What is reflection effect in prospect theory?
The reflection effect (Tversky & Kahneman, 1981) refers to having opposite preferences for gambles differing in the sign of the outcomes (i.e. whether the outcomes are gains or losses). Reflection effects involve gambles whose outcomes are opposite in sign, although they do have the same magnitude.
What is the shape of the value function in prospect theory concave?
The value function is defined in terms of gains and losses relative to a psychologically neutral reference point. The value function is S-shaped; concave in the region of gains above the reference point, convex in the region of losses (see Fig. 1).
What are the main components of prospect theory?
In essence, prospect theory has three components, which concern the role played by decision frames, mistakes in relation to evaluating probabilities, and a risk preference structure.
What is the cancellation principle?
The logic underlying expected utility is that when two risks share a common outcome X with common probability p(X), that common (X,p(X)) element can be cancelled out when comparing the two risks. This cancellation principle is logically appealing.
How does prospect theory affects your decision making?
Prospect theory states that decision-making depends on choosing among options that may themselves rest on biased judgments. Thus, it built on earlier work conducted by Kahneman and Tversky on judgmental heuristics and the biases that can accompany assessments of frequency and probability.
How does prospect theory affect decision-making?
What are the key elements of Prospect Theory?
Following this will be, a discussion of the key elements of prospect theory – the value function including a small reference to endowment effect and the status quo bias, reflection and framing effect, isolation effect and probabilistic insurance.
How is the value function defined in prospect theory?
The value function is thus defined on deviations from the reference point, generally concave for gains and commonly convex for losses and steeper for losses than for gains. If This means that for a fixed ratio of probabilities the decision weights are closer to unity when probabilities are low than when they are high.
How does prospect theory differ from expected utility theory?
The theory departs from the traditional expected utility theory because it attempts to explain how people really make decisions between risky alternatives, which attempts to model optimal decisions. This vital difference leads to the prospect theory departing from the traditional framework in important ways.
How does the prospect theory relate to risk aversion?
The prospect theory starts with the concept of loss aversion, an asymmetric form of risk aversion, from the observation that people react differently between potential losses and potential gains.