Definition
Prospect theory is a descriptive model of how people actually make decisions involving risk, developed by daniel-kahneman and Amos Tversky. Unlike expected utility theory (which assumes rational decision-making), prospect theory describes systematic deviations from rationality based on psychological principles.
Core Principles
Reference Dependence
- People evaluate outcomes relative to a reference point (current state, expectation, etc.) rather than in absolute terms
- The same outcome feels different as a gain vs. a loss depending on the reference point
- People are loss-averse relative to their reference point
Loss Aversion
- Losses loom roughly 2-3 times larger than equivalent gains
- People are more sensitive to changes away from the reference point than to absolute outcomes
- This explains risk aversion for gains but risk-seeking for losses
Probability Weighting
- People don’t weight probabilities rationally
- Small probabilities are overweighted (people care more about small-risk events than objective probability suggests)
- Large probabilities are underweighted
- Certain outcomes are overweighted relative to probable outcomes
Diminishing Sensitivity
- Subjective value increases with magnitude of gain/loss, but at a decreasing rate
- Difference between 100 feels larger than 1100
- This is true for both gains and losses
The Prospect Theory Value Function
The value function is:
- Concave for gains: Each additional dollar provides less value (diminishing returns)
- Convex for losses: Each additional loss hurts less as loss magnitude increases
- Steeper for losses than gains: Loss of 100 pleases (loss aversion)
- Defined relative to reference point: Not absolute wealth, but changes from reference point
Key Findings
Framing Effects
- Identical choices presented as gains vs. losses yield different decisions
- Classic Asian Disease Problem shows preference reversal based on frame
- See framing-effects for detailed examples
Preference Reversals
- Different choice tasks (direct choice vs. pricing) can yield different preferences
- Contradicts rational choice theory assumptions
- Suggests decisions are constructed rather than revealed
Certainty Effects
- Certain outcomes preferred over probable outcomes more than objectively justified
- People overvalue certainty
- Related to loss-aversion: certainty preferred especially for avoiding losses
Connections
loss-aversion
loss-aversion is a core component of prospect theory, mathematically modeling how losses feel more significant than equivalent gains.
framing-effects
framing-effects are explained by prospect theory: framing determines reference points, which determine whether outcomes feel like gains or losses.
richard-thaler
richard-thaler built on prospect theory, applying these insights to behavioral economics through concepts like mental-accounting and nudge-theory.
behavioral-economics
Prospect theory is foundational to behavioral-economics, replacing rational choice models with descriptive models of actual behavior.
Empirical Support
Evidence
- Decades of experimental research confirm prospect theory predictions
- Real-world financial and insurance decisions show prospect theory patterns
- Cross-cultural studies show similar patterns in diverse populations
Limitations
- Some predictions don’t always hold in all contexts
- Exact parameter values vary with context
- Prospect theory has been refined and extended by later research
Applications
Finance and Insurance
- Explains why people buy insurance (overweight small-probability catastrophic losses)
- Explains lottery ticket purchases (overweight small-probability large gains)
- Predicts investment behavior and risk-taking patterns
Marketing and Consumer Behavior
- Framing products as preventing losses vs. enabling gains affects choices
- Reference points shift consumer perception of value
- Prospect theory explains why identical deals get different uptake based on framing
Public Policy and Nudges
- Understanding prospect theory enables more effective policy design
- nudge-theory applies prospect theory insights to guide decisions
- Framing choices to align with prospect theory patterns improves outcomes
Historical Impact
Nobel Prize
Kahneman received the 2002 Nobel Prize in Economics for prospect theory and related behavioral economics work (Tversky had passed away in 1996 and could not be included).
Theory Evolution
- Cumulative prospect theory extended the model
- Reference-dependent preferences, probability weighting refined
- Still foundational to behavioral economics and decision science