Prospect Theory is a behavioral economics principle that describes how individuals choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are uncertain. Developed by Daniel Kahneman and Amos Tversky in 1979, this theory revolutionized the understanding of decision-making under risk by introducing psychological insights into economic theory. The key premise of Prospect Theory is that people value gains and losses differently, leading to decision making that deviates from traditional expected utility theory. For instance, losses are felt more intensely than equivalent gains—a phenomenon known as loss aversion. This suggests that if given a choice between a sure gain and a probable gain with higher expected value, individuals are likely to choose the sure gain, avoiding risk.
A central aspect of Prospect Theory is the decision weighting function, which illustrates how people perceive the probability of gains or losses. Unlike in expected utility theory, where probabilities are weighted linearly, Prospect Theory suggests that probabilities are distorted in a person's mind. Low probabilities are generally overweighted, and high probabilities are underweighted. This means that extremely unlikely outcomes are given more attention than their reality would suggest, influencing decisions in a non-linear manner. This distortion leads to behaviors like purchasing lottery tickets or insurance, where the outcomes are highly improbable but are perceived as more likely due to overweighting of small probabilities.
Another important concept within Prospect Theory is the framing effect, which refers to the way choices are presented or framed, significantly impacting decision-making. The same problem can elicit different responses depending on how it is described, emphasizing either potential gains or potential losses. For example, Kahneman and Tversky's original experiment showed that more people chose a surgery when told it had a 90% survival rate versus a 10% mortality rate, despite both rates conveying the same information. This demonstrates how psychological framing can play a critical role in influencing an individual's decisions, highlighting the non-rational way in which choices are made under uncertainty.
Prospect Theory has broad applications, influencing fields like economics, finance, psychology, and public policy. It aids in understanding a range of behaviors such as investment choices, insurance purchase, and even voting behavior. The theory helps explain why people may opt for financial decisions that do not align with expected utility maximization, such as holding onto losing stocks or choosing fixed-rate mortgages over potentially cheaper variable rates. By acknowledging the irrationalities and cognitive biases, such as anchoring, endowment_effect, and status_quo_bias, that skew human judgment, Prospect Theory offers a more accurate and nuanced framework for predicting economic behaviors in the face of risk and uncertainty.