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