New Prospect Theory

PROSPECT THEORY

Carlo Gozalo

ECN 132 – Microeconomics

Every human being in their everyday life has to make decisions under extreme or normal conditions. There is a theory known as prospect theory, this theory shows how people make decisions in situations where must undergo certain risks; It typically emphasizes the financial decisions. It is also based on statistics and estimates to anticipate possible outcomes according to the best decision.

Prospect theory was developed by Daniel Kahneman and Amos Tversky both psychologists, this study showed how people assumed risks according to the probabilities of obtaining benefits or not, based on an empirical decision making. However is not based on the final result obtained by a decision making but in probabilities of having gains or losses, since normally applies in financial matters (Epley, 2012). This theory consists of two phases, editing where the person imposes a point of reference with respect to the results that you want to obtain and then evaluate the risk and possibilities to have earnings or losses; and the evaluating phase where people evaluated the risk according to the most probable results, and then take an effective decision that provides secure profits (Gaynard, 2009). For example: a person is given to choose get safely 1000$ or $ 2500. but with half of the probabilities of obtaining them; This example shows as result that the majority of people would risk if there is at least a 50% probability of profits, if the risk they assume is greater the decision will go for the sure way, in this case $ 1000 (Watkins, 2012).

It can be concluded that prospect theory was a research focus on how people make decisions according to the circumstances and risks having to assume. This study shows that people decided to take risks based on probabilities and estimates of results. This theory can also be applied in the area of finance, since thanks to the mathematical...