Prospect Theory

The Basic Idea

In the game of Monopoly, chance cards either give a player an advantage or a consequence. For example, they may reveal that a player has won $100, or force a player to pay the bank the same amount.

Imagine you are playing Monopoly and pick one of each of these cards throughout the game. How do you think you’d feel if you gained $100? How do you think you’d feel if you lost $100? Would it matter how much money you had already?

According to Daniel Kahneman and Amos Tversky’s famous prospect theory, we value losses and gains disproportionately. We are more likely to feel worse about losing $100 than we are to feel better about gaining $100, regardless of our absolute wealth. This is because prospect theory suggests we evaluate outcomes based on their relative utility rather than their absolute utility.

Due to our disproportionate perspectives on losses and gains, prospect theory stipulates that we would prefer to avoid a potential loss than risk a potential gain. Since we are naturally risk averse, the theory also suggests that we tend to choose options with more certain outcomes. Lastly, because we evaluate outcomes relatively, we tend to focus on the differences between our options rather than the similarities.2

Gains and losses are short-term. They’re immediate, emotional reactions. This makes an enormous difference to the quality of decisions.

– Daniel Kahneman, in an interview part of a series on Nobel Laureates in Economics, conducted by the UBS investment banking company.1

Key Terms

Expected Utility Theory: A traditional economics theory that suggests that when individuals make a choice under uncertainty, they will choose the option with the highest expected utility (potential benefits).

Loss Aversion: A cognitive bias that suggests because the psychological pain of losing is twice as powerful as the pleasure of gaining, people tend to try to avoid loss rather than trying to acquire equivalent gains.

Framing Effect: The fact that our decisions are influenced by how options are presented to us. If the presentation emphasizes a potential gain over a potential loss, people are more likely to choose that option.

Reference Point: The relative utility that individuals consider when evaluating potential losses or gains, instead of evaluating the options according to one’s overall wealth.

History

Until recently, traditional economics was the prominent mode of modeling human behavior. Traditional economics based its theories and models on the concept of humans as homo economicus: beings who behave in accordance with rationality, who therefore make decisions which maximize utility. Utility maximization suggests people will make decisions that benefit them the most economically. Acting in a way that maximizes utility is known as expected utility theory. When it comes to evaluating losses and gains, traditional economics would predict that the level of happiness one feels when gaining $10 would be equal to the level of sadness when losing $10, because losses and gains are valued equally.

However, some economists in the late 1970s began to see the limitations to traditional economics. While it may accurately describe the way people should behave, it did not accurately predict how people actually behave. Mathematical psychologist Amos Tversky and his colleague Daniel Kahneman, started to look at things differently and helped establish the field of behavioral economics. Behavioral economics does not focus solely on utility, but instead incorporates factors like emotions and cognitive biases that cause individuals to deviate from rational decisions.

Behavioral economics dispels the expected utility theory and shows that people do not actually value all money in the same way. Whether money is being gained or lost matters to how people perceive its value. Tversky and Kahneman outlined this phenomenon, which they coined “prospect theory” in their 1979 paper, “Prospect Theory: An Analysis of Decision Under Risk.”3

Tversky and Kahneman characterized “decisions under risks” as scenarios in which individuals choose between prospects/ gambles. While the expected utility theory suggests that people should approach these scenarios only in regard to their probability, regardless of whether one can win or lose, Tversky and Kahneman’s experiments demonstrated ways that people did not behave according to the expected utility theory. Due to the zero risk bias, people tend to underweigh outcomes that are merely probable in favor of outcomes that are certain, and because of loss aversion, people tend to avoid risk, sometimes at the expense of potentially gaining more money.3

From their observations, Tversky and Kahneman developed a new model: the prospect theory. The prospect theory suggests there are two phases of decision-making: an initial editing phase, followed by an evaluation phase. In the editing phase, people transform the outcomes from absolute states of wealth to perceived gains and losses. For example, if someone with cancer was given a choice between receiving a surgery or undergoing chemotherapy, they would edit these two choices by comparing where each ranks on a mortality/survivability scale. Only then would they evaluate the two choices. Gains and losses are defined not according to the absolute potential benefits (like their current state of wealth), but instead according to a reference point.4

Tversky and Kahneman continued to develop their model and published a subsequent paper in 1992 entitled, “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” which extended the theory and concretized the concept of loss aversion.

In 2002, Kahneman was awarded the Nobel Prize in Economics for the contributions that prospect theory made to behavioral economics Unfortunately, Tversky had passed away six years prior and the award is not presented posthumously.4

Consequences

Prospect theory is important because it explains how we understand and value gains and losses differently, and therefore how we make economic decisions.

