Prospect theory explains how people make choices under uncertainty, challenging traditional expected utility theory. It introduces concepts like reference points, loss aversion, and probability weighting, revealing systematic deviations from rational decision-making in various contexts.
Framing effects show how presenting information can significantly impact decisions. By understanding and leveraging framing, businesses can influence preferences, negotiations, and choices. Awareness of these effects helps in making more balanced decisions and crafting persuasive messages.
Prospect Theory
Principles of prospect theory
- Developed by Kahneman and Tversky as an alternative to expected utility theory which describes how people make choices under risk and uncertainty
- Reference point is the status quo or current state, and outcomes are evaluated as gains or losses relative to this reference point
- Value function assigns subjective values to gains and losses, is concave for gains and convex for losses, and is steeper for losses than gains (loss aversion)
- Probability weighting function overweights small probabilities (lottery tickets) and underweights high probabilities (insurance), leading to risk-seeking behavior for losses and risk-averse behavior for gains
- Implies that people are more sensitive to losses than equivalent gains, framing of outcomes as gains or losses affects risk preferences, and there are deviations from expected utility theory predictions
Prospect theory vs utility theory
- Insurance: People are willing to pay more for insurance than the expected value of losses due to overweighting small probabilities of large losses
- Gambling: Attraction to lotteries with small chances of large gains, while simultaneously purchasing insurance to protect against losses
- Investing: Disposition effect where investors hold losing investments too long and sell winning ones too soon, and myopic loss aversion causing overweighting of short-term volatility and underweighting of long-term returns
- Consumer behavior: Endowment effect where people value owned items more than identical non-owned items, and preference for avoiding losses over acquiring equivalent gains
Framing Effects
Framing effects in business
- Framing involves presenting the same information in different ways, such as positive (gain) frames vs. negative (loss) frames
- Attribute framing describes attributes or characteristics positively or negatively (ground beef as 75% lean vs. 25% fat)
- Risky choice framing presents outcomes as gains or losses (treatment with 90% survival rate vs. 10% mortality rate)
- Goal framing emphasizes consequences in terms of gains or losses (benefits of meeting a deadline vs. costs of missing it)
- Influences preferences and decision-making, with positive frames generally leading to risk aversion and negative frames to risk-seeking, and can reverse preferences in violation of the invariance principle
Leveraging framing for decisions
- Identify the reference point by considering the other party's status quo or expectations and frame proposals as gains relative to their reference point
- Use positive frames for favorable outcomes (emphasize benefits and opportunities) and negative frames for unfavorable ones (highlight potential losses or costs)
- Be aware of framing effects in your own decision-making by considering alternative frames, reframing problems if necessary, and seeking outside perspectives to challenge initial framing
- In negotiations, frame concessions as losses to increase their perceived value and gains as wins to emphasize their positive impact