The Relevancy of the Prospect Theory - Term Paper Example

Introduction Prospect theory is the critique made on the utility theory to create a descriptive model that is an alternative model in decision making for risk management. This theory was discovered by Kahneman in collaboration with Tversky who discovered that majority of the people underweight outcomes which are simply probable when it comes to comparison with the results received with certainty. The theory also states that people normally discard components which are shared by the entire prospects in consideration (Gonzalez1676–9). However, in prospective theory a certain value is allocated to gains as well as losses instead to the final assets and the probabilities are reinstated by the decision weights. The operating value is stated on deviations at a given reference point which is generally in concave shape for risk aversion or gains and in convex shape to represent risk seeking or losses, the losses are steeper than gains. This means that decision weights are normally below unlike with the corresponding probabilities which are always high as illustrated below; Fig. Hypothetic value operation Fig. Weighting functions gain (w+) and losses (w+) The good side of Prospect theory Prospect theory is considered to have challenged the normal alternative approach. This is particularly indicated in the challenge for notion invariance since the description of the option need not to affect the results of the choice made. The theory was created by several psychologists such as; Tversky and Kahneman and it is doing very pretty good duty of clarifying the several situations that the normal utility theory presents the wrong predictions Lattimore & Baker (1992, p. 377–400). The bad side of Prospect theory The major idea is that the implementation of the information security measures or programs is very hard and in most cases a gamble. Such difficulties twist the decision making procedures for the business. This causes a negative impact to the information security experts as they are regularly left outside the easy business reason and economic principles. The information security professional challenge involves how the problem of Prospect theory can be managed in an organization. The challenge requires the usual fiscal attention and people being risk loving in discussing the likely impact of security limitations. To a larger extent, compliance to the rules has greatly forced several private sectors to unwillingly invest in some risk management as well as mitigation programs. However, several organizations still need to be convinced yet the prospect theory states that selling the risk aversion idea in the loss-focused situations will definitely not work. The relevancy of the Prospect theory The prospect theory illustrates very vital milestone, Kahneman in collaboration with Amos have proved in their several experiments that the everyday reality among decision makers changes depending on the assumptions maintained by the economists. The theory is concerned with the behaviors reflected among the decision makers who time and again face the problem of choice making between two options. Decision making in risks which is the subject of discussion is considered as the choice made between prospects. The decisions in relation to risks are used to indicate the choice between some alternative events that are related to specific probabilities. This theoretical model was later on elaborated and changed (Tversky & Kahneman 263–292). The Prospect theory has greatly contributed to the association of psychology and economic analysis. Many economists are still making use of the utility theory model in their problem solving; however, the prospect theory has achieved increased ground in the current years occupying the second position on the schedule of research especially to the mainstream economists. Prospect theory comprise of strong mathematical basis ideal for efficient use by the economists, unlike with psychology. However, with utility theory, there is great concern on how the decisions found to be under uncertainty ought to be made or rather be prescribed. The Prospect theory deals with how the various decisions are made or described and it was established by two professional psychologists namely; Tversky and Kahneman who aimed at building a parsimonious model that suits various violations within the classical nationality of which them and other people had actually uncovered within the experimental work (Plous 60-75). The theory is considered as one among the frequently quoted and well-documented principles in the economic psychology. Prospect theory clearly states that people possess irrational tendency of being less willing in the gambling for profits very much than for losses. This reflects that there is the ability to sell faster when profits are earned than if people are running into losses. Prospect theory assists in the clarification of how the loss aversion and the limited control to sunk costs, involve people in actions which are not of their really interest (Tversky & Kahneman 263–292). The Prospect theory shows great improvement compared to the utility theory. The numerous violations found in utility theory are clearly forecasted with the prospect theory. The theory is considered as the most suitable comprehensive description for decision process illustration. It summarizes a variety of centuries’ insights and research findings that are related to the decision behaviors of individuals and it has offered a unique yield of the latest approaches and forecasts of the human behavior reflected in decision making. The irrelevancies of prospect theory First as well as second generation of prospect theory share similar limitation, such limitations include the following. Reference points that provide a platform for prospects evaluation are being considered as certainties. In case this reference points are interpreted to be the endowments, then the theory may not be applicable to the kinds of problems that involve the endowment of the decision maker with the lottery for selling. These kinds of problems are very widespread in the actual economic lives. The theory also feature in several experimental plans and as a result of this, an efficient attempt is considered on how the decision-makers react to them. This evidence illustrates some well-established and vigorous patterns that contribute to the deviation from the available predictions of conventional utility theory (Keele & Joseph 123). The Willingness-to-accept valuations that involve lotteries seem to be more than the Willingness-to-pay assessments. Intuitively, an individual may expect loss aversion found in the prospect theory to clarify the effect. However, as a result of Willingness-to-accept assessment of lottery is created from the reference point where the expected decision-maker is instead endowed with such lottery rendering the intuition not to be in a position to express within the existing prospect theory versions. The instances of preference reversal consist of the decisions that are related to two gambles. Due to the increased tendency among the agents in revealing preference for a P bet as a choice while $ bet for valuation, there is creation of inconsistencies between the choice made and the valuation that arise via chance or sometimes as an error. However, opposite inconsistency where the $ bet has been chosen but for the P bet has been assigned higher value has been less frequently identified. Therefore, as a result of such identity between reversals that creates the preference reversal puzzle. Since the available prospect theory versions cannot really handle the Willingness-to-accept assessments of lotteries and may not be applicable to the classic preference reversal difficulties (Karmarkar 61-72). Why the prospect