Question

TRUE/FALSE

Q. Prospect theory includes loss aversion by having the PT value function be steeper for losses than gains.

Answer 1

True

Prospect theory is a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are unknown. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.

The value function in prospect theory reflects three important properties that distinguish it from the traditional utility function

1. Value is measured in terms of changes in wealth from a reference point whereas a utility function measures value based on the level of wealth.

2. The value function is convex for losses reflecting risk taking and concave for gains reflecting risk aversion whereas an individual’s utility function evaluates risk aversion, risk neutrality, or risk loving.
3. The value function is steeper for losses than for gains due to loss aversion.