Term Paper on "Prospect Theory"

Term Paper 5 pages (1703 words) Sources: 3

[EXCERPT] . . . .

Human Behavior Through the Lens of Prospect Theory

Human beings base their everyday decisions and actions upon a very specific assessment of risk and reward. When human beings are offered a choice, they naturally begin top narrow down the potential outcomes of any decisions relative to these choices, usually using some sort of weighted scale or process to help decide which decision or set of action will lead to the most favorable outcome. When the outcomes are less predictable, or when large amounts of risk are involved, human beings use much more complicated thought and reasoning processes to make decisions and act upon these decisions. These situations, where the complexity of the reality and decisions to be made are increased, represent very good real life examples of the problems and situations faced by humans each day. Certain decision-making scenarios, where the potential for limitless possibilities and outcomes exists, are much harder to make. These decisions and scenarios are governed by what theorists have deemed The Prospect Theory. This theory takes into account the fact that humans often perform complex risk and reward assessments when making decisions, but that each decision is not created equal, and the complexities of the real world certainly present the decider with some interesting and often limitless possibilities.

The original developers of Prospect Theory, Daniel Kahneman and Amos Tversky, began to compartmentalize the world of decisions and risk assessment into several key points, or considerations. These key elements help to break down the natural thought and risk assessment patterns into a much less complex and more understandable format. Within these key elements is a general understanding that human beings often have a difficult time imagining the sheer number of possibilities or potential outcomes. This comes from the way in which most people live their lives and make decisions that are less complex. As the complexity of a decision or action increases and as the familiarity with the decision or the outcomes decreases, the decider is often left without the benefit of experience or the ability to see or understand all of the potential outcomes (Tversky and Kahneman, 299). This concept is also referred to as the "certainty effect," where human beings begin a sometimes-complex risk assessment as they begin to ponder the potential outcomes of a decision. Interestingly enough, when human beings are faced with a scenario where a sure loss is more likely, they tend to be more prone to risk taking and an "all or nothing" attitude (Tversky and Kahneman, 302). Researchers Markman and Medin as well as Holyoak all present individual hypotheses relative to this sort of behavior in their writings after conducting real life experiments, complete with controls and a limited set of variables.

These experiments, or tests involve the use of real life decisions and human behavior, specifically gambling. They have a set number of variations and variables, just as with any game or gamble, and the choices that are studied within these experiments are based upon a certain series of factors. Since the Prospect Theory is itself quite complex, containing many theories within it as well, it is important to make the distinction between this theory and the way people assign value to certain outcomes and the successful aversion of risk (Markman and Medin, 414). This assignment of value is based upon the notion, or theory that human beings take into account the specific risks individually, and assess the potential for gains or losses on a much more sporadic scale (Holyoak, 277). This is not to say that humans aren't necessarily concerned with the aggregate result of a decision or series of decisions, but that this cumulative result is often not the final or ultimate consideration when faced with a risky or difficult decision. Many of the most important or critical decisions that humans make over the course of their lives involves the splitting of several potential outcomes or risks into separate categories or possibilities (Holyoak, 278). These possibilities have a lot to do with the calculation of probabilities, whether known or unknown to the human who is faced with the decision. Designating a low probability outcome as an option of high weight directly contributes to the appeal of taking risks and gambling with choices (Holyoak, 280). Holyoak offers an inside look on several instances in which this claim can be supported.

One of the best examples of the use of Prospect Theory in the everyday lives of humans comes in the form of water usage relative to the overall health and well being of humans. Since, from an economic standpoint, water has no real substitutes, it is an extremely valuable and life-sustaining resource, perhaps the most valuable resource on the planet. Yet the way in which water usage is regulated, and how it is used and polluted has become a subject of contention much more often as humans realize the importance of the substance. Since the outcomes of these disputes and regulations is of utmost importance to any government or group of people genuinely concerned with the sustainability and potential for survival within a closed water system, it is easy to understand how these same regulating bodies would want to have a firm grasp on exactly how human beings make decisions based on risk assessment relative to water consumption.

Whether good or bad, human psychology plays a rather large role in the allocation and regulation of the entire planet's water supply. Humans have the potential to sustain themselves or completely wipe themselves out, based solely on how well equipped they are to handle complex decision-making. Going even more deeply into the human psyche, the theory clearly illustrates that at the most basic level, humans are afraid of death and dying (Markman and Medin, 415). The aversion of this event or risk of death often plays a large role in how the decisions are framed and finally made. This is just one example of how Prospect Theory is relevant to the human condition, but it is perhaps the best, most dire example as well.

Another excellent example of how Prospect Theory is utilized in everyday life occurs within the United States. This country, existing as a relative representative democracy, is faced with dozens of social, political, and cultural dilemmas each day. These problems are often so complex and convoluted as to require a vote or shared public opinion on the matter. The final decisions that are made relative to these problems and their solutions often involve extremely complex risk assessments, sometimes even to the point of not assessing the final amalgamation and end result. This shows clearly the basic tendency for humans to consider many of the underlying potentials for risk based on specific outcomes yet be completely blind or inconsiderate relative to the aggregate outcomes and the limitless potential for infinite possibilities.

Perhaps one of the most interesting examples of how human beings use Prospect Theory to help categorize and navigate their everyday lives is in the relationships people chose to take part in. These relationships often have other psychological influences and benefits like the realization and affirmation of the ego, but the way in which people approach relationships has a lot to do with risk aversion and the calculation of potential outcomes, sometimes without consideration for the limitless possibilities that could become reality. With billions of people on the planet, there is no real way for humans to meet every potential mate, not even 1% of the potential mates on the planet. Yet, faced with this fact, many people only date a couple of people before they chose to marry. This is interesting, because mathematically, the potential and sheer number of possibilities in a mate that exist even within a small radius of the person selecting a mate should dictate that that person should try to meet as many people as possible for the best fit. As far as Prospect Theory is concerned, meeting a mate is certainly more complex than just saying "hello," and the complexities of this decision are many. In fact, humans often get caught up in these very complexities and short-term outcomes when looking for a mate or relationship, rather than considering the aggregate outcome. So many marriages fail within the United Stares for many different reasons, but this, as an aggregate outcome, is rarely considered the first time two people meet. They are far more considered with the intricacies of that particular night or date or interaction, and leave the aggregate outcome and risk assessments to be dealt with later, sometimes over the course of many months or years. The math behind the amount of people on the planet and the number of people that humans take the time to get to know exists, yet humans are often incapable of seeing the nearly infinite possible outcomes that are potentially waiting for them.

Prospect Theory goes a long way in describing how human beings make decisions based on risk assessment and outcomes. Human beings are guided by their own psychological limitations and needs, but… READ MORE

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