Legal Definitions - prospect theory

Prospect theory is a theory from behavioral economics that describes how individuals make decisions when faced with uncertain outcomes, particularly when evaluating potential gains and losses. Unlike traditional economic models that assume people make perfectly rational choices based on the absolute value of outcomes, prospect theory suggests that people evaluate outcomes relative to a "reference point" (often their current state or expectation).

Key insights of prospect theory include:

• Loss Aversion: People feel the pain of a loss more intensely than the pleasure of an equivalent gain. For example, losing $100 might feel worse than gaining $100 feels good.
• Diminishing Sensitivity: The psychological impact of gains and losses diminishes as they move further from the reference point. For instance, the difference between gaining $10 and $20 feels more significant than the difference between gaining $1,000 and $1,010.
• Framing Effects: How choices are presented (e.g., in terms of potential gains versus potential losses) can significantly influence decisions. People tend to be risk-averse when choices are framed as potential gains but risk-seeking when choices are framed as potential losses.

This theory helps explain why people often make choices that appear inconsistent with pure economic rationality.

Here are some examples illustrating prospect theory:

• Example 1: Investment Decisions

  Imagine an investor who owns shares in a company that have dropped significantly in value. They have two options: sell the shares now and realize a definite loss, or hold onto them in the hope that the stock will recover, even though there's a significant risk it could fall further. According to prospect theory, the investor might be more inclined to hold onto the losing shares (taking a risk) rather than selling them and accepting a certain loss. The pain of realizing the loss is so strong that they prefer to gamble on a recovery, even if the odds are not favorable, to avoid that immediate feeling of loss.

• Example 2: Insurance Choices

  Consider a person deciding whether to purchase extended warranty insurance for a new appliance. The warranty costs a certain amount, and the appliance has a low probability of breaking down within the warranty period. From a purely rational, expected-value perspective, buying the warranty might not be the most financially sound decision. However, prospect theory suggests that the potential "loss" of having the appliance break down and needing to pay for repairs out-of-pocket feels much more significant than the "gain" of saving the warranty cost. The fear of this potential loss drives many people to purchase insurance, even for low-probability events, because it provides a sense of security against a highly aversive outcome.

• Example 3: Legal Settlement Negotiations

  A defendant in a lawsuit is offered a settlement of $50,000. Their lawyer advises that going to trial carries a 60% chance of winning and paying nothing, but a 40% chance of losing and having to pay $150,000. A purely rational defendant might calculate the expected value of going to trial. However, under prospect theory, the defendant might be strongly influenced by the potential "loss" of $150,000 if they lose at trial. The pain of this large potential loss could make them risk-averse, leading them to accept the certain $50,000 settlement, even if the expected value of going to trial might statistically be more favorable. They prefer a smaller, certain loss over a gamble that could result in a much larger, more painful loss.