Prospect Theory: An Analysis of Decision under Risk

Prospect theory, introduced by Daniel Kahneman and Amos Tversky, serves as a descriptive alternative to the traditional expected utility theory. While expected utility theory posits that individuals make rational choices based on final asset positions and objective probabilities, prospect theory argues that human decision-making is fundamentally shaped by psychological biases, specifically how we perceive changes in wealth and interpret uncertainty.

Kahneman and Tversky propose that the decision process occurs in two distinct stages: the editing phase and the evaluation phase. During the editing phase, individuals simplify complex prospects by coding outcomes as gains or losses relative to a reference point—usually the status quo—and by discarding components shared by all options (the isolation effect). In the evaluation phase, individuals assign subjective values to these gains and losses and apply decision weights to probabilities, rather than using objective probability values.

The authors identify several systematic violations of expected utility theory. First, the value function is typically S-shaped: concave for gains (leading to risk aversion) and convex for losses (leading to risk seeking). Furthermore, the function is steeper for losses than for gains, meaning the pain of a loss is felt more intensely than the pleasure of an equivalent gain. Second, the weighting function reveals that people tend to overweight low-probability events, which explains the simultaneous appeal of gambling and insurance. Finally, the isolation effect demonstrates that how a problem is framed can lead to inconsistent preferences, as people often ignore common components of choices.

This paper fundamentally shifted the field of economics by providing a more realistic model of human behavior. By accounting for the fact that people are not purely rational utility maximizers, prospect theory explains common economic anomalies—such as why people buy insurance for small risks or why they hold onto losing investments. It remains a cornerstone of behavioral economics, influencing how researchers understand financial markets, public policy, and individual decision-making.