theory worked Prospect theory in the management of risks and the ambiguities produces the primary comprehensive as well as accessible textbook about the ways for managing decisions. The theory illustrates how such decisions are made basing on the available statistical probabilities that are related to uncertain occasions in the future and during the time they are not available or ambiguity time (Bernstein 45-9). Models which are tractable and also psychologically realistic are presented in the book under the prospect theory. A suitable method for the presentation is selected which make empirical meaning for every theoretical model that is absolutely transparent. The theory has several applications in a wider range of disciplines. Given the various exercises with worked examples, the information which is contained in the book was carefully organized to enable the readers to choose pathways that interest them. This has made the book very ideal for the needs of those students who take courses for decision theory in the field of mathematics, economics, management science, psychology, engineering, computer science, and health. The increased need for the economic decisions models which are realistic and involve risk as well as uncertainty under the reasonable behavioral foundation. The prospective theory has been widely accepted and considered as the basic alternative to the rational utility model. The theory has massive potential for the clarification of a wide range from the international behavior to the availability of hypotheses for the rationalization of the observed behaviors. Prospect theory has been considered as the main influential behavioral paradigm reliable for choice in social sciences. The founders won the Nobel Prize in the field of economics (Hastie& Dawes 15-21). Why the prospect theory failed to work People may decide to avoid losses simply because losses related to hierarchical class; power and status are always difficult to be taken psychologically. It is considered that majority of the people usually experience too much regrets as a result of commission error making than when compared to the experience of omission errors. This assists in the clarification of the reasons as to why value function that is consistent within the prospect theory generates the trend in loss aversion. People are also found to be very far away from willingness to engage themselves in risk behaviors. This is so because they always want to avoid and cover themselves from potential losses instead of willingly taking risks to better their positions. Such paired choices kind of pattern is inconsistent in relation to the standard economic hypothesis concerning people’s preference functions (Prelec 497-527). The prospect theorists group the inconsistencies and the rationality assumptions into the following problem anomalies; i. Framing which states that people may at times make distinct choices in case similar problem is presented in various ways ii. Loss aversion which suggests that potential losses appears to be more than comparatively equivalent potential gains. The identified symmetry in the differences is very large than it can be explained solely with income effects iii. Nonlinear preferences which suggest that people at times make choices which are consistent with the assumptions concerning preference functions iv. Source which is taken to be the mechanism is very significant particularly if the possible outcomes are found to be identical. This means that people may opt to go for a good just because of its packaging mechanisms than going for an item which they are aware of it being identical although packaged differently. v. Risk aversion vs. risk seeking where some people will simultaneously and intentionally undertake unfair bets in order to avoid and the unfair bets so as to increase the risk. Examples in the prospect theory The following examples illustrate the recent application of prospect theory. Reasons as to why NATO are not in Asia Rationalists as well as the constructivists make arguments on the impact of identity, institution, and power to clarify on this issue. Prospect theory was introduced from the political psychology point of view that suggests a prospect –threat coalition model so as to account for the variations in the world and particularly in Asia. This can be achieved through the setting up of the threat baseline to act as the reference point which can be used by leaders’ prospects for losses or rather gains. This indicates that prospect-threat coalition model argues; i. Increased threats places the decision makers within the domain of loss such that multilateral alliances, this turn out to be helpful alliance choice since various states are in a position to undertake the risk of constraining the freedom of any solid action for a great support ii. Low threats, position the leaders to a domain for gains with bilateral coalition is achieved since several states are considered to be risk-averse, in such a way that maintains their agreed freedom to take an action in the attempt of in quest of security via alliances. Recommendations In order to effectively apply the prospect theory to the various empirical cases, the involved analysts should not only demonstrate how empirical behavior is very consistent, but also understand that the observed kind of behavior cannot absolutely be explained by the rational choice method that hypothesizes the maximization of probable value. So as to enable people to effectively adopt something, there is need to greatly focus on the side of gain, while to have them reject that particular thing effective focus on whatever they may lose is very important. This reflects that if people perceive too much risk, then a focus on the loss should be considered, whereas if they lowly perceive risks, then a focus on the gains need to be taken into consideration. However, in case of either focus on gain or loss, then such perceived risk must be set up accordingly. In defending choices, people should be aware of the kinds of words that may lead him or her off course. There great need to reason in such a balanced manner concerning potential gains as well as losses. Conclusion In summary, normally people have the tendency of valuing gains that are very certain compared to gain found not to be certain, this is even true when the value expected from each is similar. The opposite is considered to be more similar fort the losses, people tend to hold at straws in order to avoid certain loss; this is even if to them it means undertaking more risks. Generally, when people perceive greater risks they focus on the losses, while if the risk is lower people shift to gains. Works Cited Kahneman, Daniel, & Amos TVERSKY, Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263–292. 2000. PLOUS, Scott. The Psychology of Judgment and Decision Making. New York: McGraw-Hill. 1999. Lattimore, P. K., Baker, J. R., The influence of probability on risky choice:a parametric examination’, Journal of Economic Behavior and Organization, Vol. 17, pp. 377–400. 1992. Gonzalez, R., Curvature of the probability weighting functions, Management Science, Vol. 42, , pp. 1676–90. 1996. Peter Bernstein, Against the Gods: The Remarkable Story of Risk, John Wiley & Sons, New York, 1996. Keele, Luke. & Bafumi, Joseph. Rationality, Prospect Theory and Economic Evaluations of the President, Chicago, Illinois, Apr 15, 2004. HASTIE, Reid, and Robyn M. DAWES, Rational Choice in an Uncertain World: The Psychology of Judgment and Decision Making. Thousand Oaks: Sage Publications, 2001. Karmarkar, U., Subjective weighted utility: a descriptive extension of the expected utility model, Organizational Behavior and Human Performance, Vol. 21, pp. 61–72. 1999. Prelec, D., The probability weighting function. Econometrica, Vol. 66, pp. 497–527.19. Read More