Prospect Theory: Isolation Effect

The isolation effect, part of prospect theory, explains how people focus on differences between options while disregarding shared elements, which can lead to inconsistent decisions.

Consider Sarah, an entrepreneur managing her e-commerce store’s marketing campaigns. Sarah faces two scenarios

 With a $1,000 marketing budget, she has two options: Plan A guarantees a $400 profit, and Plan B offers a 50% chance of earning $800 and a 50% chance of earning nothing. Sarah chooses Plan A, demonstrating risk aversion in the low-budget context.

With a $5,000 marketing budget, she has two options: Plan C guarantees a $2,000 profit and Plan D offers a 50% chance of earning $4,000 and a 50% chance of earning nothing. This time, Sarah chooses Plan D, displaying risk-seeking behavior.   

Although Sarah's choices appear rational within each scenario, a closer look reveals an inconsistency. 

Plan A and Plan C are structurally similar, as are Plan B and Plan D, yet she makes opposite decisions because the budgets differ and, showing how framing shapes decision-making.