What is Prospect Theory?

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Indian Institute of Technology Madras (IIT Madras) researchers recently devised a mathematical model on contract farming to predict farmers' delivery of commodities using a decision-theoretic framework based on the 'Prospect Theory.'

About Prospect Theory:

  • It is a psychology theory that describes how people make decisions when presented with alternatives that involve risk, probability, and uncertainty.
  • The theory was introduced by two psychologists, Daniel Kahneman, and Amos Tversky, to describe how humans make decisions when presented with several choices.
  • It holds that people make decisions based on perceived losses or gains.
  • Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Individuals are particularly averse to losing what they already have and less concerned to gain.
  • Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.
  • For example, most people prefer winning $50 with certainty rather than taking a risky bet in which they can toss a coin and either win $100 or nothing.
  • Applications:
    • The theory finds application in behavioral finance and economics.
    • It is used to evaluate various aspects of political decision-making in international relations.


Q1) What is behavioral economics?

Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. Behavioral economics is often related with normative economics. It draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models.

Source: IIT Madras researchers devise a mathematical model that promises equal benefits to both farmers & agri-firms