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Prospect Theory

Prospect Theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky that describes how people make decisions involving risk and uncertainty. It demonstrates that humans systematically deviate from rational choice theory in predictable ways, revolutionizing our understanding of decision-making.

Core Principles

1. Reference Point Dependence

People evaluate outcomes relative to a reference point (usually the status quo) rather than in absolute terms:

  • Gains and losses are more psychologically meaningful than final wealth levels

  • The same objective outcome can be framed as either a gain or loss

  • Moving the reference point changes preferences even when options remain identical

2. Loss Aversion

Losses feel approximately twice as painful as equivalent gains feel good:

  • A $100 loss hurts more than a $100 gain helps

  • This asymmetry drives many seemingly irrational behaviors

  • Ratio typically estimated between 2:1 and 2.5:1

3. Diminishing Sensitivity

The psychological impact of changes decreases as you move away from the reference point:

  • The difference between $0 and $100 feels larger than between $1000 and $1100

  • Applies to both gains and losses

  • Creates the characteristic S-shaped value function

4. Probability Weighting

People don't process probabilities linearly:

  • Overweight small probabilities: 1% feels more significant than it mathematically is

  • Underweight moderate to high probabilities: 80% feels less significant than it should

  • Certainty effect: 100% probability gets special psychological treatment

The Value Function

The prospect theory value function has distinctive characteristics:

\[v(x) = \begin{cases} x^\alpha & \text{if } x \geq 0 \\ -\lambda(-x)^\beta & \text{if } x < 0 \end{cases}\]

Where:

  • \(\alpha, \beta < 1\) (diminishing sensitivity)

  • \(\lambda > 1\) (loss aversion coefficient)

  • Function is steeper for losses than gains

  • Concave in gains domain, convex in losses domain

Key Phenomena

The Endowment Effect

Once we own something, we value it more highly:

  • People demand more money to sell a mug they own than they'd pay to buy the same mug

  • Status quo becomes the reference point

  • Explains resistance to change and trade

Framing Effects

Identical options presented differently lead to different choices:

Asian Disease Problem (Tversky & Kahneman):

  • Gain Frame: "Program A will save 200 lives" vs "Program B has ⅓ chance to save 600 lives"

  • Loss Frame: "Program C will result in 400 deaths" vs "Program D has ⅓ chance of no deaths"

  • Programs A and C are identical, as are B and D

  • People prefer A over B but D over C

Risk Seeking in Losses

Contrary to traditional economic theory, people become risk-seeking when facing losses:

  • Would rather take a 50% chance of losing $1000 than definitely lose $500

  • Explains escalation of commitment and "throwing good money after bad"

  • Gambling behavior often occurs in loss domain

Small Probability Overweighting

Explains seemingly contradictory behaviors:

  • People buy lottery tickets (overweight small chance of winning)

  • People buy insurance (overweight small chance of loss)

  • Both involve overweighting low-probability events

Real-World Applications

Financial Markets

  • Disposition Effect: Investors hold losing stocks too long and sell winners too quickly

  • Equity Premium Puzzle: Stock market returns seem too high relative to bonds given rational risk preferences

  • Market Volatility: Price movements often exceed what fundamental analysis would predict

Insurance and Gambling

  • People simultaneously gamble and buy insurance

  • Both involve overweighting small probabilities

  • Explains why insurance companies profit and lotteries exist

Marketing and Pricing

  • Loss-Framed Marketing: "Don't lose out on these savings"

  • Free Trial Periods: Create endowment effect with the service

  • Decoy Pricing: Using reference points to make preferred options look better

Policy Design

  • Opt-out vs Opt-in: Default options leverage status quo bias

  • Tax Policy: Framing taxes as losses vs benefits as gains

  • Retirement Savings: Automatic enrollment increases participation

Experimental Evidence

Classic Experiments

Kahneman & Tversky Coffee Mug Study:

  • Students given mugs valued them at ~$7

  • Students without mugs would only pay ~$3 for identical mugs

  • Demonstrates endowment effect and loss aversion

Asian Disease Problem:

  • 72% chose certain option in gain frame

  • 22% chose certain option in loss frame

  • Same outcomes, different preferences

Modern Neuroscience

Brain imaging shows:

  • Loss processing activates pain centers

  • Gain processing activates reward systems

  • Different neural pathways for gains and losses

  • Supports psychological reality of prospect theory

Criticisms and Limitations

Descriptive vs Normative

  • Prospect theory describes how people actually behave

  • Doesn't necessarily prescribe how they should behave

  • Debate about whether deviations represent "errors" or adaptive responses

Cultural Variation

  • Most research conducted on WEIRD populations (Western, Educated, Industrialized, Rich, Democratic)

  • Some effects vary across cultures

  • Reference points may be culturally determined

Dynamic Considerations

  • Original theory focuses on single decisions

  • Real decisions often involve sequences and learning

  • Reference points may shift over time

Individual Differences

  • Significant variation between individuals

  • Some people show more prospect theory effects than others

  • Expertise and training can reduce some biases

Developments and Extensions

Cumulative Prospect Theory

Refinement that better handles complex probability distributions and provides more accurate predictions for multi-outcome scenarios.

Temporal Prospect Theory

Extensions to decisions involving time delays, incorporating similar biases in temporal discounting.

Social Prospect Theory

Applications to social comparisons and relative status considerations.

Nobel Prize Recognition

Kahneman won the 2002 Nobel Prize in Economics for prospect theory (Tversky had died in 1996). The theory fundamentally challenged rational choice theory and established behavioral economics as a legitimate field.

Key Insights

Prospect theory reveals that human decision-making is:

  1. Context-dependent: Reference points matter enormously

  2. Asymmetric: Losses and gains are processed differently

  3. Non-linear: People don't process probabilities or values proportionally

  4. Predictably irrational: Deviations from rationality follow systematic patterns

These insights have profound implications for economics, policy, marketing, and any field involving human decision-making under uncertainty.