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Prospect theory assesses the loss and gain perspectives of individuals. Losses are not perceived equally as Gains
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The following principles govern Prospect Theory
- Adaptation Level - evaluation is relative to a neutral reference point. Tastes are not fixed, they vary with this reference point.
- Diminishing Sensitivity - sensitivity depends on scale. Small increments are only noticeable at small scales.
- Loss Aversion - There is an asymmetry where we weigh a loss more than an equal gain.
- Evolutionarily, this makes sense. An organism that perceives threats as more urgent survives better.
- A byproduct of this is a single bad in many good things stands out more, and a single good in many bad things stands out less.
- When we make decisions, we undervalue opportunity costs
- This makes negotiations more difficult. the exploitation of market power to impose losses on others is unacceptable
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Ambiguity Effect - the tendency where decision making is affected by a lack of information. People select options for which the probability of a favorable outcome is known.
- Can stem from a heuristic to avoid options where information is missing.
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Disposition effect - the tendency of investors to sell assets that have increased in value and keep assets that have dropped in value.
- We sell valuable assets because we are risk-averse with gains. The increased value increases certainty in these assets.
- We keep depreciated assets because we are risk-seeking with loss. We take the risk that these assets will gain value some time in the future.
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Dread Aversion - dread yields double the emotional impact of savoring
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Endowment Effect - people are more likely to retain an object they own than acquire the same object they do not own.
- Another way to say this is loss aversion associated with parting from an owned item. We see that we lose the item we own rather than what we gain from parting with it.
- Another way to view this is that the item is valued differently between the buyer and the seller. Thus, it may happen because people do not want a bad deal. It happens when there is a gap between a buyer’s willingness to pay and a seller’s willingness to accept a price.
- Can also be attributed to liking things associated with ourselves, this extends to “psychological ownership” where we think we own the item even if we do not physically own it.
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Pseudocertainty effect - the tendency to perceive an outcome as certain when it is actual uncertain in multi-stage decision making.
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Status Quo Bias - a preference for the status quo. Losses and gains are taken with reference to the status quo.
- A corollary to this is a resistance to change.
- We prefer the norm because we perceive deviation as a loss, and we want to avoid regrets that may stem from deviating from the safety of the norm.
- We prefer the norm to reduce uncertainty and risk and the cognitive load this brings.
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System Justification - the tendency to defend and bolster the status quo. Alternatives are disparaged even at the expense of individual or collective self-interest.