Behavioural Economics: The Prospect Theory

It was found that individuals who are subject to losses (i.e. the current market price of similar listings is below initial purchase price) set asking price of about 25-35% above expected selling (market) price and indeed sell property at about 3-18% higher price than the expected price is. However, this was usually achieved by listing the property on market longer which presents two drawbacks: 1) loss of potential interest that could have been gained by selling at a lower price earlier; 2) typically sellers also buy properties; therefore unwillingness to sell at a loss (while market is in decline) could imply missing opportunity to buy another property at low price. Genesove and Mayer (2001) further found that property sales volume decreased when market prices declined (while in most instances lower price would imply higher demand and higher sales). Authors explain such phenomenon by loss aversion – as prices fall people might be unwilling to sell and thus withdraw listings.
Standard economic model (SEM) allows economic agents to evaluate prospects subject to final outcomes and their utilities. The underlying assumption of SEM is that preferences are well defined. Cartwright (2014) and Braun (2006) emphasise that economic agents are humans rather than homo-economicus. Humans often use relative rather than absolute judgement, our preferences are time-inconsistent, and we care about others. Prospect theory and reference dependent preferences depart from SEM by extending the model. Taking into account human nature allows prospect theory to explain some problems from an alternative (possibly better) point of view. However, even Daniel Kahneman, one of the greatest contributors to prospect theory, in his book “Thinking, fast and slow” (2011) agrees that while being simplified, SEM works very well in most cases and thrives to explain how things (should) work.

…