Prospect theory

Prospect theory is a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics. The model is descriptive: it tries to model real-life choices, rather than optimal decisions. The theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a psychologically more accurate description of decision making, comparing to the expected utility theory. In the original formulation the term prospect referred to a lottery.

The paper “Prospect Theory: An Analysis of Decision under Risk” has been called a “seminal paper in behavioral economics”.

The theory describes the decision processes in two stages: editing and evaluation. During editing, outcomes of a decision are ordered according to a certain heuristic. In particular, people decide which outcomes they consider equivalent, set a reference point and then consider lesser outcomes as losses and greater ones as gains. The editing phase aims to alleviate any Framing effects. It also aims to resolve isolation effects stemming from individuals’ propensity to often isolate consecutive probabilities instead of treating them together. In the subsequent evaluation phase, people behave as if they would compute a value (utility), based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility.