Prospect Theory is a behavioral economic theory that describes how people choose between probabilistic alternatives that involve risk, where probabilities of outcomes are known.
Proposed by Daniel Kahneman and Amos Tversky in 1979, the theory illustrates how people make decisions based on the potential value of losses and gains rather than the final outcome. People are generally more sensitive to losses than equivalent gains, and their decision-making process is influenced more by potential losses. For example, in a game of flipping a coin, if the choice is between 100% chance of winning $1000 or 50% chance for $2000, that's where most individuals would opt for the sure shot $1000, although the expected values are same, reasoning it as a loss aversion strategy. This illustrates they're more willing to take a risk to prevent a loss.
People react to losses and potential gains differently. Loss aversion could lead to riskier decisions, as individuals are willing to take more risks to avoid certain losses.
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