Prospect theory can also help us understand how best to present options to others. A financial advisor, for example, would want to market her mutual fund pitch to a potential client in a way that highlights its potential gains. Imagine the same mutual fund is presented in these two different ways:

  1. The mutual fund had an average return of 11% over the past two years.
  2. The mutual fund had above-average returns in the past ten years, but in the past year, it has been declining.

Although the mutual fund is the same in both instances, the prospect theory predicts that we’d be more likely to invest if it was marketed to us in Form A since this form markets it as an overall gain, instead of a series of gains and losses.5 We are, after all, averse to loss.

Prospect theory also plays a role is gambling. Despite the fact that we tend to avoid loss and prefer certain outcomes, an individual is more likely to continue gambling after losing money in an effort to make back the money they lost. An individual that has lost $200 playing blackjack is more likely to take a risk again to try and make up that $200 and not face an overall loss, compared to a player that has won $50. The player who has won money – even though less – is less likely to play again, for fear of losing it.2

Controversies

The prospect theory has been well received, as demonstrated by Kahneman’s Nobel Prize in economics, awarded for the model’s contributions to the field. It seems to demonstrate how people actually behave, instead of how they should behave, which many would consider a more useful model for predicting behavior.

However, while the theory acknowledges that people make decisions based on perceived gains and losses (with a special attention to avoiding losses), it does not comprehensively explain why. Although loss aversion is attributed to the psychological experiences of pain and pleasure, Tversky and Kahneman did not offer up a theory as to why the psychological pain of loss is so much more powerful than the psychological pleasure of gain. The theory therefore doesn’t comprehensively address how emotions factor into our decisions, but only claims that they do.

Prospect theory and loss aversion are also often referenced as a reason people choose to purchase insurance: in overweighing the small probability that something bad could happen to our apartment, we buy insurance because we’d rather endure a small, certain loss, than risk a large expense.6 Expected utility theory demonstrates that buying insurance is actually quite irrational; yet, the prospective psychological weight of losing so much money to a rare emergency is so heavy that we irrationally invest in protection against it.

Prospect Theory and Relocating

If you’ve ever had to move to a new house or apartment, you know how daunting the task can be. Moving takes time and money and means that you have to leave your current home behind. Since it is a high-stress situation that involves a lot of uncertainty, prospect theory might be useful in explaining why people choose to stay or relocate.

In their 2017 study, William Clark and William Lisowski suggest that the riskier a move seems (the further from one’s local community, for example), the less likely someone is to move. They attribute this to the prospect theory as well as the endowment effect, which describes the tendency to value things we already own (like houses) more than we would if they didn’t already belong to us.8

Related TDL Resources

To Vote Or Not To Vote?

To get an insight into how prospect theory influences not only our economic decisions, but our political ones, check out this article by our writer Pooja Salhotra. Salhotra highlights the importance of framing in influencing voter turnout.

Learning Within Limits: How Curated Content Affects Education

Offering trigger warnings before exposing someone to potentially distressing content has become commonplace. In this article, our writer Katharine Sephton analyzes the value and effectiveness of these warnings. She suggests that trigger warnings make use of prospect theory, as they cause an individual to evaluate whether, based on the warning, they will experience a psychological gain (ie. knowledge) or a psychological loss (ie. distress).

Sources

  1. UBS. (n.d.). Daniel Kahneman: Nobel 2002 – What determines human decisions? Retrieved March 6, 2021, from https://www.ubs.com/microsites/nobel-perspectives/en/laureates/daniel-kahneman.html
  2. Boyce, P. (2020, October 21). Prospect Theory Definition. BoyceWire. https://boycewire.com/prospect-theory-definition-and-examples
  3. Kahneman, D., & Tversky, A. (1979). Prospect theory. An analysis of decision making under risk. Econometrica, 47(2), 263-292. https://doi.org/10.21236/ada045771
  4. The Decision Lab. (2021, March 1). Reference point. https://thedecisionlab.com/reference-guide/economics/reference-point/
  5. Chen, J. (2020, July 28). Prospect theory. Investopedia. https://www.investopedia.com/terms/p/prospecttheory.asp
  6. Harley, A. (2016, June 19). Prospect Theory and Loss Aversion: How Users Make Decisions. Nielsen Norman Group. https://www.nngroup.com/articles/prospect-theory/
  7. Kiesnoski, K. (2020, June 7). Despite worries over coronavirus, most people booking travel don’t plan to buy trip insurance, survey finds. CNBC. https://www.cnbc.com/2020/06/07/coronavirus-why-most-people-still-arent-buying-travel-insurance.html
  8. Clark, W. A., & Lisowski, W. (2017). Prospect theory and the decision to move or stay. Proceedings of the National Academy of Sciences, 114(36), E7432-E7440. https://doi.org/10.1073/pnas.1708505114

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