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):
| GAINS | LOSSES | |
| 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 health (Stolk-Vos et al., 2022), consumption choice, labor supply, and insurance (Barberis, 2013).
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References
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.
Stolk-Vos, A. C., Attema, A. E., Manzulli, M., & van de Klundert, J. J. (2022). Do patients and other stakeholders value health service quality equally? A prospect theory based choice experiment in cataract care. Social Science & Medicine, 294, 114730.