Prospect Theory

What Is Prospect Theory?

Prospect theory is a model of how people actually make choices under risk, developed by psychologists Daniel Kahneman and Amos Tversky and published in Econometrica in 1979. It departs from the standard assumption that people maximize expected utility. Instead, prospect theory holds that people evaluate outcomes as gains and losses relative to a reference point rather than in terms of final wealth, that they are more sensitive to losses than to equivalent gains, and that they systematically overweight small probabilities and underweight large ones. The result is a set of predictable departures from pure rationality, including the way logically equivalent framings of the same choice can lead people to decide differently.

Why It Matters

Prospect theory is a foundational achievement of behavioral economics and helped bring psychology firmly into the study of decision-making. Its core finding of loss aversion explains behavior that expected-utility theory struggles with, such as reluctance to accept fair gambles and attachment to things already owned. The theory informs how economists and policymakers understand insurance, investing, and consumer choice, and it underlies later concepts like the endowment effect and mental accounting. Daniel Kahneman received the economics prize in 2002 for integrating insights from psychological research into economic science; Amos Tversky, who died in 1996, could not share it because the prize is not awarded posthumously.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• Which two psychologists developed prospect theory, published in Econometrica in 1979?
  Daniel Kahneman and Amos Tversky
• What does "loss aversion," a central finding of prospect theory, describe?
  That a loss feels psychologically larger than a gain of the same size