Prospect theory was developed by Amos Tversky and Daniel Kahneman in 1979. This model was developed as the psychologically realistic alternative approach to the expected utility theory. The prospect theory of economics describes how the investors can choose the right alternatives involving risks. The theory helps people to opt for the right financial decision. Interestingly, the model even considers empirical evidence in order to describe how people evaluate potential gains and losses.
The Prospect theory describes decisions in two stages - editing and evaluation. In the first process the possible outcomes of the decision are ordered following some probability. In the evaluation phase of the model, people seem to compute a value on the basis of the potential outcomes and their respective probabilities. Then they choose the alternative, which is having a higher utility than the other. The prospect theory is now connected to optimal foraging theory by the scholars.
The formula for the evaluation phase assumed by Kahneman and Tversky is given by:
U = w(p1) v(x1) + w(p2) v(x2) + ……….
Here,
x1, x2, x3 ……. represent potential outcomes
p1, p2, p3 …… are the respective probabilities of x1, x2, x3…..
v stands for the value function
Some behaviors of economics such as the disposition effect or the reversing of risk aversion or risk seeking in case of losses or gains can also be explained with the help of the prospect theory.
An important use of prospect theory is that the approach used by the economic agents in framing the outcome or transaction has direct or indirect effect on the utility received or expected. In case of the mental accounting and behavioral economics, the aspect of prospect theory is widely implemented. The prospect theory has also been applied to a varied range of economic situations that seem to appear inconsistent with respect to the standard economic rationality, the status quo bias, the equity premium puzzle, various betting and gambling puzzles, endowment effect and inter-temporal consumption.