Prospect Theory

Definition

Prospect theory is a psychological account that describes how people make decisions under conditions of uncertainty. These may involve decisions about nearly anything where the outcome of the decision is somewhat risky or uncertain, from deciding whether to buy a lottery ticket, to marry one's current romantic partner, to undergo chemotherapy treatment, or to invest in life insurance.

Prospect theory predicts that people go through two distinct stages when deciding between risky options like these. In the first phase, decision makers are predicted to edit a complicated decision into a simpler decision, usually specified as gains versus losses. Purchasing a car is simplified into losing $20,000 and gaining a car, whereas buying a lottery ticket is simplified into losing $1 and gaining a small chance to win $100,000. A key feature of this editing phase is that the way in which people edit or simplify a decision may vary from one moment to the next, depending on situational circumstances. A person may think of a lottery as a .001% chance to gain $1 million, for instance, or as a 99.999% chance to lose $1. People make decisions based on these edited prospects, and the way that prospects are edited is therefore a critical determinant of the decisions they will make.

In the second phase, decision makers choose between the edited options available to them. This choice is based on two dimensions: the apparent value of each attribute or option and the weight (similar, although not identical to, the objective likelihood) assigned to those values or options. These two features—overall value and its weight—are then combined by the decision maker, and the option with the highest combined value is chosen by the decision maker.

The most interesting feature of prospect theory for most psychologists is that it predicts when (and why) people will make decisions that differ from perfectly rational or normative decisions, and has therefore figured prominently in explanations of why people make a variety of transparently bad decisions in daily life.

Background and History

Decision-making research before the 1970s was dominated by normative theories that prescribe how people “ought” to make decisions in a perfectly rational way, and many implicitly assumed that most people, in daily lives, followed these normative rules. Prospect theory was a notable departure from these existing theories because it offered a descriptive theory of how people actually make decisions, rather than providing a perfectly rational account of how they ought to do so.

The simplest way to choose between risky options is to choose the option with the highest expected value—the likelihood that an option will occur, multiplied by the value of that option. Imagine, for instance, that you are deciding whether to pay $1 for a lottery ticket that offers a 10% chance of winning $10. The expected value of this lottery ticket is $1 (0.1 × $10), the same as the cost of the ticket. Rationally speaking, you should therefore be perfectly indifferent about buying this ticket or not. The problem, noted by both economists and psychologists, is that rational theories did not always describe people's actual behavior very well. Few people, for instance, would actually purchase the lottery ticket in the last example. The certain loss of $1 simply does not compensate for the 10% chance of winning $10 and a 90% chance of winning nothing. In general, research found that people were more averse to taking risks than the expected value of outcomes would predict.

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