Question

Discuss and Explain at least 3 psychological effects related
to prospect theory.

Answer 1

Prospect Theory highlights psychological effects such as loss aversion, where individuals fear losses more than they value equivalent gains; reference dependence, where assessments are made in relation to a reference point; and non-linear probability weighing, leading to overestimation or underestimation of probabilities affecting risk-related decisions.

Step-by-step explanation:

Prospect Theory, developed by Daniel Kahneman and Amos Tversky, addresses the psychological effects of decision-making under risk. Three notable psychological effects associated with Prospect Theory include:

1. Loss Aversion: Individuals tend to prefer avoiding losses rather than acquiring equivalent gains because losses are psychologically more impactful than gains.
2. Reference Dependence: This effect implies that people evaluate outcomes relative to a reference point, usually their current status or expectations, rather than based on the final outcome’s absolute value.
3. Non-linear Probability Weighing: People tend to overweigh small probabilities and underweigh large ones, leading to risk-averse behavior in the face of gains and risk-seeking behavior when facing losses.

Each of these effects can lead to decision-making that deviates from expected utility theory, demonstrating the importance of psychological factors in economic behavior.