Prospect Theory (part 2)

Note: This is a continuation of yesterday’s posts, and it is crucial you read that before this, so please do take the time to read it.

Diminishing Sensitivity is the idea that as outcomes become larger, their psychological impact diminishes. To put it in an example, let’s take 2 people. One day, he is given two choices: he could work 4 hours and get $100 or 8 hours and get $200. Now another person gets two similar choices: work 4 hours and get $1100 or work 8 hours and get $1200. Now, what would you do in each situation? Taking financial need and other external factors out of the situation, people felt the difference between $100 and $200 to be bigger than the $1100 vs $1200 and preferred to work 8 hours in the first scenario and 4 hours in the next, even though both were the same $100 difference.

Reference Dependence is the idea that people evaluate outcomes relative to a reference point, not in absolute terms. This means that our perception of a gain or loss depends on what we expect or compare it to. If you wanted a $3000 bonus but got a $5000 bonus, you would feel great. On the other hand, if you got the $5000 bonus while expecting $8000, you would be disappointed, even though the bonus money was the same in both situations.

Prospect theory is fascinating, and it can be seen everywhere ranging from investing to marketing, from gambling to government policies, etc.