# Prospect theory example. Prospect Theory 2019-03-05

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## Prospect Theory and Loss Aversion: How Users Make Decisions

We would all like to believe that we are logical decision makers. I have this coffee mug, red and white with the Swiss flag. This means that differences between small gains or losses close to the reference point are assigned a high value, whereas differences farther away from the reference point are assigned smaller values. For example, suppose the probability of being involved in an automobile accident on any one trip is 0. If a website is aware of this perception, it can attempt to modify it, for instance, by stating how long the application takes on average, and what pieces of information would be needed to complete it.

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## Prospect Theory

The editing process can be viewed as composed of coding, combination, segregation, cancellation, simplification and detection of dominance. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. In a situation you could interpret as either one large gain with a smaller loss or a single smaller gain i. Risky practices will likely be sought in an unlikely attempt to rid oneself of certain loss. This is called risk-seeking behavior.

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## Prospect Theory, Risk and Innovation

Most of us are like him, according to prospect theory. Likewise, loss making companies such as new start-ups or companies facing economic difficulties are more likely to embrace new product and service ideas as they offer the opportunity to reduce loss. You're going to sell it to me. When issues are framed in terms of emotional gains and losses, our image of probability becomes distorted through the fisheye lens of loss aversion. Avoiding the Disposition Effect It is possible to reduce the disposition effect, thanks to a concept called. We can either risk using something else that has a possibility of being better than our current method, or we can continue to use our tried-and-true tool.

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## What Is Prospect Theory?

In the first phase, decision makers are predicted to edit a complicated decision into a simpler decision, usually specified as gains versus losses. The value function is thus defined on deviations from the reference point, generally concave for gains and commonly convex for losses and steeper for losses than for gains. The value function that passes through the reference point is s-shaped and asymmetrical. Thus, in an established firm, process efficiency ideas, which reduce costs, are more attractive to the typical human than are product ideas. That is, when faced with certain loss, we are prone to believing a risk to be less than it really is. They are loss averse over these fluctuations, and the degree of loss aversion depends on their prior investment performance.

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## Prospect Theory, Risk and Innovation

And once you know those mental patterns, you start to see ways to influence them. Investors find the idea of losing more painful than they find the idea of winning pleasurable. Insurance companies often capitalize on our overweighing of unlikely how many cats get brain cancer? In other words, they would rather risk losing more money with a small chance of not losing anything. If you offer a reward for users who write a product review, for example, consider giving all reviewers a coupon for 10% their next purchase. Remembering all the details of each individual option creates too much of a , so it only makes sense to focus on the differentiators. The distorted perception of risk probability has been quantified experimentally by Kahneman and Tyversky. Why do some securities consistently have lower returns than others? As we approach the extremes of 0% and 100%, most rational people weigh these risks fairly.

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## the economist

Prospect Theory: An Analysis of Decision under Risk. But of course humans are not logical. When dealing with gains, people are risk averse and will choose the sure gain denoted by the red line over a riskier prospect, even though with the risk there is a possibility of gaining a larger reward. Prospect Theory Importance for Social Psychology At its heart, social psychology investigates how situationsâ€”typically social situationsâ€”influence judgment and behavior. First, value is assigned to changes in value rather than to absolute value. A person may think of a lottery as a. For instance, White Americans in public opinion surveys typically report that racial conditions have improved significantly more than Black Americans do.

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## Prospect Theory

Classical utility theory assumes that decision makers value a 50 percent chance of winning as exactly that: a 50 percent chance of winning. Kahneman refers to the defendant who is likely to lose a large case. But it is useful in tackling some of the longstanding puzzles of financial markets. Traditional consumption-based models of asset prices which rely on expected utility theory cannot account for this disparity. But from the moment the start-up begins operations, money is disappearing. It has also been argued that prospect theory can explain several empirical regularities observed in the context of such as secret reserve prices which are difficult to reconcile with standard economic theory. Later theoretical improvements overcame this problem, but at the cost of introducing in preferences.

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## Prospect Theory: How Users Make Decisions

But that trip to Florida might not sound nearly as wonderful when compared with an all-expenses-paid trip to Fiji. Kahneman and Tyversky also pointed out that weights we place on decisions are not linear with actual probabilities. To persuade users to take an action, consider using the certainty bias to your advantage: people would rather accept a small but certain reward over a mere chance at a larger gain. Likewise, gamblers who have experienced significant losses will often continue to gamble in attempts to recoup losses, rather than cutting their losses and going home. We tend to overweight risk when faced with possible loss of a perceived gain.

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## the economist

Seventy percent of the students opted for the coin-flip. The prospect theory was proposed by psychologists Daniel Kahneman and Amos Tversky in 1979, and later in 2002 Kahneman was awarded the Nobel Prize in economics for it. Third, the asymmetry between gains and losses means that people are likely to be risk seeking in the domain of losses, but risk averse in the domain of gains. We react more strongly to moments of loss â€” in the form of frustration or confusion that may occur during an interaction with a website or an app. They minimize losses and maximize gains without distorting probabilities.

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## Prospect Theory, Risk and Innovation

Prospect theory would seem also to be applicable to innovation and, indeed, shows that start-ups are likely to be more risk-seeking, and hence innovative, than established companies. For real probabilities over 35%, we tend to weigh risks higher than the actual numbers. Recent advances in prospect theory involved demonstrations in field settings such as with New York taxi drivers , and the more complicated treatment of decisions with a very large number of possible outcomes called cumulative prospect theory. Let me give you an example. These will be given more probabilistic weight than is reasonable. This is a possible explanation for why the same person may buy both an policy and a ticket.

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