Prospect Theory

Prospect Theory is a behavioral economic theory that describes the way people chose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics. The model is descriptive: it tries to model real-life choices, rather than optimal decisions.

The theory was developed by Daniel Kahneman, a professor at Princeton University’s Department of Psychology, and Amos Tversky in 1979 as a psychologically more accurate description of decision making, comparing to the expected utility theory. In the original formulation the term prospect referred to a lottery.

Prospect Theory can be applied to consumer psychology and product adoption. It explains the psychological impact of gains and losses, showing how “losses loom larger than gains” (loss aversion). You can read more about this topic in this presentation Psychology of Product Adoption.

prospect_theory

The function portrayed in the slide above is known as the Value Function.

The theory describes the decision processes in two stages: editing and evaluation. During editing, outcomes of the decision are ordered following certain heuristic. In particular, people decide which outcomes they see as identical, set a reference point and then consider lesser outcomes as losses and greater ones as gains. In the following evaluation phase, people behave as if they would compute a value (utility), based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility.

The paper “Prospect Theory: An Analysis of Decision under Risk” has been called a “seminal paper in behavioral economics.”

Source: Prospect Theory: An Analysis of Decision under Risk, Kahneman, Tversky (1979)
Source: Why Consumers Don’t Buy, HBR, Gourville (2004)

Business frameworks like Prospect Theory are invaluable to evaluating and analyzing various business problems. You can download business frameworks developed by management consultants and other business professionals at Flevy here.

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