Prospect Theory
What is Prospect Theory?
Prospect theory describes how people choose among risky options based on perceived gains and losses relative to a reference point, not final wealth.
Developed by Kahneman and Tversky, it shows people weight losses more than gains (loss aversion) and overweight small probabilities. It explains many real choices that expected-utility theory cannot.
Prospect Theory: a worked example
Two questions, same person. First: take a sure $450, or flip a coin for $1,000 or nothing? The gamble averages 0.5 × $1,000 = $500, more than $450, yet most people take the sure thing. Second: accept a sure loss of $450, or flip a coin to lose $1,000 or lose nothing? The gamble averages a $500 loss, worse than $450, yet most people flip. One risk-averse utility curve over final wealth cannot deliver both answers. Prospect theory can: its value function is concave over gains and convex over losses, so caution reverses into risk seeking the moment the reference point is crossed.
The mistake students make with prospect theory
Prospect theory is often summarized as people being risk-averse, which misses the point, since it predicts risk seeking whenever a choice is framed in losses. The deeper error is treating it as expected utility with a different curve. Expected utility scores final wealth; prospect theory scores changes from a reference point, so one ending balance counts as a gain or a loss depending on where you started. Decision weights on probabilities are the other departure.
Prospect Theory questions
What is the difference between prospect theory and expected utility theory?
Prospect theory and expected utility theory differ on what people evaluate and how they treat probabilities. Expected utility scores final wealth levels and multiplies outcomes by their true probabilities. Prospect theory scores gains and losses measured from a reference point, weights losses more heavily than gains, and replaces raw probabilities with decision weights that overstate rare events and understate near-certain ones. Framing can therefore change the answer under prospect theory and cannot under expected utility.
What is the reference point in prospect theory?
The reference point in prospect theory is the baseline a person measures outcomes against, so everything above it reads as a gain and everything below reads as a loss. The baseline is often the status quo, but it can also be the price you paid, last month's salary, what a colleague earns, or simply what you were led to expect. Move the reference point and the choice changes without a single payoff changing.
Why do people buy insurance and lottery tickets at the same time?
Buying insurance and lottery tickets together looks contradictory but follows directly from prospect theory's probability weighting. People overweight small probabilities, so a tiny chance of a huge loss feels bigger than its odds warrant, which makes insurance attractive, and a tiny chance of a huge win feels bigger too, which makes the ticket attractive. One mechanism, two opposite-looking purchases, both at prices above their expected value.
Related terms
Common comparisons
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