Final answer:
The concept explained by the difference between subjective and objective probabilities in prospect theory is the Certainty Effect. This occurs because people tend to prefer certainty over probability, which is highlighted by individuals who often choose a certain outcome over a higher valued probable outcome.
Step-by-step explanation:
The concept in prospect theory that is explained by the difference between subjective and objective probabilities is the Certainty Effect. The Certainty Effect occurs when people overweigh outcomes that are considered certain, compared to outcomes which are merely probable. Prospect Theory, developed by Daniel Kahneman and Amos Tversky, describes how people make choices in situations involving risk and uncertainty. People prefer certain gains over probable ones but are willing to accept risks to avoid losses, even when the expected outcomes may be equivalent. This aversion to uncertainty can also lead to inconsistency in decision-making, as subjective probabilities of an event occurring can differ significantly from the objective, statistically calculated probabilities.
Let's take an example to illustrate the concept. Imagine you have two options: 1) receiving $100 for sure, and 2) having a 95% chance to win $105. Many people would choose the certain gain of $100 over the probable gain of $105, demonstrating the Certainty Effect. This is despite the expected value of the second option being higher ($99.75), which is the probability of winning times the amount that could be won.