Question

explain what the prospect theory function is and how the rate of decline in utility for losses differs from the rate of utility increase for gains.

Also, explain two potential impacts of the prospect theory

Answer 1

Prospect theory in behavioural economic shows the decision making of the people under the risky situation, where they used cognitive psychology which explains the divergence of economic decisions. The backward bending labour supply curve, asymmetric price elasticities, tax evasion and cooperative movement of the stock price and consumption were explained under this prospect theory. Reference dependence, loss aversion, non linear probability weighting and diminishing sensitivity to gain and loss are the major psychological principles which used to evaluate the risky alternatives existed in the market condition. Psychological traits like over confidence, projection bias and the effects of limited attention were explained under this theory. Here the losers and gainers give preference for something which is greater than their utility. The losers have greater emotional impact than gainers. The investors are more aware and conscious about the loss, not the gain. The losers were tried to evaluate the phase which compute the utility based on the probability under certain outcomes. The losers will get low level of utility than the gainers and this will remain them as risk averse and they will get back from the given investment programme.
This theory explained that the individuals are more concerned about loss than gain. They will give more preference for loss activities during the investment period. The investors will try to avoid risk and uncertainty under the criteria of expected utility.