Prospect Theory

Prospect theory is a descriptive theory of decision-making under risk, developed by Daniel Kahneman and Amos Tversky in 1979 as an alternative to expected utility theory. It proposes that people evaluate outcomes relative to a reference point rather than in absolute terms, and that they are loss-averse — losses hurt more than equivalent gains please. The theory also posits that people overweight small probabilities and underweight moderate to high probabilities, producing a fourfold pattern of risk attitudes: risk-averse for gains and risk-seeking for losses at moderate probabilities, but the reverse for small probabilities.

The theory is not merely a correction to expected utility; it is a reconceptualization of what decision-making is. Rather than maximizing expected utility over final wealth states, agents maximize a value function defined on changes from a reference point, with a specific curvature (concave for gains, convex for losses) and a kink at the origin representing loss aversion. This structure predicts the endowment effect, the disposition effect in finance, the equity premium puzzle, and the reluctance to buy insurance against likely losses while overbuying insurance against unlikely catastrophes.

Prospect theory remains the most empirically supported descriptive model of risky choice, though it has been challenged by rank-dependent utility models, cumulative prospect theory (which extends the original to arbitrary outcome distributions), and more recent process models of decision-making that attempt to specify the cognitive mechanisms underlying its predictions.