19.8 : Prospect Theory: Certainty of Gains

Prospect theory describes how individuals assess gains and losses, revealing that they exhibit loss aversion by placing a greater emphasis on potential losses than on equivalent gains. This leads to risk-averse behavior when gains are involved and risk-seeking behavior when faced with losses, as individuals try to avoid certain losses in most cases.

For instance, consider Daniel, a small business owner, who is deciding how to allocate his budget. He has two options for a profitable project. The first guarantees a profit of $1,200. The second offers a 75% chance of earning $1,500 but a 25% chance of earning nothing. Daniel selects the guaranteed $1,200 instead of the option with a higher expected value, prioritizing the certainty of a smaller gain over the possibility of a slightly higher profit.This demonstrates the certainty effect, which shows that people favor definite gains over those that are probable.

Now consider Daniel facing potential losses. He must decide between accepting a guaranteed $1,200 loss or taking a 75% chance of losing $1,500 with a 25% chance of losing nothing. In this situation, Daniel opts for the gamble, hoping to avoid a definite loss as the expected value of the gamble is a loss of $1,125, meaning the rational choice would be the sure loss of $1,200. This illustrates risk-seeking behavior in the face of losses, even though the gamble might result in a worse outcome.

These tendencies demonstrate how perceptions of certainty influence decision-making. People favor secure outcomes when gaining but are more willing to take risks to avoid losses. Understanding this bias allows for better decision-making by encouraging a more balanced assessment of risks and rewards.