# Prospect Theory Prospect Theory is a behavioral economic theory developed by [[Daniel Kahneman]] and [[Amos Tversky]] in 1979 that describes how people make choices involving risk and uncertainty. It challenged the classical Expected Utility Theory by showing that people evaluate outcomes relative to a reference point (usually the status quo), feel losses more strongly than equivalent gains (loss aversion), and distort probabilities. This work earned Kahneman the Nobel Prize in Economics in 2002. The theory explains many "irrational" behaviors: why people buy insurance (overweighting small probabilities of loss) while also buying lottery tickets (overweighting small probabilities of gain); why investors hold losing stocks too long (loss aversion) and sell winners too soon (reference dependence). Prospect theory has become foundational to [[Behavioral Economics]], influencing fields from finance to public policy to marketing. ## Key Components | Component | Description | |-----------|-------------| | **Reference dependence** | Outcomes evaluated relative to reference point | | **Loss aversion** | Losses feel ~2× worse than equivalent gains | | **Diminishing sensitivity** | Marginal impact decreases with distance from reference | | **Probability weighting** | Overweight small, underweight large probabilities | ## Value Function ``` VALUE │ │ ╱ Gains │ ╱ (concave: diminishing │ ╱ sensitivity) │ ╱ │ ╱ ──────────────────┼────────────────── OUTCOME LOSSES │ GAINS ╲ │ ╲ │ ╲ │ Losses ╲ │ (convex, steeper: ╲ │ loss aversion) Key features: • S-shaped curve • Steeper for losses than gains (≈2:1 ratio) • Reference point at origin ``` ## Probability Weighting Function ``` DECISION │ WEIGHT │ 1.0 ─────────┼─────────────────• │ • │ • │ • (underweight │ • high probs) │ • │ • │ • (overweight 0.0 ─────────•───────────────── PROBABILITY 0 1.0 People overweight low probabilities (lottery tickets) People underweight high probabilities (insurance) ``` ## Prospect Theory vs Expected Utility | Aspect | Expected Utility | Prospect Theory | |--------|-----------------|-----------------| | **Reference** | Absolute wealth | Gains/losses from reference | | **Risk attitude** | Consistent | Different for gains vs losses | | **Probability** | Linear | S-shaped weighting | | **Loss/gain weight** | Equal | Losses weighted ~2× | | **Framing** | Shouldn't matter | Significantly affects choice | ## Four-Fold Pattern of Risk Attitudes | | Small Probability | Large Probability | |---|---|---| | **GAINS** | Risk-seeking (lottery) | Risk-averse (sure thing) | | **LOSSES** | Risk-averse (insurance) | Risk-seeking (gambling to recover) | ## Real-World Applications | Domain | Application | |--------|-------------| | **Investing** | Disposition effect (sell winners, hold losers) | | **Insurance** | Overinsure against rare losses | | **Marketing** | Frame as avoiding loss, not gaining | | **Negotiations** | Reference point manipulation | | **Public policy** | Default options, loss-framed messages | ## Classic Examples | Example | Explanation | |---------|-------------| | **Lottery tickets** | Overweight tiny probability of large gain | | **Insurance** | Overweight small probability of loss | | **Status quo bias** | Losses from change loom larger than gains | | **Endowment effect** | Owning increases value (loss of giving up) | | **Sunk cost fallacy** | Past investment creates reference point | ## References - Kahneman & Tversky (1979). "Prospect Theory: An Analysis of Decision Under Risk" - Tversky & Kahneman (1992). "Advances in Prospect Theory: Cumulative Representation of Uncertainty" - https://en.wikipedia.org/wiki/Prospect_theory ## Related - [[Decision Making]] - [[Behavioral Economics]] - [[Daniel Kahneman]] - [[Amos Tversky]] - [[Cognitive biases]] - [[Heuristics]] - [[Loss Aversion]] - [[Expected Utility Theory]]