Prospect theory

The dominant theory of how people actually choose under risk did not come from economics but from two psychologists, and it overturned a long-standing assumption.

Prospect theory, developed by Daniel Kahneman and Amos Tversky, describes how people really evaluate risky choices: in terms of gains and losses measured from a reference point, rather than in terms of final wealth, and with systematic distortions that standard expected-utility theory misses. It is the foundation stone of behavioural economics.

Reference points, not final states

The classical theory assumed people judge outcomes by their resulting total wealth. Prospect theory found instead that people judge outcomes as changes, gains or losses relative to a reference point, usually the status quo. The same final position feels like a triumph or a disaster depending on where you started. This shift, from absolute states to relative changes, reorganises everything that follows.

Loss aversion and a curved value

Two features define the theory. First, losses loom larger than equivalent gains, the loss aversion that makes a loss hurt roughly twice as much as a same-sized gain pleases. Second, the value function is curved so that people are risk-averse when facing gains, preferring a sure thing, but risk-seeking when facing losses, gambling to avoid a certain loss. This explains why the same person buys insurance and lottery tickets, and why framing a choice as a gain or a loss flips their risk appetite.

Probability misjudged

Prospect theory also holds that people do not treat probabilities linearly. They overweight small probabilities, which is why remote risks and tiny jackpots loom large, and underweight moderate to high ones. Combined with the value function, this accounts for a wide range of choices that expected-utility theory cannot.

Prospect theory matters because it replaced an elegant but inaccurate account of decision under risk with a messier, more accurate one, and did so rigorously enough to win economics its attention and, eventually, a Nobel prize. It is the clearest demonstration that how a choice is framed and referenced changes the choice itself.