Prospect theory, developed by Daniel Kahneman and Amos Tversky (1979), is the most influential descriptive model of decision making under risk. It replaced expected utility theory's assumption of rational, utility-maximizing agents with a psychologically realistic account of how people actually evaluate risky prospects. The theory earned Kahneman the 2002 Nobel Prize in Economics (Tversky had died in 1996).
Key Components
Prospect theory has two key components. The value function describes how outcomes are evaluated: relative to a reference point (gains and losses, not absolute wealth), with diminishing sensitivity (the difference between $10 and $20 feels larger than between $110 and $120), and with loss aversion (a loss of $100 hurts roughly twice as much as a gain of $100 feels good — the loss aversion coefficient is approximately 2). The probability weighting function describes how probabilities are transformed: small probabilities are overweighted (explaining why people buy lottery tickets and insurance) and moderate-to-high probabilities are underweighted.
v(x) = −λ(−x)^β for losses (β ≈ 0.88, λ ≈ 2.25)
Reference dependence + Diminishing sensitivity + Loss aversion
Prospect theory predicts a distinctive fourfold pattern: risk aversion for moderate-to-high probability gains (preferring a sure $900 over a 90% chance of $1000), risk seeking for moderate-to-high probability losses (preferring a 90% chance of losing $1000 over a sure loss of $900), risk seeking for low-probability gains (lottery tickets), and risk aversion for low-probability losses (insurance). This pattern, well-supported empirically, cannot be explained by expected utility theory.