Prospect Theory
Kahneman and Tversky's account of decision under risk featuring loss aversion and reference dependence.
Prospect Theory is a descriptive theory of decision-making under risk that systematically displaces expected utility theory's predictions where the latter fails empirically. Its core machinery comprises a value function defined over gains and losses relative to a reference point — concave for gains, convex for losses, and steeper for losses than for gains (loss aversion, with coefficient roughly 2) — and a probability weighting function that overweights small probabilities and underweights moderate-to-high probabilities. Cumulative Prospect Theory (Tversky & Kahneman 1992) extended the framework to handle stochastic dominance and arbitrary outcome distributions. The framework was a foundational contribution to behavioral economics and was central to Kahneman's 2002 Nobel Prize.
Core components
- Value function (concave on gains, convex on losses, kinked at reference point)
- Loss aversion (~2x weighting of losses)
- Probability weighting function
- Reference dependence
- Editing/framing phase
- Cumulative formulation (1992) handling rank-dependence
Primary use case
Descriptive theory of risky choice; foundation for behavioral economics and behavioral finance; underpins much nudge and choice-architecture work in policy.
Common criticisms
- Reference-point determination is often left ambiguous and post hoc
- parameter estimates vary across populations and stakes
- some experimental paradigms have shown weaker or context-dependent effects in replication
- doesn't fully predict all behavioral anomalies
- mostly tested at small-to-moderate stakes.
Lineage
- Parent of
- Loss Aversion
- Child of
- Behavioral Economics
- Siblings
- Behavioral Economics, Loss Aversion, Mental Accounting, Hyperbolic Discounting
- Derived from
- Behavioral Economics