Prospect Theory is a behavioral economic theory that explains how people make decisions when faced with uncertainty. It was developed by Daniel Kahneman and Amos Tversky in 1979 as a response to the traditional economic theory that assumes people make rational decisions based on the expected utility of each option. Prospect Theory, on the other hand, suggests that people make decisions based on the potential outcomes they can expect, and that their choices are influenced by their perception of gains and losses rather than the final outcome itself. One of the key aspects of Prospect Theory is the concept of reference points. People tend to evaluate outcomes relative to a reference point, which can be influenced by their past experiences, expectations, and social norms. When faced with a decision, people will compare the potential outcomes to their reference point and choose the option that they perceive as the most favorable. This means that people are more likely to take risks to avoid losses than to achieve gains, as losses are perceived as more significant than gains. Another important aspect of Prospect Theory is the value function, which describes how people evaluate gains and losses. The value function is S-shaped, meaning that people are more sensitive to losses than to gains, and that the marginal value of a gain decreases as the size of the gain increases. This explains why people are more likely to take risks when the potential reward is smaller but more certain, rather than when it is larger but more uncertain. Overall, Prospect Theory provides a more realistic and nuanced understanding of how people make decisions in uncertain situations. It acknowledges that people are not always rational and that their choices are influenced by a range of factors beyond the expected utility of each option. By taking into account the role of reference points and the value function, Prospect Theory offers a more accurate model of human decision-making that can be applied to a range of fields, from finance to public policy.
Behavioral economics, Decision-making, Reference points, Value function, Uncertainty
Prospect Theory is a concept in psychology that explains how people make decisions when faced with uncertain situations. It states that people tend to make decisions based on the potential outcomes they can expect. This means that when faced with two options, people will usually choose the one with the most potential reward, even if it has a greater risk associated with it. It also suggests that people are more likely to take risks when they perceive the potential reward to be greater than the potential loss. For example, if someone was presented with the option of investing in a company's stock, they might be more likely to choose that option if they believe the potential reward is greater than the potential risk.
Risk, reward, utility, probability, heuristic, cognitive bias, framing effect.
CITATION : "Thomas Lee. 'Prospect Theory.' Design+Encyclopedia. https://design-encyclopedia.com/?E=214245 (Accessed on July 03, 2025)"
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