Daniel Kahneman’s prospect theory.

A theory of how we value the possibility of losing or winning when making a decision.

In the field of psychology applied to economic behavior, Daniel Kahneman's the figure of Daniel Kahnemanan American-Israeli author whose work has focused on the determinants of decision-making in situations where profits and losses are uncertain.

This psychologist, in addition to being one of the few to have won a Nobel Prize, is known for his research on bounded rationality, in which he challenges the idea that human beings are fundamentally rational.

In this article we will look at the prospect theory of Kahneman and his regular collaborator, Amos Tversky.. This model is one of the main developments of the classic concept of subjective expected utility, which is very relevant in economics and psychology.

Biography and work of Daniel Kahneman

Daniel Kahneman was born in 1934 in Tel Aviv, although he grew up in France in the period surrounding World War II. His family later moved to Palestine. Of his childhood and youth, Kahneman highlights the relevance of human interaction and complexity in Jewish culture and his own interest in existentialism. and his own interest in existentialism as fundamental factors in his decision to become a psychologist.

In 1961 he received his Ph.D. in psychology from the University of Berkeley, California, where he also studied mathematics. He later became a key figure in the study of a key figure in the study of human judgment, in behavioral economics and in hedonistic psychology, an aspect of psychology that has been a key factor in his decision to become a psychologist.a branch of positive psychology that focuses on the analysis of pleasure and the aspects that favor or harm it.

In 2002 Kahneman was awarded the Nobel Prize in Economics in recognition of the multiple contributions to this field that he has made from psychology in collaboration with the late Amos Tversky. His work on decision making under uncertainty was especially noted. He has also received awards from the American Psychological Association and the Society of Experimental Psychologists, among others.

Kahneman is currently professor emeritus and senior research fellow at the Woodrow Wilson School of Public and International Affairs, which is part of Princeton University in New Jersey. He is also an honorary member of the universities of Berkeley and British Columbia, as well as the Hebrew University of Jerusalem and other institutions.

Kahneman and Tversky's prospect theory

Kahneman and Tversky's prospect theory, also known as prospect theory or loss aversion theory, develops the expected utility hypothesis, a concept from economic game theory that states that people choose the alternative that we consider the most useful from among those available to deal with a given situation.

According to prospect theory, when there is uncertainty with respect to outcomes we tend to opt for certain rewards over less probable ones, even if the value of the former is higher than that of the latter.even if the value of the former is lower.

In addition, we attach more importance to small losses, even if they are unlikely, than to moderate gains; the authors call this "loss aversion".. Because of our aversion to losses, if we are presented with two equivalent alternatives, one of which is formulated in terms of profit and the other in terms of loss, we will most likely choose to avoid the latter. In short, we would rather avoid losses than make a profit.

Thus, for example, if two financial advisors offer us to invest in the same stocks but the first stresses that they have a moderate average return and the second that their profit ratio has declined in recent years, we will prefer the offer of the first advisor.

Kahneman and Tversky stated that the prospect of losses has a greater emotional impact than the prospect of profits and that we tend to perceive the probability of losses as being 50/50, regardless of how much smaller it is.

Main concepts

In addition to the concept of loss aversion that we have already seen, prospect theory provides two other fundamental aspects: evaluation relative to a benchmark and variable sensitivity..

The benchmark is broadly identified with the average expectation with respect to a given profit or cost.. This benchmark can be an amount of money, such as the usual price of a good or the salary we earn each month, or any other quantitative indicator.

The concept of variable sensitivity refers to the fact that our sensitivity to losses decreases as the benchmark increases. as the benchmark increases. For example, if a kilo of tomatoes costs 60 cents in a store in our street and 50 cents in another one 15 minutes away, we will probably choose to buy in the second one, but we will not make the same effort to save 10 cents in the purchase of a household appliance.

Applications of this model

The prospect theory is often applied to people's economic behavior. It is useful for predicting behavior in areas such as organizational psychology, gambling and economics itself.

This model explains various psychological effects, such as the "status quo". In economics, this term refers to the fact that people often prefer to maintain their current state if they are offered alternatives that do not provide greater satisfaction, as happens when someone rejects a better paying job than the one they already have because accepting it would imply a change of address and lifestyle.

Likewise, Kahneman's theory also justifies the so-called endowment effectwhich causes people to place a higher value on some things than they objectively have for emotional reasons. Following the previous example, it is possible that someone might choose to continue living in his current city because most of his loved ones reside there.