Prospect theory is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty (e.g. % likelihood of gains or losses). It demonstrates that people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes. Prospect theory was developed by framing risky choices and indicates that people are loss-averse; since individuals dislike losses more than equivalent gains, they are more willing to take risks to avoid a loss. Due to the biased weighting of probabilities (see certainty/possibility effects) and loss aversion, the theory leads to the following pattern in relation to risk (Kahneman & Tversky, 1979; Kahneman, 2011):

GAINSLOSSES
HIGH PROBABILITY

(Certainty Effect)
95% chance to win $10,000

Fear of disappointment

RISK-AVERSE
95% chance to lose $10,000

Hope to avoid loss

RISK-SEEKING
LOW PROBABILITY

(Possibility Effect)
5% chance to win $10,000

Hope of large gain

RISK-SEEKING
5% chance to lose $10,000

Fear of large loss

RISK-AVERSE

Prospect theory has been applied in diverse economic settings, such as consumption choice, labor supply, and insurance (Barberis, 2013).

 

Barberis, N. C. (2013). Thirty years of prospect theory in economics: A review and assessment. Journal of Economic Perspectives27(1), 173-96.

Kahneman, D. (2011). Thinking, fast and slow. London: Allen Lane.

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.

 

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