting function in Cumulative Prospect Theory.
Prospect theory and loss aversion suggests that most people would choose option B as they prefer the guaranteed $920 since there is a probability of winning $0, even though it is only 1%. This demonstrates that people think in terms of expected utility relative to a reference point (i.e. current wealth) as opposed to absolute payoffs.
Reference dependence is a central principle in prospect theory and behavioral economics generally. It holds that people evaluate outcomes and express preferences relative to an existing reference point, or status quo. It is related to loss aversion and the endowment effect. [1] [2]
One of the most famous examples of the endowment effect in the literature is from a study by Daniel Kahneman, Jack Knetsch & Richard Thaler, [4] in which Cornell University undergraduates were given a mug and then offered the chance to sell it or trade it for an equally valued alternative (pens).
It is an idea introduced in prospect theory. Normally a reduction in the probability of winning a reward (e.g., a reduction from 80% to 20% in the chance of winning a reward) creates a psychological effect such as displeasure to individuals, which leads to the perception of loss from the original probability thus favoring a risk-averse decision.
The classic counter example to the expected value theory (where everyone makes the same "correct" choice) is the St. Petersburg Paradox. [ 3 ] In empirical applications, several violations of expected utility theory are systematic, and these falsifications have deepened our understanding of how people decide.
Some explanations rely on assumptions about individual behavior and preferences different from those made by Mehra and Prescott. Examples include the prospect theory model of Benartzi and Thaler (1995) based on loss aversion. [19] A problem for this model is the lack of a general model of portfolio choice and asset valuation for prospect theory.