Prospect theory differs from expected utility theory in a number of important respects. First, it differs from expected utility theory in the way it handles the probabilities attached to particular outcomes. Prospect theory treats preferences as a funcion of "decision weights", and it assumes that these weights do not always correspond to probabilities. Specifically, prospect theory postulates that decision weights tend to overweight small probabilities and underweight moderate and high probabilities.
Prospect theory also replaces the notion of "utility" with "value". Whereas utility is usually defined only in terms of net wealth, value is defined in terms of gains and losses (deviations from a reference point). The value function has a different shape for gains and losses. For losses it is convex and relatively steep, for gains it is concave and not quite so steep.
Based on these assumptions some deviations from normative theories can be explained like loss aversion, reflection effect or framing effect.
See also: Allais paradox, reflection effect, framing effect
Literature: Kahneman & Tversky (1979)
|Entry by: Susanne Haberstroh|
June 17, 1999
Direct questions and comments to: Glossary master