Prospect Theory

The 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 which passes through this point is s-shaped and as its asymmetric implies, given the same variation in absolute value, 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)