Prospect Theory
Definition
Prospect theory is the psychological model of decision under uncertainty developed by Daniel Kahneman and Amos Tversky (1979). It replaces expected utility theory — which models rational agents maximizing the expected utility of wealth — with an empirically grounded model of how people actually evaluate risky outcomes.
Prospect theory has three core features:
- Reference-dependence: outcomes are evaluated as gains or losses relative to a reference point (typically the status quo), not as final states of wealth.
- Loss aversion: losses are weighted approximately twice as heavily as equivalent gains. Losing $100 is experienced as roughly as painful as gaining $200 is pleasurable.
- Diminishing sensitivity: the marginal impact of changes diminishes as they move further from the reference point — the difference between losing $100 and $200 is felt more strongly than the difference between losing $1,100 and $1,200.
These three features produce the characteristic S-shaped value function: concave in the gain domain (risk-averse), convex in the loss domain (risk-seeking), with the function steeper for losses than for gains.
Why it matters
Why expected utility theory failed
Expected utility theory (Bernoulli, 1738; Von Neumann and Morgenstern, 1944) models decisions as choices among lotteries, evaluated by multiplying each outcome’s probability by its utility and summing. This model is prescriptively compelling and analytically tractable — but empirically wrong.
The most fundamental failure: expected utility theory defines utility over final states of wealth. It has no place for reference points. But Kahneman and Tversky demonstrated that the same final wealth state is evaluated very differently depending on how it was reached — whether through a gain or a loss from a prior reference point. The reference point, not the final state, is the key psychological variable.
The fourfold pattern of risk attitudes
Prospect theory, combined with the probability weighting function (which overweights low probabilities and underweights high ones), predicts four distinct risk attitudes:
| Domain | Probability | Risk attitude | Example |
|---|---|---|---|
| Gains | High | Risk-averse | Prefer the sure gain |
| Gains | Low | Risk-seeking | Buy lottery tickets |
| Losses | High | Risk-seeking | Prefer the gamble to certain large loss |
| Losses | Low | Risk-averse | Buy insurance |
This fourfold pattern explains seemingly contradictory behavior — the same person buying lottery tickets and insurance. Both are explained by prospect theory’s probability weighting function applied to the gain and loss domains.
Applications across behavioral economics
Prospect theory is the theoretical foundation for much of behavioral economics. It predicts:
- Endowment effect: ownership creates a reference point; selling feels like a loss
- Status quo bias: departing from current state activates loss aversion
- Mental accounting: sunk costs are tracked as losses from the investment reference point
- Disposition effect in investing: investors sell winners (lock in gain) and hold losers (avoid locking in loss)
- Negotiation asymmetry: concessions feel like losses; equivalent gains from the other side feel smaller
Key takeaways
Key takeaways
- Prospect theory's three features: reference-dependence, loss aversion (~2× weighting), and diminishing sensitivity in both gain and loss domains.
- S-shaped value function: concave (risk-averse) above the reference point, convex (risk-seeking) below it, steeper on the loss side.
- Bernoulli's error: expected utility theory evaluates final wealth states; prospect theory evaluates gains and losses from a reference point — the empirically correct variable.
- Fourfold pattern: high-probability gains → risk-averse; low-probability gains → risk-seeking; high-probability losses → risk-seeking; low-probability losses → risk-averse.
- Broad applications: endowment effect, status quo bias, sunk cost fallacy, and the disposition effect in investing all follow from prospect theory's core mechanisms.
- Reference points are malleable: framing, context, and stated baselines all shift the reference point, producing predictable changes in risk preference — the basis of nudge design.
Mental model
Read it as: The reference point is the psychological zero. Above it, the value function is concave — each additional gain adds less pleasure, producing risk aversion (prefer the certain gain). Below it, the value function is convex — each additional loss adds less pain, producing risk-seeking (prefer the gamble). The loss side is steeper than the gain side — loss aversion — meaning losses hurt approximately twice as much as equivalent gains feel good.
Related lessons
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