Thaler Wins Nobel For Behavioral Econ

09 Oct 2017

Prospect theory contains four main elements.

First, individuals derive utility not from wealth (or consumption) levels, but rather from gains and losses relative to some reference point.

Second, individuals are more sensitive to losses than to gains, i.e., they exhibit loss aversion. The utility function captures the loss aversion of individuals in a kink at the reference point, with the function being steeper in the losses region compared to the gains region.

Third, individuals exhibit diminishing sensitivity to gains and losses, i.e., moving from a $100 to a $200 gain (or loss) has a larger utility impact than moving from a $10,100 to a $10,200 gain (or loss).

Fourth, the theory incorporates probability weighting: individuals weigh outcomes by subjective, transformed probabilities or decision weights, overweighting low probabilities and underweighting high probabilities.

Prize Announcement and Research Summary