Prospect Theory

Prospect theory is a psychological depiction of how people make choices between different outcomes or prospects under conditions of uncertainty and therefore risk. Since its introduction by Daniel Kahneman and Amos Tversky, prospect theory has been the leading alternative to expected utility as a theory for decision making in situations involving risk. Prospect theory posits that people think in terms of gains and losses from a set reference point as opposed to net levels of assets. In other words, relative gains and relative losses are more important than absolute gains and losses. The identified reference point is crucial in decision making because it determines the weight of the relative loss or gain. When assigning value weights (i.e., utility) to gains and losses, more weight or ...