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Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. Starting from empirical evidence, it describes how individuals evaluate losses and gains. In the original formulation the term prospect referred to a lottery.
The theory is basically divided into two stages, editing and evaluation. In the first, the different choices are ordered following some heuristic so as to let the evaluation phase be more simple. The evaluations around losses and gains are developed starting from a reference point. The value function (sketched in the Figure) which passes through this point is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains (loss aversion). Some behaviors observed in economics, like the disposition effect or the reversing of risk aversion/risk seeking in case of gains or losses (termed the reflection effect), can be explained referring to the prospect theory.
An important implication of prospect theory is that the way economic agents subjectively frame an outcome or transaction in their mind affects the utility they expect or receive. This aspect of prospect theory, in particular, has been widely used in behavioural economics and mental accounting. Framing and prospect theory has been applied to a diverse range of situations which appear inconsistent with standard economic rationality; the equity premium puzzle, the status quo bias, various gambling and betting puzzles, intertemporal consumption and the endowment effect.
Another possible implication of prospect theory for economics is that utility might be reference based, in contrast with additive utility functions underlying much of neo-classical economics. This hypothesis is consistent with psychological research into happiness which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in wellbeing (Easterlin, 1974; Frank, 1997)
The original version of prospect theory gave rise to violations of first-order stochastic dominance. That is, one prospect might be preferred to another even if it yielded a worse outcome with probability one. The editing phase overcame this problem, but at the cost of introducing intransitivity in preferences. A revised version, called cumulative prospect theory overcame this problem by using a probability weighting function derived from Rank-dependent expected utility theory. Cumulative prospect theory can also be used for infinitely many or even continuous outcomes (e.g. if the outcome can be any real number).
- Easterlin, Richard A. (1974) "Does Economic Growth Improve the Human Lot?" in Paul A. David and Melvin W. Reder, eds., Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, New York: Academic Press, Inc.
- Frank, Robert H. (1997) "The Frame of Reference as a Public Good", The Economic Journal 107 (November), 1832-1847.
- Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", Econometrica, XVLII (1979), 263-291.
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