Prospect Theory, developed by psychologists Daniel Kahneman and Amos Tversky in 1979, is a behavioral economic theory that describes how people make decisions under risk and uncertainty. It challenges traditional economic models, like expected utility theory, which assume people act rationally. Prospect theory suggests that people value gains and losses differently, leading to decisions that deviate from rationality. Here’s a breakdown of its key concepts:
1. Reference Dependence:
- People evaluate outcomes based on a reference point (often the status quo), rather than in absolute terms. Gains and losses are defined relative to this reference point.
2. Loss Aversion:
- Losses loom larger than gains. In other words, the pain of losing something is psychologically more significant than the pleasure of gaining something of equivalent value. For example, losing $100 feels worse than gaining $100 feels good.
3. Diminishing Sensitivity:
- The subjective value of both gains and losses decreases as their magnitude increases. The difference between $10 and $20 feels more significant than the difference between $110 and $120, even though both involve a $10 change.
4. Probability Weighting:
- People tend to overweigh small probabilities and underweigh large probabilities. This explains behaviors like purchasing lottery tickets (overestimating small chances of winning) or avoiding unlikely risks (like the fear of flying despite its low accident rate).
Applications in Business and Marketing:
- Pricing strategies: Companies can frame discounts as avoiding losses (“save $20”) rather than as gains (“get $20 off”), capitalizing on loss aversion.
- Risky decisions: Customers tend to avoid risks in the domain of gains but are more risk-seeking when facing potential losses.
- Framing effects: The way options are presented (as losses or gains) can dramatically impact consumer behavior and decision-making.
In your e-commerce business, understanding prospect theory can help tailor marketing messages and offers to better appeal to customer psychology. By leveraging loss aversion and framing techniques, you can encourage more conversions.
