How Prospect Theory Contradicts Classical Economic Theories

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The Prospect Theory of Behavioral Economics
Definition of Prospect Theory
According to CITATION Bar13 \l 1033 (Barberis, 2013)prospect theory suggests that humans are not rational in decision making which entails losses and gains, and they think in terms of ‘expected utility relative to reference point rather than absolute outcomes.’ when similar options with similar outcomes are framed differently, Kahneman and Tversky found that humans were more risk-averse, and individuals disliked losses more than equivalent gains such that they were willing to risk more to avoid a loss CITATION Lev96 \l 1033 (Levy, 1996). In other words, if a concept has two similar choices with similar outcomes for the individual, and one of the options if framed in the context of the potential gains the individual can derive and the other in terms of the potential losses the individual can suffer, individuals are more likely to choose the option presenting the gains.
How Prospect Theory Contradicts Classical Economic Theories
In traditional economic theory, economists assume that humans are rational decisionmakers. They evaluate information and calculate the value is accounting for the potential losses and or gains and make the decision that is in their best interest. In a classical economic perspective, ‘framing’ of the information is irrelevant because the potential losses and gains from the situation are equal. On the other hand, prospect theory shows that classical theorists and Kahneman overlooked the innate human nature and Tversky argues that traditional economic models and reality are rarely aligned. Concisely, according to prospect theory, humans are not rational decision-makers, and their decisions are anchored on the potential gains rather than the facts.
The implications of Prospect Theory
Prospect theory implies that since humans are not rational decision-makers even with factual information, the presentation of information is important. Thus, ‘relative gain or loss relative to a reference point is valued more than an absolute gain or loss’ CITATION Jha14 \l 1033 (Jha & Powell, 2014). This is unlike the perspective outlines by von Neuman Morgenstern’s classical economic theory of expected utility (UET). According to expected utility theory, if a gamble is framed regarding its losses and or gains it is not important but the result CITATION Lev06 \l 1033 (Levin, 2006). Hence, a new perspective that overlooks ultimate determinant of utility as described in expected utility theory implies that value is based on relative change in wealth rather than resulting levels of wealth CITATION Wil09 \l 1033 (Forbes, 2009).
Secondly, risk aversion for individuals is more sensitive on losses than gains of the same magnitude. Thus, an individual is likely to choose an option that has a lower expected value at higher profitability ...