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Prospect theory challenges traditional economic theory from "summary" of Thinking, Fast and Slow by Daniel Kahneman
Traditional economic theory assumes that individuals are rational decision-makers who carefully weigh the costs and benefits of each option before making a choice. This theory suggests that people make decisions based on the expected value of the outcomes and strive to maximize their utility. However, Prospect theory challenges this assumption by proposing that individuals do not always make rational decisions when faced with uncertainty. According to Prospect theory, people tend to evaluate potential losses and gains in a non-linear way, placing more emphasis on avoiding losses than on achieving gains. This asymmetry in decision-making can lead to risk aversion when faced with potential losses and risk-seeking behavior when faced with potential gains. This finding contradicts the traditional economic notion that individuals always make decisions based on the expected value of the outcomes. Moreover, Prospect theory highlights the role of cognitive biases and heuristics in decision-making processes. These mental shortcuts can lead individuals to make irrational choices, deviating from the rational decision-making model proposed by traditional economic theory. For example, the framing effect demonstrates how the way information is presented can significantly influence decision-making, leading individuals to make different choices based on how the options are framed.- Prospect theory challenges the traditional economic assumption of human rationality by showing that individuals often make decisions based on emotional and psychological factors rather than purely rational considerations. By incorporating insights from psychology and behavioral economics, Prospect theory provides a more nuanced understanding of how people make decisions in uncertain situations. This alternative perspective on decision-making has important implications for various fields, including economics, finance, and public policy.
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