Reference dependence, loss aversion, and diminishing sensitivity are key concepts that are embedded in Prospect Theory. Carefully define and explain each of these concepts, in doing so highlighting how they depart from the standard economic model. Provide a narrative of the evidence that supports incorporating these concepts in models of choice.

Behavioral Economics: Prospect Theory Student’s Name Institutional Affiliation Behavioral Economics: Prospect Theory Prospect theory is a vital model in decision-making bearing its accommodation of real-world applications. The theory differs from the conventional economic theories that showcase maximization of utility as the primary component of decision-making. Developed by Daniel Kahneman and Amos Tversky, the theory instills the idea that decision-making is influenced by a range of other factors. To showcase their insight, Daniel Kahneman and Amos Tversky developed three concepts understood to be the anchors of real-life decision-making. The three concepts of prospect theory are reference dependence, loss aversion, and diminishing sensitivity. This paper analyses prospect theory on the grounds of the three prospects. The analysis constitute real-life examples to outline the relative elements of prospect theory compared to conventional economic theories. This analysis is vital in understanding contemporary decision-making as instills strategies that individuals can employ to make the right decisions in real-life aspects like negotiations or in investment decisions. The Prospect Theory Prospect theory was developed by Daniel Kahneman and Amos Tversky and offers an insight into the details of through processes that culminate into decisions (Tversky & Kahneman, 1992). The proponents of this theory largely differed with conventional decision-making models. Their understanding was that logic alone does not influence the decisions that individuals make. Instead, people have other influences, mostly stemming from their experiences that influence the decisions. As such, the theory’s understanding of reality in decision-making is marked with an insight into the emotional and psychological factors that influence perceptions and decisions by extension. Unlike the conventional economic models that rely on formulas to define decisions, prospect theory emphasizes two key functions to describe how people value outcomes and probabilities. The first function is the value function (v(x)), which showcases how people perceive the desirability of different outcomes (gains or losses) measured in terms of value (Tversky & Kahneman, 1992). Notably, the value function is typically S-shaped, which means that small gains provide increasing value, but this increase tapers off for larger gains. Conversely, losses are steeper, reflecting loss aversion. The second function in this theory is the probability weighting function (π(p)), which defines how people perceive the likelihood of events (probabilities) (Tversky & Kahneman, 1992). The probability weighting function is typically non-linear, overweighting small probabilities (making them seem more likely) and underweighting large probabilities (making them seem less likely than they actually are). The primary idea of prospect theory is that people evaluate prospects in decision-making. That is, people gamble with different outcomes and probabilities to reach specific decisions. This decision process is marked by first transforming them into a format based on the above two functions (Tian, 2021). The value function translates outcomes into decision weights, and the probability weighting function transforms probabilities into decision weights as well. Then, depending on whether the prospect involves gains or losses, a specific formula is used to combine these decision weights to arrive at an overall evaluation of the prospect (Beißner & Werner, 2023). As such, for gains, the overall value is calculated by taking the weighted sum of the decision weights associated with each possible gain. The weight for the higher gain is typically greater than for the lower gain. However, for losses, the overall value is calculated by taking the weighted sum of the decision weights associated with each possible loss. However, due to loss aversion, the weights for losses are typically larger in magnitude (more negative) than for gains of the same size. The prospect theory bears three key concepts, reference dependence, loss aversion, and diminishing sensitivity, which it employs to challenge the conventional decision models. Reference Dependence Reference dependence is the first component of the prospect theory that defines the decision-making process. This concept describes how people make decisions based on a comparison point, rather than absolut...