Prospect theory tells us that consumers are:

Question

BlackTom AI · Accepted Answer

Prospect theory posits that people are loss averse: losses loom larger than gains of the same magnitude.

1) Relevant knowledge points and concepts
- Prospect theory (Kahneman & Tversky) replaces expected utility with a value function defined over gains and losses relative to a reference point.
- Key properties: reference dependence, concavity for gains (risk aversion), convexity for losses (risk seeking), and loss aversion (the loss side of the value function is steeper than the gain side).
- Loss aversion is typically captured by a parameter λ > 1, meaning a loss of size x feels about λ times as painful as a gain of size x feels pleasurable.

2) Step-by-step reasoning
- Consumers evaluate outcomes relative to a reference point rather than final wealth.
- The value function v(x) has two branches: for gains (x > 0) and losses (x < 0).
- Because the negative branch is steeper, the disutility of a loss outweighs the utility of an equal-size gain.
- Therefore consumers react more strongly (are more sensitive) to losses than to equivalent gains.

3) Example calculation (intermediate steps)
- Use a simple prospect-theory specification: v(x) = x for gains, v(x) = −λ(−x) for losses, with λ = 2.
- For a $100 gain: v(100) = 100.
- For a $100 loss: v(−100) = −2 × 100 = −200.
- The loss (−200) has twice the subjective impact of the gain (+100), illustrating greater sensitivity to losses.

4) Why the correct answer is correct
- The option "More sensitive to losses than gains" directly states loss aversion, the central empirical regularity of prospect theory. The functional form and empirical findings support this asymmetry.

5) Why the other choices are incorrect
- "More sensitive to gains than losses" contradicts loss aversion and empirical evidence.
- "Equally sensitive to losses and gains of equal magnitude" implies symmetry, which prospect theory rejects.
- "None of the above" is incorrect because one option correctly states loss aversion.

6) Conclusion
- The correct answer is "More sensitive to losses than gains," which matches the provided answer.

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