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Prospect theory is a psychologically-based framework that describes the mental processes involved when an individual makes a choice among uncertain prospects. In the 1970s Israeli-born psychologists Daniel Kahneman and Amos Tversky (1937–1996) developed prospect theory along with a body of work that came to be known as heuristics and biases. The Nobel Prize committee singled out prospect theory when they awarded Kahneman the 2002 Nobel Prize in Economics, which he shared with economist Vernon Smith.
Prospect theory holds that people’s psychological makeup induces them to value the outcomes of decision tasks as either gains or losses relative to some reference point. Moreover, people tend to become less sensitive to incremental gains or losses, meaning that the additional sensation associated with either an incremental gain or loss is less than the previous comparable increment. In addition, losses are experienced more acutely than gains, a feature that Kahneman and Tversky called loss aversion. Taken together, the features just described give rise to a value function over gains and losses that is S-shaped— concave in gains and convex in losses. Moreover, the function features a kink at the origin, and is more steeply sloped for losses than for gains.
Prospect theory also holds that psychologically people overweight low probabilities and underweight probabilities whose magnitudes are moderate or high. According to prospect theory, a person facing a decision task evaluates each possible decision in the decision menu using a rating function. The rating function is a sum of products, where each product combines a value and an uncertainty weight. The decision that receives the highest rating is the one the decision maker chooses.
The S-shaped value function typically induces people to behave in a risk-averse fashion when the potential outcomes involve only gains, and to behave in a risk-seeking fashion when the potential outcomes involve only losses. However, because of the weighting function, this pattern can be reversed when low probabilities are involved. Specifically, the weighting function can induce people to behave in a risk-seeking fashion when the potential outcomes involve only gains, and in a risk-averse fashion when the potential outcomes involve only losses.
When prospects involve a mixture of potential gains and losses, loss aversion will tend to induce people to act as if they are averse to risk. In particular, the kink at the origin of the value function leads people to exhibit a strong preference for certain outcomes over uncertain outcomes.
The manner in which a decision task is framed is known as framing. When people frame their decision tasks they are said to engage in editing. Prospect theory explains why people often frame complex decision tasks as sequences of simpler decision tasks, and then make decisions by applying value functions and weighting functions to each of the subtasks. In doing so, they might overlook connections among subtasks, and as a result choose inferior decisions, behaving as if they were throwing away money.
Prospect theory has had a profound influence on economic scholarship. It has been used to explain investors’ disposition to sell their winners too early and hold their losers too long; corporate managers’ reluctance to terminate losing projects; the equity premium puzzle about why the difference between the return to stocks and the return to bonds is puzzlingly high; why certain types of investors find cash dividends attractive; and why corporate managers appear willing to leave money on the table when their firms participate in initial public offerings. Prospect theory, especially the concept of loss aversion, has also had an impact on psychological research.
Prospect theory is a descriptive theory, unlike expected utility theory, which is the normative framework most commonly used in economic modeling. A comprehensive treatment of expected utility theory can be found in the Handbook of Utility Theory (1998). Whereas expected utility theory assumes that final wealth is the carrier of value, prospect theory assumes that change in wealth is the carrier of value. Whereas expected utility theory assumes that people are immune to framing effects, prospect theory assumes that framing has an effect on people’s choices. Whereas expected utility theory assumes that people do not distort probability values, prospect theory assumes that people overweight low probabilities and underweight moderate to high probabilities. Whereas expected utility theory assumes that people are uniform in their attitude toward risk, prospect theory assumes that people’s attitude toward risk is situation specific. Whereas the axioms that underlie expected utility are normatively desirable, experimental evidence suggests that in practice, people tend to violate some of these axioms, and instead behave more in accordance with prospect theory.
- Hammond, Peter, Christian Seidl, and Salvador Barberà, eds. 1998. Handbook of Utility Theory. Boston and Dordrecht, Netherlands: Kluwer Academic.
- Kahneman, Daniel, and Amos Tversky. 1979. Prospect Theory: An Analysis of Decision Under Risk. Econometrica 47 (2): 263–292.
- Tversky, Amos, and Daniel Kahneman. 1992. Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty 5: 297–323.
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