Lesson preview · Behavioral Economics
Prospect Theory
~6 min · Free to read
Prospect theory (Kahneman & Tversky, 1979) challenges expected utility theory by describing how people actually make decisions under risk, rather than how they should. The key departure: people evaluate outcomes relative to a reference point (usually their current situation), not in terms of total wealth. They experience gains and losses, not final states.
Key Term
Prospect Theory -- Key Features
- Reference dependence: Outcomes are coded as gains or losses relative to a reference point, not as total wealth levels.
- Loss aversion: Losses loom larger than gains — the pain of losing 100 dollars exceeds the pleasure of gaining 100 dollars. Typically, losses are weighted about 2-2.5x more than equivalent gains.
- Diminishing sensitivity: The value function is concave for gains (risk-averse) and convex for losses (risk-seeking). Going from 0 to 100 dollars feels bigger than going from 1,000 to 1,100 dollars.
- S-shaped value function: Concave above the reference point, convex below it, steeper for losses.
The prospect theory value function: (diminishing sensitivity), (loss aversion)
Picture the value function as a curve plotted against gains (right of zero) and losses (left of zero). It has three features that work together.
S-shape and concavity in gains. The curve bends over in the gain region. Going from 0 to 100 dollars feels like a big jump; going from 1{,}000 to 1{,}100 dollars barely registers. Each extra dollar adds less excitement than the one before. This makes people risk-averse when choosing among gains.
Convexity in losses. Below zero the curve bends the other way. The first 100 dollars lost stings hard; after losing 1{,}000 dollars, another 100 hurts less. Diminishing pain makes people risk-seeking among losses — they will gamble to avoid a sure hit.
Loss aversion. The curve is steeper on the loss side than on the gain side. Losing 100 dollars hurts roughly 2.25 times as much as winning 100 dollars pleases. The same dollar carries more weight as a loss than as a gain.
Together these features explain a stack of real-world puzzles: people buy insurance (loss-averse) and lottery tickets (risk-seeking over small-probability gains), investors hold losing stocks too long (risk-seeking in losses) but sell winners too quickly (risk-averse in gains).
Worked Example
Under prospect theory with for gains and for losses, evaluate: (A) a certain gain of 100 dollars, (B) a 50/50 gamble of gaining 200 dollars or gaining 0, (C) a certain loss of 100 dollars, (D) a 50/50 gamble of losing 200 dollars or losing 0.
Check yourself · no marks
Why did Kahneman and Tversky’s work merit a Nobel Prize? What does prospect theory explain that expected utility cannot?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
In prospect theory, the value function is:
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