A Literacy Review of The Prospect Theory: Why Has It Been Revolutionary and How It Has Changed the Way We Conceptualize Decision-Making Under Risk
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School of Business |
Bachelor's thesis
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Authors
Date
2019
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Mcode
Degree programme
Taloustiede
Language
en
Pages
31
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Abstract
To conclude, in this paper we discussed, in great detail, the revolutional axioms presented by Daniel Kahneman and Amos Tversky in 1979, namely the prospect theory. Prospect theory has forever changed the way we conseptualize the decision-making process under risk. The theory itself is divided into two separate phases; editing and evaluation phase. The most prominent part of the editing phase is coding, in which, decision makers change the meaning of, e.g., monetary sums of money, to more easily approachable form; gains and losses. This has been one of the biggest conceptual insights of this theory. However, as we established before, to review events in the light of gains and losses, they need to be in reference to something. In prospect theory, this was named as a reference point. The problem with coding (gains and losses) and the reference point is that, in the real-life applications, it has been unclear what a gain or loss represents in any given situation. This challenge remains unsolved. Addressing it is a key-challenge for the future of the prospect theory and its real-life applications. On top of this, prospect theorems strong suit has been the weighting function, which demonstrates the way in which decision makers over and undervalues mathematical probabilities. In figure 2, this is truly brilliantly demonstrated. This finding is to a great extent used in the field of, e.g., insurance since the uncertainty is an inherent part of the industry. The weighting function does also question the expected utility theorems axiom about a rational decision maker, because it shows how, even when decision makers are greatly exposed to the true mathematical probability, the anomalies of over and underweighting still occurs. Anomalies emerging from the evaluation of a prospect were greatly also noted by the value function. In the value function, it was demonstrated through empirical evidence, how decision makers were constantly feeling more pain (pleasure), from losing (gaining) an exactly equivalent monetary sum of money. In more conservative models, e.g., the expected utility theorem, this contradiction would be not possible. These emerged anomalies were truly hard to fathom within the economists and were, therefore, criticised extensively. The experiments were conducted multiple times, each time with more like real-life situations for the decisions made under risk. Even though the best efforts, these anomalies stayed. Because of this truly strong empirical evidence, the prospect theory is today widely recognized. The applications of this the prospect theory have been the most vital in the areas of finance and insurance since they are, in essence, concerned with situations involving uncertainty. This is why in these fields the prospect theory have naturally had a stronger foothold and also the framework has been adapted to the academic reasoning as well. In fact, this theorem has been an inherent part of the formulation in the field we today call behavioural economics. One of the first foot steps were made in that direction by Kahneman and Tversky and soon after by Thaler. In other fields, the theory itself has proven to be truly difficult to be modelled into a given situation at hand. There have been plenty of practical problems, one of which have to do in regard to the definition of the reference point. Despite this, during this millennium, successful attempts have been made and, therefore, the prospect theory has been more widely utilized. Thus, in the near future, we might be able to model the prospect theory to fit a larger range of applications. To conclude, the failure to endogenize all of the relevant variables at this stage of the prospect theory is a limitation of the theory but not a fatal flaw. Therefore, “we should see it as an opportunity to improve the theory rather than as a reason to reject it” (Rat Choice 1997). On top of that, the expected utility theorem is based on a normatively pleasing set of axioms, where as the prospect theory is mainly descriptive model, which has yielded inexplicable solid empirical evidence supporting this descriptive way of reasoning. When all this is taken into account, prospect theory has been a revolutionary descriptive model and even though it faces challenges in the real life applications, the potential behind the prospect theory is enormous.Description
Thesis advisor
Mustonen, MikkoMurto, Pauli
Keywords
prospect theory, behavioural economics, behavioural finance, endowment effect, Suomi, Finland