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When prospect theory was added to a previously existing model that was attempting to explain consumer behavior during auctions, out-of-sample predictions were shown to be more accurate than a corresponding expected utility model. Specifically, prospect theory was boiled down to certain elements: preference, loss aversion and probability weighting.
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]
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.
Amos Nathan Tversky (Hebrew: עמוס טברסקי; March 16, 1937 – June 2, 1996) was an Israeli cognitive and mathematical psychologist and a key figure in the discovery of systematic human cognitive bias and handling of risk.
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.
The main modification to prospect theory is that, as in rank-dependent expected utility theory, cumulative probabilities are transformed, rather than the probabilities themselves. This leads to the aforementioned overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events.
In 1979, Daniel Kahneman and Amos Tversky traced the cause of the disposition effect to the so-called "prospect theory". [3] The prospect theory proposes that when an individual is presented with two equal choices, one having possible gains and the other with possible losses, the individual is more likely to opt for the former choice even ...
Theory of Literature is a book on literary scholarship by René Wellek, of the structuralist Prague school, and Austin Warren, a self-described "old New Critic". [1] The two met at the University of Iowa in the late 1930s, and by 1940 had begun writing the book; they wrote collaboratively, in a single voice over a period of three years.