Prospect Theory

Daniel Kahneman and Amos Tversky published prospect theory in 1979 as a description of how people actually choose, set against the standard economic theory of expected utility, which assumes people judge the total wealth an option leaves them with. Kahneman later received the Nobel Prize in economics, in large part for this work; Tversky had died by then. The theory rests on three observations. First, outcomes are coded as gains or losses relative to a reference point, usually the status quo and sometimes an expectation, which is why a raise can feel like a loss to someone who expected more. Second, sensitivity diminishes: the first thousand lira of a bonus feels larger than the step from ten thousand to eleven. Third, losses loom larger than gains, roughly twice as large in many studies. Together these explain why people play safe when choosing between gains but gamble to avoid a sure loss, which is why a player who is behind keeps playing; add the overweighting of small probabilities and the same person buys both lottery tickets and insurance. Kahneman sets out the pattern in Thinking, Fast and Slow, and its practical lesson is plain: whoever sets the reference point shapes the choice.