Definition
Developed by Kahneman and Tversky, prospect theory replaces expected utility theory with a more realistic model of decision-making under uncertainty. Key features: decisions are framed relative to a reference point (usually the status quo), losses loom larger than gains (loss aversion), and people overweight small probabilities while underweighting large ones (probability weighting).
lightbulb Example
A gamble offering 50% chance of gaining $1,000 or 50% chance of losing $800 has positive expected value (+$100) but most people reject it because the potential $800 loss feels worse than the $1,000 gain feels good.
verified_user Key Points
- People evaluate outcomes relative to reference points
- Loss aversion: losses feel ~2x worse than equivalent gains
- Probability weighting distorts risk perception
- Replaced expected utility as the behavioral standard