Glossary
Prospect Theory
What is prospect theory?
Prospect theory is a descriptive model of decisions under risk, introduced by Daniel Kahneman and Amos Tversky in 1979. It evaluates outcomes as gains or losses relative to a reference point and provides an alternative to expected utility theory for explaining certain observed choices.
Core features of prospect theory
Its central features include reference dependence, diminishing sensitivity to changes farther from the reference point, loss aversion, and decision weights that need not equal objective probabilities. Loss aversion describes greater weight on losses than equivalent gains; it is not a fixed rule that every loss has exactly twice the impact.
To illustrate diminishing sensitivity, suppose the reference point is no gain. The difference between gaining $100 and $200 may feel larger than the difference between gaining $1,100 and $1,200, although both increments are $100. That is a claim about how outcome amounts are valued. Probability weighting is a different component: how a stated chance enters the evaluation of a gamble.
How it works
As the authors explain in their work on framing, changing the representation of equivalent outcomes can change choices. The 1992 cumulative version extends the model to multiple outcomes and uncertainty. Its fourfold pattern includes risk aversion for high-probability gains and risk seeking for high-probability losses, with the reverse pattern for low probabilities.
A matched gain-and-loss comparison
In the 1979 paper, hypothetical choices used Israeli pounds. For Problem 3, 80% of 95 respondents chose a certain gain of 3,000 over an 80% chance of gaining 4,000 and a 20% chance of gaining nothing. In the corresponding loss problem, 92% chose an 80% chance of losing 4,000 and a 20% chance of losing nothing over a certain loss of 3,000.
The sign of the outcomes was reversed while amounts and probabilities were matched. This illustrates the reported reflection effect: the majority favored certainty for these gains and a gamble for these losses. It is a result from those choice problems, not a rule that people always avoid risk for gains and seek it for losses.
Prospect theory example
A homeowner who paid $500,000 may judge a $450,000 offer against that purchase price and experience it as a $50,000 loss. This illustrates a possible reference point. It does not establish why any particular homeowner rejects an offer, because alternatives, costs and expectations also matter.
Why it matters
The model helps researchers specify how reference points and probability weighting can shape choice. Applications need testing in their intended setting.