Indian Institute of Technology Madras (IIT Madras) researchers recently devised a mathematical model on contract farming to predict farmers’ delivery of commodities using a decision-theoretic framework based on the ‘Prospect Theory.’
What is Prospect Theory?
Prospect theory is a psychology theory that describes how people make decisions when presented with alternatives that involve risk, probability, and uncertainty. It holds that people make decisions based on perceived losses or gains.
Given the choice of equal probabilities, most people would choose to retain the wealth that they already have, rather than risk the chance to increase their current wealth. People are usually averse to the possibility of losing, such that they would rather avoid a loss rather than take a risk to make an equivalent gain.
Sometimes, people refer to the prospect theory as the loss-aversion theory. Two psychologists, Daniel Kahneman and Amos Tversky, introduced the theory to describe how humans make decisions when presented with several choices.
The theory was contained in the paper “Prospect Theory: The “Econometrica” journal published an analysis of decision under risk in 1979, which has been used in various disciplines since the development of the prospect theory. It is used to evaluate various aspects of political decision-making in international relations.
1. Editing phase
2. Evaluation phase
2. Small probabilities
3. Relative positioning
4. Loss aversion
Criticism of Prospect Theory
One of the criticisms of the prospects theory is that it lacks psychological explanations for the process it talks about. The criticism comes from other psychologists who notes that factors such as human emotional and affective responses that are important in the decision-making process are absent in the model.
Critics also point out that the theory inadequately explains why actors generate the frames they use. Decision-makers often need to deal with competing frames across various issues.
The theory finds application in behavioural finance and economics.
It is used to evaluate various aspects of political decision-making in international relations.
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