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):
|95% chance to win $10,000|
Fear of disappointment
|95% chance to lose $10,000
Hope to avoid loss
|5% chance to win $10,000|
Hope of large gain
|5% chance to lose $10,000
Fear of large loss
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 Perspectives, 27(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.