Definition
Prospect Theory is a behavioral economics theory developed by Daniel Kahneman and Amos Tversky that describes how people make decisions between alternatives that involve risk and uncertainty. It demonstrates that people value gains and losses differently, leading to inconsistent decision-making compared to Expected Utility Theory.
Why It Matters
If you model humans as perfectly rational, you will fail in marketing, public policy, and finance. Prospect theory explains why people stay in losing trades, refuse to switch to better energy providers, or accept bad status quos—ignoring it means failing to account for the “pain of loss” that drives actual human behavior. It is the key to designing effective nudges.
Core Concepts
- Loss Aversion: The psychological pain of losing is approximately twice as powerful as the pleasure of gaining.
- How to read: “The feeling of losing 100 feels good.”
- Meaning: Value function is steeper for losses than gains—people are risk-averse over gains but risk-seeking over losses.
- Reference Point Dependency: People evaluate outcomes relative to a reference point (usually the status quo) rather than in absolute terms.
- Diminishing Sensitivity: The marginal impact of a change decreases as one moves further from the reference point.
- How to read: “The difference from 100 feels bigger than 1100.”
- Meaning: Subjective value is concave—each additional dollar matters less as wealth increases from the reference point.
- Probability Weighting: People tend to overweight small probabilities and underweight large probabilities.