Prospect Theory or Skill Signaling?

Abstract

Formalizing early social psychology models, we show that a rational desire to avoid looking unskilled generates prospect theory's anomalies of loss aversion, probability weighting, and framing. Loss aversion arises because losing any gamble, even a friendly bet with little or no money at stake, reflects poorly on the decision maker's skill. Probability weighting emerges because winning a gamble with a low probability of success is a strong signal of skill, while losing a gamble with a high probability of success is a strong signal of incompetence. Framing can affect behavior by selecting among multiple equilibria.

Keywords: prospect theory, regret theory, probability weighting, loss aversion, framing

JEL Classification: D81, D82, C92, G11