Prospect Theory

This entry discusses the most prominent psychological theory of decision making under conditions of risk, called prospect theory. It was developed by the psychologists Daniel Kahneman and Amos Tversky to explain decision making under conditions of risk, originally published in 1979 in Econometrica. Kahneman won the Nobel Prize in Economics in 2002 for the work he conducted in this area with Tversky, who died in 1996. This work represents the apex of models of cognitive psychology in both timing and importance. The model has been imported into a number of fields and has been used to analyze various aspects of political decision making, especially in international relations.

Prospect theory was developed in explicit opposition to theories of rational choice based on more normative assumptions. The intuition that guided the original work grew out of insights into the nature of bounded rationality and a desire to explore the nature and limits of those constraints. Prospect theory was based on a series of experimental empirical demonstrations of actual human choice behavior; it was explicitly developed to present a descriptively accurate model of human decision making. Nevertheless, the domain in which prospect theory explored human decision making was primarily based on choices among a series of financial bets and gambles. It was not originally intended to provide wider generalization beyond that domain, although it has subsequently been invoked to explain a wide variety of phenomena across many fields, including law, political science, and economics.

Prospect theory states that decision making depends on choosing among options that may themselves rest on biased judgments. Thus, it built on earlier work conducted by Kaheman and Tversky on judgmental heuristics and the biases that can accompany assessments of frequency and probability. Such judgments involve evaluations of the external world; decisions involve more fundamentally internal choices across values. Thus, the essence of decision making involves a trade-off between values. Prospect theory encompasses two distinct phases: (1) an editing phase and (2) an evaluation phase.

The editing phase refers to the way in which individuals characterize options for choice. Most frequently, these are referred to as framing effects. Framing effects demonstrate the way in which, contrary to the axiomatic assumptions of expected utility models, which argue that choice should remain invariant, the substance of people's choice can be affected by the order, method, or wording in which it is presented. The classic demonstration of this effect took place in the so-called Asian flu paradigm, in which people were asked to make a choice among public policy plans for responding to an endemic disease. Although the actual statistical probabilities remained identical, the percentage of people supporting a given plan changed dramatically based on whether or not the outcomes were [Page 2144]presented in terms of the number of people who would live versus the number of people who would die. In perhaps the most dramatic demonstration of this effect, real-world patients suffering from cancer made different choices of whether to undergo surgery or chemotherapy for treatment of their illness based on whether the outcome percentages were presented in terms of survival or mortality. Once people are presented with both choices side by side, they can easily see that the substance of the decision remains the same, even if the psychic pull to perceive them differently remains.

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